Last week ended with the realization that inflation hadn’t peaked. This week began with markets pricing in a 75 bp rate hike based on a whisper from someone who was in the know. The Fed’s hike puts the U.S. on the steepest tightening path in the G-10, up 1.50% so far this year. To slow inflation and rising prices, the Fed needs to reduce consumption demand. As demand cools, companies take note and start to reduce spending, and then as a second step, curtail employment. This causes the economy to shift into recession which can quickly reduce corporate profits.
With dire warnings from blue chip financial leaders indicating we are heading for an economic and market hurricane, it’s time to sit up and take notice. With record inflation numbers driven by wage-price pressures not seen since the 1970s, we need to analyze that inflation cycle and what happened to markets. Buckle up folks because it is not pretty!
Every day, we get questions from investors who want to know what’s driving inflation. First, it was Federal Reserve Policy, then government fiscal stimulus, subsequent supply disruptions from Covid and Putin’s war and sanctions.
Following increased volatility in the third quarter, the last quarter of 2021 brought an unnerving amount of optimism in the markets especially considering sky-high inflation readings, a hawkish Fed announcing moves to eliminate easy monetary policy from the past 10+ years, and concerns over the Omicron COVID-19 variant surge. Virtually all sectors ended the year strong during the fourth quarter of 2021 and benefitted from a December “Santa Claus rally” once again. The S&P 500 Index rose 10.65% during the fourth quarter to end the year up 26.89%. The tech-heavy NASDAQ closed out the year with an 8.28% gain for the quarter, almost all of which occurred in the month of October. In contrast to other indices, the NASDAQ squeezed out a mere 0.69% return in December. Furthermore, as we write this commentary, it is clear that was just the beginning of relative underperformance in the technology sector that would continue into the early weeks of 2022. The Dow Jones Industrial Average ended the fourth quarter up 7.37% and 18.73% for the entire year.
Inflation is a much more embedded problem than the Fed and politicians have been indicating. Shifts in the social system driving redistribution politics, the Fed’s easy monetary policy, and a pandemic have collided together to drive a very dangerous wave of wage and price inflation into the economic system. We have not seen this type of inflation set up since the 1970’s Stagflation crippled the U.S. economy.