Interest Rates Surge on Inflation Fears and a More Hawkish Fed
While the equity markets rallied back after setting a fresh year-to-date low, the real story was in the bond market as interest rates surged. During March, the Fed raised the overnight interest rate by 25bps – the first interest rate increase from the near zero level set in March 2020 – prompted by inflation not seen in over forty years. With the Consumer Price Index reaching 7.9%[1], the Fed was forced to begin tightening monetary policy. Since then, the rhetoric from Fed officials became increasingly hawkish and the bond market reacted by pricing in eight quarter-point hikes this year.
Bond yields have soared across the board this year. As of this writing, the 10 Year U.S. Treasury bond yield has increased from 1.50% to 2.70%. Mortgages rates reached 5% and bond prices fell significantly. Bonds, which are normally viewed as safe investments, have been anything but safe. To put this rare occurrence in perspective, the Bloomberg Barclays Aggregate Bond index finished March down -5.9% for the year while the S&P 500 index is only down -4.6%. It's not often bonds lose more than stocks.
Adding to general inflation fears, the war in Ukraine placed significant upward pressure on oil prices. According to the American Automobile Association, the nationwide average for gasoline prices surged from $3.66 to $4.22 per gallon. In addition, the world’s reliance on Russia, Ukraine and Belarus for wheat, corn and key fertilizer feedstocks have led to soaring prices for these commodities. So, food inflation and food security in certain parts of the world became a greater focus during March.
Market Update
The U.S equity markets experienced another volatile month with indices initially selling off only to recover by month end. The S&P 500 and the Nasdaq gained +3.7% and +3.5%, respectively. The Dow lagged somewhat gaining +2.5% as increasing doubts on the economy hurt cyclicals more. This bounce left the S&P 500 just 4.5% from its record high.
Fixed income once again failed to protect capital. The U.S. 10 Year Treasury bond (“UST10”) yield, as mentioned above, surged to 2.70% from 1.73% as the markets refocused on inflation. Fixed income indices broadly followed. The Bloomberg Barclays U.S. Aggregate Bond Index declined -2.8% while the riskier U.S. High Yield Bond Index finished down -1.1%.
It should also be noted that during the month the yield on the UST10 fell briefly below that of the 2 Year UST bond. When this occurs, it is called yield curve inversion meaning nearer term interest rates are higher than longer term interest rates. This occurrence is notable insofar as it has at times predicted recessions. Traditionally, the yield curve inverts because the market expects aggregate demand to fall and thus the Fed will cut future interest rates to stimulate demand. However, we believe this time may be different because the curve is being driven by inflation expectations (i.e., higher in the near term and lower in the long term) and not an explicit view on aggregate demand declining to recessionary levels. Further, normally the curve inverts AFTER the Fed has raised short term rates to somewhere well above zero. As it stands today, the Fed has only just started to raise rates.
Commodities continued their incredible surge. The Bloomberg Commodity Index gained a further 8.6% in March putting it up 26.8% for the year. WTI Crude Oil spiked to $123.70 per barrel on Russian energy sanction fears only to fall to $100.28 by month end. Natural gas soared 15.0% during the month to put it up +55.1% for the year. On the agricultural front, Russia and Ukraine collectively supply 25% of the world’s wheat, which can no longer get to market. This caused wheat contracts to spike 70% at the beginning of March only to then retreat -29%.
The dramatic short-term volatility experienced by certain commodities is typical for markets experiencing negative supply shocks. It is not clear where these prices will find a new equilibrium, but we do believe that the war in Ukraine and the sanctions on Russia’s ability to export support abnormally high prices for some time to come. Just how long prices remain elevated is entirely dependent upon the length of the conflict, the duration of Russian sanctions and the speed at which that supply can be substituted - and this is true for both food and energy prices.
Durable Goods “recession” ahead
Avid readers of this newsletter know that we have been warning about the sustainability of Personal Consumption Expenditures (i.e., personal spending or “PCE”). Since February 2020, the last normal month before the Pandemic ensnarled the economy, PCE has grown $1.9 trillion representing a 13.1% CAGR[2]. Spending on Durable Goods, which accounts for approximately 15% of PCE and includes spending on autos, RVs, furniture and other big-ticket items, accounted 31% of total PCE growth as it grew at a 17.9% CAGR since February 2020[3].
The drivers of the acceleration of Durables Goods spending included zero interest rates, fiscal stimulus checks and social mobility restrictions that encouraged work-from-home and outdoor activities, such as boating and cycling. Naturally, the mix of spending by consumers shifted to Durable Goods and away from Services as consumers traded spending on restaurants, travel and entertainment for new patio furniture and a new car as evidenced from data from the Bureau of Economic Analysis.
We believe that Durable Goods spending has or will soon peak and begin to steadily decline over the next 12-24 months as the drivers for its surge in growth reverse and become a headwind. Specifically, interest rates are rising making such purchases more expensive. Fiscal stimulus dollars were spent and social mobility is normalizing thereby creating pent up demand to eat out at restaurants, take vacations and attend concerts.
There is a further disincentive to spend on Durable Goods that comes in the form of inflation. According to the Bureau of Labor Statistics and our analysis, inflation on Durable Goods accounts for approximately 30% of total CPI inflation today. As an example, take Used Car & Truck prices shown below. Since February 2020, this price index has increased 48.5%! This extraordinary increase has made buying a car much less affordable and increasing interest rates will only compound the issue. We expect car purchases to decline sharply and ultimately prices will follow. There are numerous similar examples of Durable Goods that we expect to follow a similar fate over the coming months.
The anticipated pullback in Durable Goods spending – for all the reasons cited above – is likely to create a recessionary environment for those industries. The length of this recession is also likely to vary according to the degree to which demand was “pulled forward” from future quarters. For instance, work-from-home created a surge in home-related purchases, such as home furnishings, TVs, computer monitors, office chairs, Pelotons, etc. These are items that are not purchased with great frequency, therefore, we believe that demand for many of these types of products may be muted for months and possibly years to come.
This Durable Goods recession may take the form of a classic inventory-driven recession. In this scenario, inventories are built up just as demand drops forcing products to be discounted to clear the excess inventories. The hit to profit margins will in turn trigger layoffs and other cost cutting initiatives for affected businesses to preserve cash flows. The magnitude of this situation will likely vary by product and business.
Nevertheless, as seen below, we are still waiting for the anticipated demand destruction to arrive (the green line). However, the other key ingredient seems to be in place. That is Durable Goods inventories have broadly recovered. This sort of recession occurs as businesses overestimate future demand by extrapolating unsustainably high demand for their products, which leads them to over ordering inventory. We suspect that this behavior is already underway and is exacerbating the high Durable Goods-related inflation seen in both the Consumer and Producer Price Indices.
Outlook: Inflation Holds the Cards
The raging debate in the market is whether the combination of inflation and higher interest rates is a one-two punch for the economy and, hence, the stock and bond market. We have already seen significant damage done to fixed income and growth stocks both of which are highly sensitive to higher rates. The looming question is whether inflation and higher interest rates now pose a threat to consumer spending. On this front, we believe that spending on Durable Goods will weaken substantially but not all for bad reasons. It remains the case the labor market is very strong and that some of the weakness we expect in Durable Goods spending may translate to higher Services spending. For instance, there appears to be significant pent-up demand for travel, dining and entertainment as evidenced by a number of indicators, including travel bookings.
That said, we do not believe that the market understands the nuance of Durable Goods spending versus that of Nondurables and Services. The market’s current broad-brush approach to examining economic datapoints is a recipe for continued market volatility. If we are correct in our Durable Goods recession thesis, then the economy could be at or near peak inflation. If true, interest rates will halt their rise and we may see a robust rally into year end. This situation would represent exactly the economic soft landing for which investors hope.
In the meantime, commodities have been a lifesaver for portfolios, and we do not expect that to change as far as energy and agriculture commodities are concerned. The structural supply and demand imbalances that exist have only been exacerbated by the sudden and most likely prolonged omission of Russian and Ukrainian-related exports. Commodities, therefore, provide portfolio protection as we have discussed for over a year.
Conclusion
It is not abundantly clear whether we are in a bear market or not but in some ways labels like that are not relevant in today’s economy and markets. As we have said since the beginning of the Pandemic, the radical concoction of lockdowns, incredible amounts of fiscal stimulus and the loosest monetary policy in history was going to create huge excesses and deficits throughout the global economy. The global economy cannot just be turned off and on like a light switch and not expect some parts of it to break. The excessive government stimulus applied likewise solved some immediate problems but also created an enormous set of new problems that need to be worked through. That is why we have volatility because markets dislike uncertainty.
Being nimble and letting our primary research process drive how much and where to take investment risk is at the heart of a successful investment process. For example, it permits creativity, such as owning commodities. We believe there are interesting pockets of opportunities in this market, particularly in idiosyncratic ideas, while we are playing defense in other areas of the market.
Disclosures
INFORMATION PRESENTED IS FOR EDUCATIONAL PURPOSES ONLY AND DOES NOT INTEND TO MAKE AN OFFER OR SOLICITATION FOR THE SALE OR PURCHASE OF ANY SPECIFIC SECURITIES, INVESTMENTS OR INVESTMENT STRATEGIES. BLOOMBERG IS THE SOURCE OF MARKET DATA. INVESTMENTS INVOLVE RISK AND ARE NOT GUARANTEED. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RETURNS. BE SURE TO FIRST CONSULT WITH A QUALIFIED FINANCIAL ADVISER AND/OR TAX PROFESSIONAL BEFORE IMPLEMENTING ANY STRATEGY DISCUSSED HEREIN.