Summary:
* The Federal Reserve struck a more hawkish tone mid-month
* U.S. stocks rebound after a dip
* Markets appear increasingly fragile
Commentary:
Markets were stunned on June 16th as the Federal Reserve struck a more hawkish tone. Federal Reserve committee member’s projections now pointed to two interest-rate hikes in 2023 versus none before. The U.S. dollar jumped higher on the news, while many commodities reversed course from the prior month as inflation-focused investments suffered. Although the S&P 500 Index initially fell -1.6%, it fully recovered within days to end the month of June up +2.3%.[i] Overseas stock markets lost money during the same period with the MSCI EAFE net down -1.3% and the MSCI Emerging Markets losing -0.1% given U.S. dollar strength.[ii]
During the month, we reflected on the increasing criticism of the Federal Reserve by market commentators like Mohamed El-Erian, president of Queens’ College, Cambridge University, and adviser to Allianz. He believes the Federal Reserve is ignoring so-called transitory inflation at its own peril. In a June 30 Financial Times op-ed[iii], he referenced a Bank of America survey that suggests the markets are currently driven by a consensus around “durable high global growth, transitory inflation, and ever-friendly central banks.”[iv] El-Erian argues that possibility of unanticipated non-transitory inflation could upset this happy market consensus leading to significant economic and financial damage.
El-Erian has been very right in the past in our opinion. In a CNBC interview on February 3, 2020, he warned about the risks of the newly discovered COVID-19 virus. “It is big. It’s going to paralyze China. It’s going to cascade throughout the global economy. We should pay more attention to this. And we should try and resist our inclination to buy the dip”, said El-Erian.[v] The S&P 500 reached its then all-time high two weeks after that interview and then fell -35% until it reached the March 23, 2020 low.[vi]
More recently, on February 16, 2021, El-Erian warned in a CNN interview, “Investors are chasing what someone labeled the ‘rational bubble’. While they are fully aware asset prices are high, they expect prices could go even higher thanks to massive central bank liquidity and prospects of fiscal injections. Basically, investors feel confident riding what is a massive historical liquidity wave.”[vii] So far, investors have not heeded El-Erian’s warning. Indeed, as of July 9, 2021, the S&P 500 has rallied +11% from the CNN interview.[viii] The massive historical liquidity wave that El-Erian warned about in February 2021 continues to grow. Federal Reserve asset purchases shown in the green shaded area in the chart below has dramatically increased the discomfort of holding cash with 0% yield and amplified the desirability of buying risky stocks which investors expect offer higher returns.
data from https://fred.stlouisfed.org and finance.yahoo.com
Constant intervention by the Federal Reserve and other central banks since 2009 have led to an environment of self-reinforcing speculation and a rising S&P 500 index shown in the black line. Reckless fiscal policy since 2017 has only augmented the atmosphere. In our opinion, entire investment strategies have now been built around the perceived certainty of Federal Reserve and central bank support. Retail traders’ share of stock market volume has surged since the lockdowns, and the number of individuals opening brokerage accounts is at a record pace in 2021[ix]. We believe that most bubbles end when the last marginal investor is fully invested.
The belief that central bank liquidity has the capacity to support elevated markets indefinitely creates a reflexive response by the market as more and more investors jump on the bandwagon. Thus, the market becomes increasingly fragile. Consequently, a more aggressive Federal Reserve intervention is required with each market downturn which one can see in the chart above. El-Erian’s op-ed hints at the dynamics of certainty and fragility. Now markets move downward based on the Fed pretending to inch a teensy bit toward maybe raising rates over 18 to 30 months from now[x].
No matter what real world inflation we might be experiencing currently, debating the transitory nature of inflation is likely to continue to produce periodic setbacks for inflation-focused investments. Inflation expectations are changing, and it will take time for the debate to be settled in some fashion. Until these expectations are cemented in an alternative vision of the world by investors, market commentators and powerful institutions, we might expect the market to move in short order from calm to quite volatile.
For CIG’s clients, we will continue to take a risk balanced approach to this historically expensive market in these uncertain and fragile times. Risk balancing means moderating portfolios’ exposure to the consensus views of other investors as well as using hedging strategies like owning publicly traded hedge funds, gold, and volatility strategies.
Understanding and paying attention to this environment is important to achieving your financial planning goals.