“The dollar is our currency, but it’s your problem.” — John Connally, U.S. Treasury Secretary, 1971-1972
Third Quarter Recap
Financial markets fell broadly after a roller-coaster summer. Equities rose sharply for the first several weeks of the quarter, but swooned in the last half of the period. Fixed income did the same, as did oil, copper and other commodities. Even gold and other safe havens fell. The U.S. dollar was an exception, marching upward against all other major currencies with rising U.S. interest rates proving attractive to foreign investors.
After a dismal six months, oversold conditions and better-than-feared second quarter earnings led to a sharp 14% rally in the S&P through mid-August. Indeed, many market strategists and technical analysts surmised that the bear market was over and that an entirely new bull market had begun.
A Fed Plateau, Not a Pivot
The major rationale for market bulls at the beginning of the quarter was that the rate of inflation had peaked and the Fed would soon taper increases in the Federal Funds rate, perhaps even lowering rates early next year. Unfortunately, inflation reports continued to run hot with some Fed officials lamenting that the market rally made financial conditions too loose to cool off prices.
In late August, Chair Powell delivered a toughly worded speech at the annual Jackson Hole Symposium stating that lowering inflation was the number one goal. However, it would involve some economic pain, possibly even a recession, though he stopped short of actually predicting one.
Both stock and bond markets sold off sharply following Powell’s remarks and continued to do so after Labor Day, with strong non-farm Payroll and Consumer Price Reports reflecting the persistence of inflation in the economy. This was followed by another 75-basis point (0.75%) increase — the third in a row — at the Federal Open Market Committee (FOMC) meeting in late September. Committee members signaled that the Fed Funds rate could approach 4.50% by early 2023, remaining at that level for most, if not all of next year.
The Problem of “Sticky” Inflation
The rate of inflation remains uncomfortably high, even though gasoline and food prices have dropped somewhat since spring. Housing-related costs, another major inflation factor, have been weakening, although rents will continue to stay up for a while. This is due to rental contracts renewing annually and still reflecting elevated market prices from the previous 12 months.
Wages may be even more intractable, as the job market remains very tight. Salary increases are running over 5% and will continue with close to 10 million jobs still open from the pandemic. Although some companies are anticipating a recession and have announced layoffs, many others recall the difficulty of hiring people over the last two years and are hoarding employees to keep from losing them.
The Strong U.S. Dollar and Its Effects, Both Here and Abroad
A strong dollar may help the economy somewhat by making imports cheaper. At the same time, it makes our exports more expensive, hurting the earnings of U.S. multinational corporations. It also causes problems for other currencies. The quote at the top by John Connally (a former Treasury Secretary and the Texas governor who was seriously wounded during the JFK assassination), sums up a long-held fiscal and monetary truism: the American economy is looked at first, and foreign markets will be taken into consideration only if something goes horribly awry.
The U.K. recently had a brush with adversity when its new government introduced a stimulative fiscal policy that clashed with the tight monetary policy of the Bank of England (BOE). Fortunately, the British government soon reversed its course and dropped its more controversial tax proposals, which helped to stabilize the pound and its bond market. Nevertheless, the U.S. Treasury and the Fed will have to keep an eye on foreign developments.
The Outlook for the Remainder of 2022
As mentioned in previous reports, we have consistently dialed down portfolio risk this year by:
- Reducing equities
- Increasing short-term fixed income investments (such as money market funds, whose principal value does not fluctuate while their yields have jumped since spring)
- Adding to satellite (alternative) strategies
At this point, a recession by late 2023 is a 50-50 probability.
- Inflation will have to fall significantly than it has so far to cause the Fed to relent from its tight monetary policy.
- One key to inflation is the job market, which must cool off to cause inflation to follow suit.