Market Update May 2022 – Change Matters


Sometimes, trying to solve a complicated issue requires going back to the basics. And today’s global economics would certainly fall under the “complicated” category. Following the sharp COVID-induced March 2020 drop in both economic activity and the capital markets, policymakers worked to stabilize conditions. While the tools used were at times controversial, the economy and markets did respond. But rather than recapping the past two years, the focus is now on the future.

History seemingly tells us that the economic “porridge” is usually either too cold or too hot, but rarely just right. And following global efforts to stimulate a cold economy, in part by cutting interest rates, Central Banks and governmental authorities are now concerned that the economy is too hot as inflation has reached levels which threaten the economy’s health. The headline for today’s Federal Reserve’s (“Fed”) battle is now “inflation”, as demand is outstripping supply and causing prices to rise at an unhealthy pace. How might the Fed attack this imbalance.

The most-widely known “tool” used by the Fed is that of interest rate management. This has been utilized during the 21st century primarily to accelerate economic growth by keeping interest rates low which, presumably, stimulates demand. Now the Fed faces the difficult challenge of combating today’s inflationary challenges due to healthy demand outstripping supply. The Fed has recently raised its benchmark Fed Funds interest rate by 50 basis points (0.50%) and has telegraphed expectations of further, similar moves in the coming months. This leaves a critical question: Can interest rate management be an effective tool to manage supply imbalances (as opposed to prior eras challenged by demand issues)?

Using this approach to combat the inflationary impact of price imbalances essentially shifts the objective from demand stimulation to demand moderation. And in Chairman Powell’s post-meeting press conference a generalized mention was made that the Fed tools are not designed to manage supply, furthering the notion that the Fed’s tools will seek to normalize the supply/demand relationship through policies focused on managing demand. While this path does seem to be the Fed’s best available response to these conditions, it is a narrow road to navigate and avoid the possible negative consequences by overreaching in their policy response.

While this tightrope sounds risky, there may be help for the inflation issue. It does appear that in recent months inflation may be plateauing. Inflation represents a change in prices over a set period of time and earlier in the recovery year-over-year readings were strongly influenced by the comparison with the low levels during the early months of the recovery. As economic health has improved, supply and demand have both needed to recover and, not surprisingly, demand is recovering faster than supply. But as we move forward with the recovery (or out of the recovery stage) progress is being made in restoring the balance and in the coming months we may see natural influences help with this task of combating inflation. Inflation rates may remain above target but are likely to back off from recent elevated levels.

Inflation is a critical component for further economic growth. Tepid price growth signals concerns of a weakening economy. Heightened price growth and the imbalance can become an economic problem. Today’s focus on inflation is important and the situation is still developing, suggesting investors are best served by being selective in the capital markets.


Carrying on the theme of inflation, how might history further inform investors regarding the interaction of equity markets and inflation? A critical aspect for analyzing the impact of inflation is the determination of what matters most: the absolute level of inflation, or the change in the inflation rate period-to-period. The answer is “yes”, both the level and the change matter.

Jim Paulsen of The Leuthold Group recently published the accompanying chart that looks at the average annualized returns for the S&P 500 Index in the month following the stated conditions. This analysis considers different ranges of annualized inflation rates (CPI: Consumer Price Index) during months that inflation had accelerated, decelerated, or had not changed. The red and blue bars provide the average annualized returns of the S&P 500 Index for the month following that of the stated conditions.

What does this tell us? First, inflation eras between 2% and 4% appear to be the comfort level for investors. This is not surprising as these levels of inflation generally coincide with a healthy economic growth backdrop. But the picture changes quickly for months with annualized inflation at 4% or higher. Price stability has become a concern and investor activity looks to be highly influenced by “what’s next”. Inflation above 4%, that has plateaued or had receded has historically, on average, resulted in equity gains in the following month. But further acceleration of the monthly CPI data looks too often to create more uncertainty, resulting in a decline during the following month. (Inflation below 2% was excluded from the chart given the Fed’s current 2% target.)

With inflation as a headline topic today, investors are indeed looking for signs of improvement. History tells us that with today’s inflation levels, equity markets will likely act on an improving trend in inflation, rather than wait for inflation to fully recede to more comfortable levels.

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