US Inflation At 8.36% With Federal Reserve In Catch Up Mode
- Dow Jones is off 7.29 percent over the past 5 days and 16 percent year-to-date
- S&P 500 closed 9 percent lower in the past 5 days and down 21 percent year-to-date
- ASX300 is down 322 points, or 4.6 percent, including a decline of 8.3 percent over the past 5 trading days
- GDP growth and corporate earnings drive share prices, while interest rates drive PE ratios
- Prudently managed companies will continue to grow through the economic cycle, despite short term fluctuations in the economy, brought about by higher interest rates, related to inflation spikes.
The era of free money is at an end
The US Federal Reserve looks set to continue with its higher interest rate policy this week with capital markets braced for half a percent to three quarters of one percent rate rise, in response to runaway inflation. The most recent US inflation data showed US consumer prices climbed 8.36 percent year on year in May, the fastest increase since 1981.
The magnitude of this rise caught many market participants off guard. There is a fear that the US Federal Reserve has not anticipated this rapid turnaround in consumer prices, especially after an absence of inflation throughout much of its Quantitative Easing (QE) monetary policy program which officially commenced 2010. QE is the Central Bank policy of buying government bonds from pension funds, banks and other financial intermediaries, with the effect of pushing up the price of bonds. Higher bond prices result in lower bond yields, which are the benchmark for interest rates in the broader economy. This policy saw bond yields, and interest rates generally, fall to unprecedented levels, never seen before in history. In other words, QE, on the scale launched by Central Banks around the globe, was an experiment. Interest rates fell to zero, in many economies. The other effect is that the quantity of money also increased, which had the effect of stimulating business investment and household consumption, again to levels rarely seen in history. Under these circumstances, economic theory tells us that strong growth in economic output and wages will follow. However, these circumstances are also a firm primer for inflation. Interestingly, that did not occur, at least until now.
So, while the decision to inject low-cost funds into the economy is not a particularly difficult decision, the timing and velocity of its withdrawal, is not so straight forward. Businesses, consumers, and governments can easily become ‘addicted’ to free money. It appears that this is the situation facing the global economy at present, as Central Banks around the world begin to withdraw this unprecedented level of economic stimulus. Hindsight is a wonderful thing because everything is obvious once it has already happened. It now seems that the Fed and other Central Banks have painted over rust for the past few years with the prolonged QE policy stance, and it is only now that the lasting effect of this monetary stimulus is having a debilitating impact on the global economy and global markets, through runaway inflation.
The response by equity markets to significantly higher inflation prints coming out of the US and Europe has been swift.
On Monday night in New York the Dow Jones was off 876 points or 2.79 percent and is down 7.29 percent over the past 5 days and 16 percent year-to-date. The S&P 500 closed down 151 points or 3.88 percent on Monday and is off 9 percent in the past 5 days and down 21 percent year-to-date. The sell-off is widespread in that 495 of the 500 companies making up the index declined on Monday. Similarly, the technology-laden NASDAQ was down 531 points or 4.68 percent.
The US 30-year Treasury bond yield moved has now moved to 3.42 percent, the highest since 2011, and has been steadily rising since March 2020.
The Australian equity market has followed global market trends and today the ASX300 is currently down 322 points, or 4.6 percent. This includes a decline of 8.3 percent over the past 5 trading days.
Interest rates will normalise, and global QE will end. There will be pain as the world and global markets transition from this state to more normal market conditions and circumstances. How long this will take and how much further markets must fall is unknown. The 30-year US Treasury yield is currently sitting at 3.4 percent, compared to 1.8 percent in December 2021. The long run average 30-year Treasury yield is 4.8 percent, implying that interest rates have further to rise, based on historical inflation levels, compared to current readings. A recent opinion poll conducted by The Washington Post and George Mason University found that most Americans expect inflation to worsen in the coming year. However, an opinion poll is no substitute for thought.
The market will ultimately follow the economy, not the interest rate or the inflation rate. The state of the economy drives corporate earnings, as measured by Gross Domestic Product (GDP). Corporate earnings are the single most important driver of a company’s share price, followed by interest rates, which ultimately drive PE Ratios.
Despite short term market fluctuations in market sentiment and economic setbacks that result in lower share prices, GDP has grown consistently throughout history. This shows that economic growth isn’t an accident or about luck; it’s how the world works. This implies that companies which can withstand higher interest rates, with prudent debt levels, supported by strong cash flow and which enjoy pricing power through favourable market positioning, and owning privileged assets, backed up by exemplary customer service, will do well, regardless of short-term fluctuations in economic growth, interest rates or inflation.
Accordingly, investors today should spend more time thinking about the valuations of individual stocks in their portfolio and worry less about the overall state of the market, when making key long term investment decisions. The crowd doesn’t make money, individuals do, while independent thinking will always outperform the herd mentality.
The current situation requires a mix of patience and opportunism, as Central Banks work through the challenges brought about by a confluence of global events presently gripping markets as they do everything in their power to avoid a global recession.