This has proven to be a challenging year for nearly all investors as asset allocations struggled to protect investors in the first half of the year. As inflation, the Fed, and the crisis in Ukraine have continued to be driving forces in worldwide economics, there have been few places for investors to hide.
Inflation has been a key driver of investor sentiment and market moves in all asset classes. Additionally, global supply chain constraints and spiked energy prices have sent nearly all goods and service costs higher with energy and food prices being the biggest contributors to the 1.3% June increase and 9.1% year/year increase.1
There is little doubt that these factors weigh on investor minds as we look for evidence that inflation is peaking, and wonder about Fed rate hike prospects. According to the CME Group Fed watch tool, there is still more likeliness of a hike at the next Fed meeting on July 27th, and as markets grapple with understanding the latest inflation reports, expectations have been volatile.
Source: CME Group
As always, data is what really matters when we look for what might happen in the markets over the next six to twelve months. Ed Clissold of Ned Davis Research recently published a report which looked at the possibilities based on “Powell’s Three Bears” – the idea that there are three possible outcomes from the current Fed challenge in dealing with inflation.
Under the “Too Hot” scenario, inflation would remain high, forcing the Fed to continue to raise rates aggressively despite weakening business conditions. This would likely mean that the Fed would not be able to change directions fast enough to avoid a recession in 2022.
There are a couple of reasons that inflation could remain high. First are the supply side constraints that are largely due to the lockdowns in China every time a COVID spike is discovered. The Fed has no control over these factors, but they have an immediate inflationary impact on goods coming out of China. Additionally, the raging war in Ukraine and Russian energy supplies are unpredictable, but likely to continue to keep energy prices high.
Under the “Too Cold” scenario, inflation cools enough for the Fed to slow down or even pause rate hikes. Inflation does not necessarily need to plunge to accomplish this, but it does need to slow down or at least show convincing evidence that the peak of inflation is behind us.
Under this scenario, we could be looking at a strong bear market rally. Even though headline inflation may not have peaked yet, as evidenced by the latest CPI (Consumer Price Index) number, broad based commodity prices, including energy have been falling more recently, and this lends itself well to this scenario.
Unfortunately, the damage of too many business constraints and a slow economy is already done, leaving us with the possibility of slipping into a recession. However, if this scenario were to happen, it would likely be in 2023.
The “Just Right” scenario projects that the Fed will be able to bring about a Goldilocks outcome where they do just the right things at just the right time and inflation comes down, the Fed reacts perfectly, and the economy not only avoids a recession in 2022 but also avoids one in 2023.
Under this potential outcome, everything works out and we likely have gone through the worst of market tantrums and smooth sailing follows a great recovery. For this to happen, we need to see evidence that a bottom has occurred in the market and that risks begin to abate.
As we look for evidence of which way the market goes from here, we remain cautious. Some things needs to spark a movement if we are going to get a meaningful rally or get a “Goldilocks” outcome. Markets seem like they are primed to rally, but we still need to see evidence. And that seems unlikely to come from either the Fed or earnings surprises at this point.
- Consumer Price Index Summary – 2022 M06 Results (bls.gov)
- Placing odds on Powell’s three bears. Ed Clissold, CFA. Ned Davis Research Group. July 12, 2022 [7/15/22]
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