By Frank Legan
The volatility of the 2020s just won’t quit, and it seems as if it’s become the new norm. From a global pandemic and historic inflation to an unparalleled housing market and a war in Ukraine, it’s hard to believe we’re only two years into this decade. The economic uncertainty of the last few months has many anxious to know where we’re headed.
Clients are asking questions like, “Am I on track?” and “Is everything going to be okay?” At Cedar Brook Group, we understand the stress of the current economic environment, and we strive to help clients feel confident about their financial futures. That’s why we put together our Global Outlook webcast (watch the replay here) featuring Frank Legan and Geremy van Arkel. Our goal is to share our perspective on what’s happening in the world, how we should be thinking about it, and where we go from here.
Recap of U.S. Economic Condition
Both the U.S. and global economies seem to be in a period of great reset. We believe this stems from, at least in part, the unwinding of easy money policies like historically lower interest rates and money printing that boosted asset prices and encouraged speculation. Stock prices rallied at near low historic rates, and it became a game of trying to keep up with capital markets as they were racing away from investors. The economy seemed almost too perfect and economic perfection doesn’t last. In 2022, we’ve seen the market correct itself for several interconnected reasons, including:
- Historic rates of inflation and the Fed’s delayed response caused the economy to overheat. Simply put, there was too much money chasing too few goods.
- The ongoing war in Ukraine and subsequent sanctions against Russia have intensified supply-chain disruptions and increased prices in the energy, food, and commodity industries.
- Asset prices were too high and often not in line with the true value of what was being sold.
- The ongoing COVID-19 surge in China has prompted fresh rounds of lockdowns and stifled economic growth. China has also seen an increase in government regulations of business, which has exacerbated this issue.
The unexpected nature of these events is the primary driver of market volatility as investors generally do not react well to uncertainty. Below we will dive into each of these factors in greater depth and hopefully provide some insight into how we got here and what investors can expect in the future.
Inflation & the Fed’s Response
How We Got Here
Inflation is perhaps the biggest factor contributing to investor uncertainty. The Fed originally thought it would be transitory, that it would pass once the supply chain was restored, and that it was nothing to worry about. Fast-forward to the present and inflation is the primary economic concern on many investors’ minds.
At its core, inflation can come from two angles: supply and demand. The demand for goods skyrocketed during lockdown in conjunction with a significant growth in the money supply. Everyone was home ordering groceries, household goods, office supplies, workout equipment—everything under the sun to keep themselves entertained. At the same time, the supply for many of these goods plummeted due to the lack of workers who were stuck at home during lockdowns. When everyone wants the same thing but there is a very limited amount of that thing, the price will go up until consumers are no longer willing to pay the highest price. That’s exactly what happened with the housing market and it also happened with other everyday goods.
Inflation was complicated by the government’s response. The economic stimulus packages gave money to each taxpayer, and the Fed’s zero interest rate policy made it much more appealing to borrow money over the long term. Suddenly, the average American household had access to more money than they needed to make ends meet, leaving more and more people to seek the goods they wanted. It was a combination of these factors that led to the inflationary environment we’re experiencing right now.
Where We’re Headed
So, what can the Fed do? They can slow the supply of money and raise interest rates making it more expensive for people and businesses to borrow money. This will incentivize paying with credit and force investors to buy with cash instead or skip the purchase altogether, reducing the available money supply in the economy and thus bringing prices down.
This is exactly what they’ve done over the last 6 months as they’ve raised interest rates three times. The most recent rate hikes of 0.75% came on June 15th, the largest hike in a single meeting since 1994, (1) and July 27th. As alarming as this already is, further raises are expected, up to approximately 3.4% by year’s end. This suggests another 1.75% in total rate hikes, spread across the remaining four scheduled policy-setting meetings this year, a much steeper path of rate hikes than was predicted in March.
The trouble comes in when interest rates rise too quickly and stifle economic growth, potentially sending the economy into a recession. This is the issue that the Fed is dealing with right now, and a large part of the reason why they waited so long to make a move against inflation.
Unfortunately, almost any time the Fed has had to actively fight inflation, a recession has followed. (2) On the fortunate side, though, there are a lot of factors that defy what a normal recession looks like and could hopefully lessen the blow if one does arise. For instance, the economy still seems strong with low unemployment levels, continued job growth, and high profit margins.
Employment levels have steadily been returning to pre-pandemic numbers, with the June 2022 unemployment rate remaining at 3.6%, unchanged from April and May. (3) This number, about 6 million people, is similar to the February 2020 pre-pandemic rate of 3.5%, or 5.7 million people. (4)
The payroll employment sector also saw an increase of 372,000 jobs in June, which was over 100,000 jobs higher than expected estimates. (5) Education and health services were the leading industries for job creation, followed by professional and business services, then leisure and hospitality. (6) The continued growth in the payroll employment sector defies what many experts would expect from an economy headed for recession. (7)
The War in Ukraine
How We Got Here
The war in Ukraine added fuel to the uncertainty fire. The markets were already experiencing volatility due to the uncertainty surrounding high asset prices, increasing inflation, and the delayed Fed response. And then came the big surprise in the first quarter when Ukraine was invaded on February 24th. This sparked huge amounts of uncertainty and fear around where the global economy was headed. Not only did this cause volatility in the markets, but it also exacerbated inflation as food, energy, and commodities supply chains were disrupted amidst the geopolitical tensions. (8)
Where We’re Headed
If we look at other wars as a sort of base model for what’s happening in Ukraine, we would assume that resources will have to be reallocated in order to get enough food, oil, and gas to not only the Ukrainian people but also those who had previously relied on Russia for exports. The economic effect of that would more than likely lead to a slowdown of inflation as the supply chains fix themselves and adapt to the new reality.
We would also expect to see a ramp-up in military spending across Europe as they navigate the geopolitical tensions. Despite the unfortunate circumstances around why European governments would need to spend more, it is still considered a fiscal stimulus that could benefit the local economies.
Lastly, we think that the worsening tensions and supply-chain issues abroad have made many Americans realize that we can’t continue importing our basic everyday goods from abroad. Events like these often have the effect of causing countries to become more insular, or self-reliant, and shy away from global trade. We are already seeing an increase in American manufacturing with a new computer chip factory being built in Columbus, Ohio. So, this is another way that the economy can be unexpectedly affected by global events.
Asset Prices
How We Got Here
As mentioned, asset prices were historically high in the lead-up to the 2022 market volatility. So, between the high levels of inflation, the Fed’s response, supply-chain disruptions, and the uncertainty of the war in Ukraine, something had to give. The efficient market hypothesis states that prices of assets are supposed to absorb and reflect all available information. When that information is confusing, scary, or partly unknown (as most future events are), asset prices tend to drop because investors turn to cash instead of staying invested. This is exactly what’s happened over the last several months as the market officially entered bear market territory. (9)
Where We’re Headed
So the question becomes: Is the market today properly absorbing available information and pricing assets accurately? In the short term, it’s hard to say for sure. We can see that stock prices represent a much better value than they did at the beginning of the year. And because of that, today represents a better time to invest than when asset prices were at their high. This is the epitome of buying low when you think about the age-old adage of buying low and selling high.
Though there are some who see the dramatic drop in prices as a reason to go to cash, or sit in low-risk, low-return assets, we think it’s better to invest in as much stock as your personal risk tolerance can handle because that is where the growth is, and growth is necessary to outweigh the erosion of purchasing power that comes from inflation.
China
How We Got Here
It used to be that China was the growth engine of the world. It was outpacing every other developed country by leaps and bounds, and in a 30-year period, it produced truly staggering global growth. But in the post-COVID economy, China is not the global-growth contender it used to be.
China’s zero-COVID policy has forced the country into numerous prolonged lockdowns as cases have surged in Shanghai and Beijing. (10) This policy has stunted economic growth for the country, causing an 11.1% decline in consumer retail sales and a 2.9% decline in industrial production. (11) The government has also imposed a series of business regulations that have compounded the supply-chain issues, creating backorders on many everyday goods that are produced in China and exported all over the world.
Where We’re Headed
All of this adds to the sentiment that the U.S. can no longer rely solely on China and other countries to manufacture the basic items we need to survive. We believe onshoring is going to be a continued trend in the next decade as many realize the downsides to complete globalization.
We also see the slowing of China’s economic growth as a deflationary factor that could help to alleviate the mounting pricing pressures.
Where Do We Go From Here?
With all these moving pieces, it’s hard to predict exactly where we go from here. But history tells us that if the economy does end up in a recession, the stock market will likely already have it priced in long before it is officially declared and it won’t be as bad as everyone anticipates. What’s more, market downturns have historically rebounded after previous volatility. That’s why we believe that, despite the uncertainty, now is not the time to panic. Nervous energy is a great destructor of wealth. We’ve planned for this. We’ve thoughtfully allocated your portfolio to meet your needs in the short term and for your bigger future.
At Cedar Brook Group, we are here to answer your questions and ease your concerns during this uncertain time. If you would like to take a look at your portfolio, or come in for a review, please reach out to us at 440-683-9213 or flegan@cedarbrookfinancial.com or schedule a complimentary introductory call online!
About Frank
Frank Legan is Partner, Financial Advisor, and member of the Forward Look Committee at Cedar Brook Group, one of the largest independent wealth management firms in Northeast Ohio. Frank spends his days designing and implementing personalized financial planning strategies for corporate executives, closely held business owners, artists, families, and retirees. He specializes in lifetime income strategies, investment advice, and estate planning services. He also works with businesses to develop strategic and succession planning strategies. Frank has a Bachelor of Arts in Political Science from the University of Dayton, as well as a Master of Public Administration focused on municipal management from Cleveland State University. Prior to joining Cedar Brook Group, Frank was a financial advisor in the private client group at Merrill Lynch and with NatCity/PNC Investments. Frank is active in his community, serving on various councils, boards, and committees. Frank serves as Chairman of the Board of Directors for Catholic Charities Diocese of Cleveland, and is a board member of the Catholic Community Foundation. When he’s not working, you can find Frank spending time with his wife, Laura, their daughter, Reese, and their beloved collie, Charlie. Frank and his family are volunteers at St. Francis of Assisi church in Gates Mills. To learn more about Frank, connect with him on LinkedIn.
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(1) https://finance.yahoo.com/news/fed-fomc-monetary-policy-decision-june-2022-120337242.html
(2) https://www.weforum.org/agenda/2022/05/fed-soft-landing-us-economy-recession/
(3) https://www.cnbc.com/2022/07/08/jobs-report-june-2022-.html
(4) https://www.bls.gov/news.release/empsit.nr0.htm
(5) https://www.cnbc.com/2022/07/08/jobs-report-june-2022-.html
(6) https://www.cnbc.com/2022/07/08/jobs-report-june-2022-.html
(7) https://www.cnbc.com/2022/07/08/jobs-report-june-2022-.html
(10) https://www.nbcnews.com/news/world/china-shanghai-covid-lockdown-beijing-shuts-districts-rcna32696
(11) https://www.voanews.com/a/china-s-economy-contracts-sharply-in-april-on-lockdowns-/6579122.html
