Gill Capital Partners Mid-April 2022 Update
The annual tax deadline is nearly upon us, as we all struggle to complete the absurd annual negotiation with the government. The focus on tax temporarily shifts our focus from other significant events and headlines, and there are many. We have a fresh read on inflation, rumblings from the Federal Reserve, talk of a yield curve inversion, updates on Ukraine, and volatility in the markets.
Inflation
Inflation is on everyone’s mind and inflation-related headlines are dominating the news. We received a fresh read on consumer price inflation this week with the monthly CPI report, which shows that prices consumers pay for everyday items surged in March to their highest levels since Ronald Reagan was President. The consumer price index jumped 8.5% from a year ago. Markets actually reacted positively to the report as the numbers were generally in line with expectations and there was a glimmer of hope that the pace of inflation may be slowing - the pace of “core” inflation slowed more than anticipated on a month-over-month basis.
Our view – This inflation report was ugly, but everybody knew it would be. We continue to believe that we are in “peak” inflation now and that the pace of inflation will moderate in the second half of the year. In fact, we are already beginning to see signs of slowing inflation in this week’s CPI report. For example, used car prices, which have been one of the largest contributors to overall inflation, declined 3.5% in the month of March. They are still up dramatically, but this decline tells us that the appreciation rate from the past year is simply not sustainable. Surging gasoline prices accounted for roughly half of March’s price increase, but it appears that world oil markets initially overestimated the impact of supply disruptions, and we may see significant decreases in April’s number. We are also seeing evidence that supply chains are fixing their issues and we could soon see oversupply in areas. Retailers appear to have overbought and are sitting on unusually large inventories, and car lots are finally beginning to fill up. As shown in the chart below, retail inventories excluding autos have recovered and even exceeded pandemic levels.
The relationship between supply and demand is the basic tenant that drives inflation. Inflation is unbearably high at the moment, but based on the real time data we are seeing, we believe we are seeing peak inflation now. This does not necessarily mean that prices will fall precipitously (deflation), though that could occur in some areas, but the pace of inflation will likely be slowing. This is good news!
Yield Curve Inversion
The yield curve inverted recently, sounding alarm bells across the financial universe and bringing out pundits calling for the next recession. What is an inverted yield curve and what does it mean? The yield curve is a line that plots the interest rates of bonds with equal credit quality but differing maturity dates at a set point in time. As shown in the chart below, a “normal” yield curve is upward-sloping, which makes sense, as bonds with longer maturities typically offer higher yields than those with shorter maturities. This occurs because bondholders generally require incrementally higher rates of return as maturity dates increase. But when short-term yields start to climb above long-term yields, the curve slopes downward and becomes inverted. That can potentially happen when the Federal Reserve is raising short-term rates to cool down an overheated economy like it’s doing now. An inverted yield curve is often considered an early-warning sign of an impending recession.
Our view –When the yield curve inverts, it doesn’t necessarily mean that a recession will follow. Not all yield curve inversions have predicted a recession, and a recession may not happen for many months or years following the inversion signal. Looking back at the last five recessions prior to COVID-19, the data shows that there have been anywhere between 10 and 34 months between the initial point of yield-curve inversion and the official start of the recession. Furthermore, and more importantly, the periods between yield curve inversion and the subsequent recession have seen reasonably strong stock market performance. Data from Morningstar shows that, on average, the S&P 500 returned 19.89% during this period the last 5 times a yield curve inversion was followed by a recession. This isn’t to say that investors should run out and buy stocks, but rather that the inverted yield curve may not be the bad omen that you see spread across financial headlines. While we do see growth slowing in reaction to higher rates and less liquidity, we do not yet see the case for a recession.
The Federal Reserve
In reaction to the recent inflation readings, the Federal Reserve has continued to reinforce a more aggressive posture, signaling that they expect to raise the Federal Funds rate to roughly 2.8% (currently at .25%). They have also indicated that they may take more aggressive measures to shrink their balance sheet. The Federal Reserve’s messaging, along with high inflation numbers, has pushed interest rates up dramatically over the past few weeks in anticipation of Federal Reserve actions.
Our view –We continue to believe that, irrespective of their forecasts for dramatically higher rates, they are likely to stop raising rates well before they reach their targeted Fed Funds rate. As such, many fixed income investments, which appear to have already priced in the full Fed forecast, look particularly compelling at the moment.
As always, please let us know if you have any question or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.