Market Update - July 2022 | |
Image: Valleys are beautiful to look at, but they can be difficult to cross. First, you must go downslope before climbing up the other side. Recessions and bear markets are like valleys and we are about to cross one. | |
- Markets fell dramatically in early June on a bad inflation reading and then spent most of the month chopping higher as traders hoped the widely expected recession will force the Fed to cut interest rates in late 2023.
- The U.S. economy is not expected to grow this quarter, pulling recession forecasts forward from later this year.
- The Federal Reserve is expected to raise rates again by 0.75% at the end of July. This will bring its Fed funds policy rate up to 2.5%. With headline inflation of 8.6%, the Federal Reserve continues to slow-walk its policy to deal with inflation.
- Changes are imminent to IRA and 401k programs as Congress tries to raise the age for commencement of required minimum distributions.
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Table 1: Performance update (as of 6/29/2022) | |
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After a brief rally from the May market lows, stock and bond markets sold off mid-June when the headline consumer price index (CPI) was announced. The simultaneous sell-off in bonds and stocks reflects investor impatience with the governments' inflation policies. Inflation itself reflects a complicated mix of supply-chain problems, excess stimulus spending, suppressed interest rates and geo-political problems. It seems we are very far from the economic conditions of the 2010's.
Just as economic conditions today seem very different from those 5 and 10 years ago, market conditions today are also dramatically different. Speculative investments in cryptocurrency, semiconductors, venture capital, initial public offerings (IPOs), and special purpose acquisition companies (SPACs) have all generated awful returns since the middle of 2021. In 2022, as the Fed raised rates and the economy slowed down, the largest companies in the indexes such as Apple, Microsoft and Tesla weakened from their all-time highs. Volatility is higher and returns are negative for almost all asset classes.
June saw a continuation of this weakness. Despite being oversold and due for a bear-market rally, the stock and bond markets could not eek out sustainable gains. There are early signs of recession and large non-economic sellers of stocks such as the Swiss National Bank announced they are planning to enter the market as sellers. Overall, the news in June was a continuation of the bad news we've had all year.
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Interest rates continue to drift higher | |
Interest rates continue to drift higher. Already in June, we passed a decade high in the critical 10-year Treasury bond yield benchmark. It is no surprise why rates are going up; inflation is the highest in 40 years and the Federal Reserve has stated they are committed to reversing inflation. | |
Figure 1: Key interest rates US 10-year yield and US 2-year yield | |
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One way to describe the Fed's policy is that of a long tail chase. We see these in warfare, sports and childhood games. It requires enormous energy to catch someone or something running away from you. In the chart below, you can see the Fed with rates at 1.5% is only just beginning to chase down inflation at 8.6%. Remember, during the 1960-1970s, Fed policy rates were normally kept above headline CPI to prevent a breakout of inflation.
The measured policy of the 1960's did not stop inflation from accelerating. Eventually , the Fed was forced to raise rates to 20% in 1980 to stop inflation from getting higher than 15%. Figure 3 shows that history. The real question to ask is this: in the current inflationary episode, what must the Fed do to stop inflation?
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Figure 2: The long tail chase of policy rates pursue rising inflation | Figure 3: Federal funds rate and inflation 1960-1980 | Dr. Copper, PhD, will see you now | |
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There is an old joke in economics that copper has a PhD in economics because of its ability to predict economic growth. This makes sense because of its usefulness in cars, houses, buildings and infrastructure. Strong economy = strong copper demand.
So, with all the focus on inflation, it is very interesting to see how weak copper has been recently in addition to oil, lumber, palladium and cotton. Even the grain market is seeing weakness.
Many forecasters expect a recession in late-2022 or 2023. Perhaps it is closer than we think. That would explain a lot of what we are seeing in the equity market. By the way, recessionary bear markets are usually worse than the classic 20% bear market definition the TV talking heads chatter about. Additionally, inflation usually falls during bear markets.
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Figure 4: Copper and crude oil futures 2021-2022 | |
The hope in May versus the reality of June | |
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In late May, we had an encouraging inflation reading from Core PCE (personal consumptions expenditure) that indicated a potential peak in inflation. In mid-June, a different inflation reading on the headline CPI (consumer price index) was reported much worse than expected. Markets popped on the first, then melted on the second.
In the world of behavioral finance and markets, the REACTION to the data can sometimes be more important than the DATA REPORT itself. At 8.6%, May's headline CPI was only a bit higher than the 8.3% from April. However, the reaction was significantly negative as rates rose, bonds and stocks fell.
There is still a possibility of a bear market rally due to market positioning. Research on fund holdings indicates a distinct short bias to portfolios. Historically, these indicators are contrarian in nature, so they usually point to the market doing the opposite. For example, if everyone is bearish, who is left to sell? If everyone is bullish, who is left to buy? This market may be difficult to trade in the short-term but a rally should be used to de-risk a portfolio as we move further into recession.
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Figure 5: Bond markets in 2022 | |
Figure 6: Equity positioning (source: Deutsche Bank Asset Allocation) | |
Even the Fed is forecasting a slowdown | |
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Many government agencies publish research and data on the US economy. One group is located within the New York Federal Reserve where they have a gigantic quantitative model that tries to predict the future. For those worried about inflation, great news: the NY Fed is predicting inflation to slow dramatically. For those worried about the stock market, bad news: the NY Fed is predicting a significant economic slowdown.
How and when this slowdown plays out is hard to predict. While the Fed will get blamed for raising rates and triggering the slowdown, the bond market has done much of the heavy lifting in terms of raising rates and causing the economy to slow. For example, interest rates on 10-year Treasuries and mortgages have risen much faster than the Federal Funds rate controlled by the Federal Reserve as we saw in Figure 2.
In the charts below, the red line is the estimate and the grey shading are the bands of uncertainty.
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Figure 7: New York Federal Reserve forecast of GDP growth | |
Figure 8: New York Federal Reserve forecast of inflation | |
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If you were in Africa and saw an elephant running quickly toward you, what would you do? Get out of the way, of course! The markets also have elephants that leave enormous footprints when they buy or sell securities. These market elephants are the mega-funds buying and selling alongside private investors.
Before the financial crisis, it was rare for central banks to buy anything but government bonds that were held to maturity. This was a relatively benign method to implement policy. Since the financial crisis, several central banks have bought stocks as part of their policy to intervene in currency markets. In particular, Switzerland and Japan have bought large amounts. While Japan's stock purchases were in Japanese exchange traded funds (ETFs), Switzerland bought the biggest and most liquid stocks such as Apple, Microsoft, Google, etc.
As of March 2022, the Swiss central bank held a whopping $177 billion of US stocks; $25 billion of which was bought in the first quarter of 2022! The size of this portfolio makes the Swiss National Bank one of the largest active stock managers in the world.
In June, the Swiss announced they would begin selling some of this stock to unwind their recent monetary policies. What this means is that there is now a large non-economic seller in the stock market. If they decide to systematically sell, there will be creating relentless selling pressure on these stocks until the policy is changed or the positions closed.
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Table 2: Top ten holdings of the Swiss National Bank | |
The political pressure on the Fed | |
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We spend a lot of time writing about the Federal Reserve. They are a key financial player with tremendous influence over the markets. Because of this power, they receive lots of political pressure from the players of Wall Street and Washington. These groups want different policies from the Fed, however.
On the one hand, Wall Street wants interest rates to stay low, inflation to rip and the economy to grow. This will be great for earnings, debts will get paid, and stocks will probably go higher.
On the other hand, Washington wants to deal with inflation. The voters hate inflation and there is an election right around the corner in November 2022. President Biden is surely putting pressure on the Fed to take care of inflation as soon as possible.
Both groups are pulling the Fed in different directions. As you can imagine, this can't be much fun and neither constituency is happy with the resulting policy.
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Figure 9: Fed Chairman Powell before Congressional testimony June 22nd | |
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As the Fed raises rates the economy will be digesting slower growth and higher inflation. This is likely to cause more market indigestion as we go through the year. We are watching interest rates and commodities very closely for signs of where the economy is going.
Watch Europe. The energy embargo on Russia will be devastating for Europe's economy. Modern economies need cheap energy and the geopolitical response to the Ukraine situation may push Europe into a deep recession. We have no European exposure at this time.
Please call if you have any questions you would like to discuss. 281-402-8284.
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IRA changes possible in 2023 | |
The SECURE Act was originally passed in 2019 and provided many needed updates for those saving for retirement. An update to this law has been slowly working its way through Congress and is now likely to be passed sometime later this year. While there are many parts to the current update, the two most important changes are for those at or approaching retirement: 1) updates to catch-up contributions and 2) an update on how required minimum distributions work. | |
Catch-up contributions expanded | |
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Catch-up contributions are extra contributions the IRS allows if savers are over the age 50. These contributions go into retirement accounts in order to boost retirement nest eggs just before retirement when earnings are typically the highest of one's career. For IRA accounts, this is an extra $1,000 per year; for 401k accounts it is an extra $6,500. The SECURE Act 2.0 allows catch-up contributions of $10,000 for ages 62 - 64, allowing for an extra $3,500 to be saved in each of these years. The IRA catch-up limit is left unchanged at $1,000.
In addition to the above updates, the annual catch-up limits for both IRAs and the 401(k)s will be updated each year with inflation. This would be done using the same method that income tax brackets are adjusted each year, using the change in consumer price index from the previous year.
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Changes to required minimum distributions | |
Required minimum distributions, or "RMD's" for short, are minimum distributions from tax-deferred accounts like IRA's and 401k's that currently start at age 72 for most people. The original SECURE Act in 2019 raised the first year of RMD's broadly to age 72 and should this bill pass there will be additional updates. | Table 3: Proposed ages of first required minimum distribution | |
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As always, please call if you'd like to discuss:
Rob 281-402-8284
Chris 281-547-7542
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Christopher Lloyd, CFP ®
Vice President and Senior Wealth Planner
Lloyds Intrepid Wealth Management
1330 Lake Robbins Dr., Suite 560
The Woodlands, TX 77380
281-547-7542
Chris.Lloyd@lloydsintrepid.com
www.lloydsintrepid.com
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Lloyds Intrepid LLC (“LIWM”) is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from LIWM with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.
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