Context Is Key To Weathering Volatile Markets

Investors are witnessing and adjusting to the end of a very long 'easy money' era.

Worries are ratcheting up about 1970s-style stagflation settling in amid a spiral of higher prices and sharply deteriorating economic prospects, according to market commentary shared this week by Susanna Streeter, senior investment and markets analyst for Hargreaves Lansdown in the United Kingdom.

Overall, Streeter wrote, a “wait and see” mood pervades financial markets, as investors brace for a jolt of tightening from the U.S. Federal Reserve, the European Central Bank and other key central banks in different regions of the globe.

Brad McMillan, CIO at Commonwealth Financial Network, wrote in a recent commentary that the inflationary outlook is having a substantial impact on the equity and bond markets—so much so that major market indices are now formally in bear territory.

“We hit a milestone just recently, although it’s certainly not one we wanted to hit,” McMillan wrote. “The S&P 500 stock index is now officially in a bear market, down more than 20% from its highs. The Nasdaq, of course, has been in a bear market for some time. It is down more than 20%, but that is primarily technology stocks, which are notoriously volatile.”

In short, investors are witnessing the end of a very long “easy money” era, and they are instead witnessing and participating in what Streeter called a “complex game of trying to rein in escalating inflation while not suffocating growth.”

Rates in Review

In the U.S., the Federal Reserve raised interest rates by 75 basis points in one go this week, while the European Central Bank is expected to hike rates substantially later in June and July. According to Streeter and McMillan, questions about interest rates and inflation will remain dominant drivers of market behavior in the coming months.

“The ECB has signaled it would prefer to follow a gradual approach of a series of 0.25% rises, but with central banks in Australia and India already employing tougher tactics this week, the likelihood of a harder line emerging from the ECB is growing fast,” Streeter wrote. “Fresh inflationary pressures are coming from the march upwards again in the price of oil, with a barrel of the benchmark Brent Crude nudging $124. There are expectations oil will surge even higher as supply concerns take hold, amid the entrenched war in Ukraine and the expectation for demand to rebound in China as Coronavirus curbs are lifted.”

Streeter suggested that the United Arab Emirates and Saudi Arabia could expand production of oil to help ease the inflationary pressure, but other OPEC members are struggling with hitting targets, and overall, there is little capacity to close the supply gap created by the bans slapped on Russian oil in the wake of the country’s invasion of Ukraine.

“Right now, the major factor is inflation,” McMillan wrote. “While the economy continues to grow, inflation is slowing that growth. This round of price inflation started in the pandemic, with stimulus payments driving more spending, even as supply chains contracted. More recently, however, inflation has shifted to a more permanent—and more threatening—trend, driven by housing and services. That has made it a much higher risk than it appeared even a month or two ago.”

Interest Rates, Inflation and Bear Markets

According to McMillan, the S&P 500, which includes the largest and best-known companies across all industries, is a better indicator of market stress compared to the Nasdaq.

“The fact that [the S&P 500] has moved into the bear phase signifies significant market and economic stress,” McMillan wrote. “The stress is real, as we can see in the headlines. Inflation is at 40-year highs, gasoline is at unprecedented prices, we have a war in Europe for the first time in 80 years, and that is not all. This is a difficult time. If you think about it, a substantial market reaction makes sense.”

By understanding what is driving this decline, McMillan suggested, investors can begin to understand how it will end—and that depends on the economy itself.

As McMillan noted, higher energy prices have wide-ranging effects. Considering those in conjunction with everything else, the current level of inflation risk is much higher than many had thought.

“Inflation is something that can sink an economy, especially if it becomes entrenched, as we saw in the 1970s and 1980s,” McMillan wrote. “There are now signs that inflation expectations are rising, and that is forcing the Fed to act by raising interest rates more quickly, resulting in higher mortgage and auto loan rates, among other things. This is designed to slow the economy, potentially creating a recession, but also to avert even more severe damage later on.”

In McMillan’s opinion, the Fed’s commitment to stopping inflation is good news, as it will reassure markets and possibly reduce how high interest rates need to go.

“While short-term interest rates are likely to keep rising, as the Fed tightens policy, longer-term rates don’t necessarily follow suit,” McMillan wrote. “As growth slows, the likelihood of a recession in that 10-year period rises, and rates can fall. As such, while the Fed is raising rates (and that has hit the markets), once the market sees those rate hikes ending, the 10-year rate will start to drop, and that will likely mark the start of the stock market recovery.”

No investor can know exactly when this will occur, but, as McMillan pointed out, there are some signs to look for.

“We don’t know how long or deep this bear market will be, but we do know it will end,” he wrote. “And as with every other bear market, including the great financial crisis and the 2020 pandemic, we do know the U.S. economy and markets will adapt and recover.”