Market Update - June 2022 - Part II
Further to our update earlier in the week, we wanted to provide a quick update after the Fed Reserve met overnight (16th June 2022).
What is inflation?
Inflation is the decline of purchasing power of a given currency over time.
A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time.
The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
Put simply, price of goods and services rise and you can buy less with your money.
What happened?
US inflation rose again in May, increasing 8.6% from a year earlier and 1% from a month earlier. Shelter (rent), food, and gas were the largest contributors, but there was a fairly broad-based advance from most sub-components.
Core inflation, stripping out more volatile food and energy components, increased 6% from a year ago and 0.6% from the prior month.
Both came in above forecasts, and in contrast to recent talk that inflation may have peaked. This saw investors fret about faster and larger Fed rate rises than previously expected.
Why did it happen?
Record petrol prices, along with rising food and shelter costs, have been fuelled by excess demand due to fiscal indulgence and monetary settings that were too loose for too long, along with supply shortages originally fuelled by covid policies, Ukraine/Russia related supply issues including the effects of sanctions, and more recently Covid-zero policies in China.
What does it mean?
The higher inflation number implies that the US economy is running too hot and may have to be slowed with faster and larger rate rises than previously expected, which then raises the risk of a recession if the economy cools too fast.
We have seen a number of different views in the market. With people who have never lived through an inflationary period saying “What’s the big deal”.
The big deal is that inflation takes over the conversation, it drives everything else. It drives the market.
People’s expectations are set by what they have lived through. Most investors in the market have only entered into the market in the past 10, 15 or 20 years. For these investors the only inflation they have known is low and stable inflation.
This is the behavioural component for people to adjust their expectations.
To breakdown inflation we need to separate into two parts
Expected Inflation
Expected inflation Is something we can build into our financial assets. Furthermore, expected inflation is the benign part of inflation.
Unexpected Inflation
Unexpected inflation is the deadly part.
Inflation coming in higher or lower than expected is the main concern for markets around the world.
When inflation is unexpected you have not had a chance to adjust to it and financial assets have not had an opportunity to reprice assets.
Inflation is the genie in the bottle.
When it is in the bottle, you can look at it, laugh at it and talk about it.
However, as soon as the genie is out of the bottle, it is difficult to get back in.
One of the reasons Central Banks have been so slow to adjust is that they thought this was a passing phase that inflation was going to go away, what many described as “transitionary inflation”.
Rising costs are killing consumer confidence and sentiment as rates rises impact current and future demand whilst rate rises do little to help surging global commodity prices and structural changes in the way people spend and live post-covid.
However, overnight the US Fed have back pedalled on their “transitionary” inflation view and are now taking inflation seriously by raising rates by 0.75%, continuing to front load rate hikes to get control of inflation.
Markets have been trying to adjust and understand what the true inflation is going to be. Currently inflation sits at just over 8% and is probably too high, with some of it being supply chain issues and covid excuses that were given early on.
We are not going back to 1-1.5% inflation that we have experienced for the past decade. The question is where do we fall between the 1.5% and the 8% is what is driving markets.
Volatility will continue as long as uncertainty remains. As the sharemarket craves certainty.
Last night the Fed looked to provide the market with the certainty it has been screaming for, as the Fed made it clear that they are expecting a response from their front loading strategy, with the Federal Reserve chairman Jerome Powell stating rates would most likely rise at a more modest pace going forward. Confirming 0.75% increases will not be the new normal, easing concerns of a potential series of similar increases. However, if the response is not received he has left the door open to another 0.75% move in July.
Powell went on to say that the economy is strong and able to withstand tighter monetary policy.
On Wall St, shares were pressing sharply higher as, and after Powell spoke. The US stockmarket finished 1% higher overnight. With early indications pointing to the Australian sharemarket stemming the pain, by rising 0.3% on open.
In the very short-term, this certainty and confidence will provide a much needed boost to stock markets around the globe. However, the genie is not back in the bottle yet and the underlying risk and concern still remains. Furthermore, for those with a medium to longer term view, it means opportunity.
For those fully invested, there’s no need to panic, as company fundamentals continue to look sound.
For those with money to invest, dollar-cost averaging remains the most appropriate strategy during these volatile times.
Remember not to use short term metrics to make long term decisions.