Pomona Wealth Market Comment February 2022 - Are financial markets barking up the wrong tree?
Financial markets were in heightened expectation to hear what US Federal Reserve Chairman Powell had to say last Wednesday. After overblown fears that US headline inflation of 7% in December might lead to Weimar-style hyperinflation, markets demanded swift action and clarity from the Fed on raising interest rates this year in three or four or more consecutive steps of 0.25% each time or even higher. This despite data showing that inflation is going to fall significantly later this year and growth is slowing towards trend of its own free will. Financial markets may have then started to worry that the Fed might be too aggressive. As a result, the markets are confused.
The Fed statement was not terribly exciting. It was a clear signal of a rate increase as expected. There was a signal that the Fed will start reducing its bond holdings presumably in the second half of this year, perhaps a little later than some had expected. This timetable will allow the Fed to take credit where credit is not due. By raising rates in March, the Fed will be able to smugly declare that its policy is working when there is a sudden drop in headline inflation rate in the second quarter of this year. Of course, a 0.25% increase in interest rates in March will have no impact on inflation at all, certainly not in a couple of months. But spin is everything these days.
The press conference of Chairman Powell has been branded as hawkish. This was mainly because Powell was suitably vague on everything beyond March not ruling out more rate increases, not ruling out bigger rate increases. Refusing to rule things out means that they are possible and as investors wanted to see a hawkish Fed, possible can easily become probable in the market mindset.
However, taking a step back what does the Fed appear to be saying? Probably the best conclusion is that the Fed will raise rates modestly while the inflation problem is transitory and when raising interest rates has almost no effect on inflation anyway.
A roughly two thirds of the excess of inflation in the US now is due to fuel prices and to used car prices. These are not inflation but relative price moves. For readers who like to delve into statistics, this may prove to be revealing: https://www.bls.gov/opub/ted/2022/consumer-price-index-2021-in-review.htm.
Realistically nothing the Fed does will influence fuel prices and used car prices. However, if new sources of inflation come in and these new inflation drivers are areas where Fed policy can have an influence, then the Fed may tighten policy more to deal with those new inflation drivers. It is less about the level of inflation and more about the drivers of inflation. If the structure of inflation stays the same as it is today, the Fed seems unlikely to be especially aggressive. If the structure of inflation shifts and new inflation drivers emerge, then the Fed will be more aggressive in tightening policy.
We are relying on statistics which are a mere randomized guess of what is going on in the chaos of structural change in the economy – less than half of the economy is measured. This chaos has reached valuations of all tradeable assets, from equities to bonds and even the hyped-up cryptocurrencies but the long-term trends of digitization, ecommerce, and others are not affected by what the Fed may or may not say or by the movements of the financial markets. A cynic might be tempted to argue that Chairman Powell’s comments were a successful first step in tightening financial conditions: about USD 9tr. of market valuation evaporated.
It is important to remember that we are investing with a horizon of three to five years and longer. We focus on companies which are market leaders in the current structural changes. The current earning season reveals that most companies such as Microsoft, Mastercard and Apple have excellent numbers. We feel the pain with you as we are also investors, but we have experienced repeated drawdowns as the financial markets disconnect and recommend you stay invested until this storm blows over. In our view, when figures show that inflation numbers start to drop, the Fed will have less reason to raise interest rates. This should prove supportive to the financial markets.
Geneva, January 30th, 2022