Wednesday (5/18) was a day of turmoil in equity markets with the S&P 500 down about 4% as investors sold risk assets for the safety of government bonds. I personally wouldn’t jump into bonds for the long term at this point, but yesterday investors needed to do something and bonds were the easiest choice. Markets have been concerned about inflation and are suddenly rethinking Fed chairmen Powell’s comments about how far the Fed is willing to go to fight inflation, which could mean interest rates are headed much higher.
It’s already been a very volatile year in markets, but at least some of the volatility has been on the upside, otherwise the damage could be even worse. Clearly inflation, and the Fed’s plan is to manage it, is still the biggest downside risk. The Fed admits to being behind the curve but I am not sure if they even saw the curve to begin with. To me, they backed themselves into a corner and now they can’t look back from getting inflation under control… so soft landing be dammed and get the Volcker Playbook out! The recent stimulus was the largest ever, and inflation is the hottest it has been since 1981. Therefore, by my logic, the situation will demand a policy response scaled to the size of the problem, and we should be prepared for creative and enormous Fed actions that will likely create a contraction at least if not a full-blown recession (with obviously negative ramification for financial markets).
We are already starting to hear spending changes and see some drawdowns in saving as gas prices rise. But consumers are accustomed to gas prices moving up and down in any given year and think of this as more “transitory”. Consumers, however, are not used to large fluctuations in things like household goods and groceries, and a glance at a recent shopping trip receipt can make the reality of higher prices hit home. These products don’t move as aggressively, and are not noticed as much, as the gas prices you see every week. Retailers like Target are feeling the pinch of higher prices that are now impacting sales. All of this is leading investors to rethink their exposure to stocks, and since more money flew into stocks last year then anytime over the last 19 years, even a small reduction in this flow can cause instability in the markets.
Because of the unique way Astor looks at economic data we picked up on these headwinds earlier this year even though 400k jobs were being added to the economy and GDP was accelerating. Our models suggested there maybe cracks in the economic data such as weakening purchasing manager indices and comparisons of recent trends to more normal long-term trends.
Hopefully, the economy and the markets will find support at a level not too far from our current juncture, and the anticipation will prove worse than the problem. With that said, we have already reduced our exposure to stocks by about 30% since the beginning of the year, and we retain the ability to reduce risk further or even enter into an inverse position, something we have not added to the portfolio in over a decade.
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