Cenacle Commentary: Summer 2022

I’m sure most of you remember last summer when the stock market was at all-time highs. The country was emerging from lock downs and the discussion was all about whether you were still wearing your mask or not. Retail, bank, and technology stocks were riding a wave of cheap money fueled by nearly zero interest rates. And it seemed like everyone was getting a stimulus check. The party was on, and no one wanted to go back to work.

As autumn rolled in, it became clear that the good times wouldn’t last forever. Unemployment had fallen dramatically only to be followed by unfilled jobs as the long Covid layoff and free money made it unattractive to return to work. The competition for those returning exerted upward pressure on wages as employees found that changing jobs was easy and profitable...and probably meant you could stay home longer.

After the Christmas holidays we returned to find that the investor’s mood had changed. No longer was the market willing to look beyond the crazy numbers in the recovery bills and the prospect for higher interest rates. The party was swiftly coming to an end, as rising home prices, gasoline, food, and autos all combined to create the perfect inflation cocktail. The inevitable correction that many of us had been expecting since November started in early January and continued through the first quarter.

The Markets

The 2022 correction continued into April and May, as the markets posted 7 consecutive weeks of losses with intra-day ranges that reminded us of the panic selling early in the pandemic. Over-cautious investors, worried that rising interest rates and inflation might throw the economy into the recession, started selling sell technology stocks and the wash out spread across the market. Many feared the Federal Reserve would be unable to finesse a soft landing instead of a crash.

The last week in May saw a market rebound as indicators hinted that inflation may be peaking, reducing the need for extreme solutions. The rally may only be a bounce in a continued market sell off, but we believe the correction nearing its end.

The US equity market is down 15-20% year to date, depending on the portfolio mix. That is a very healthy correction by anyone’s estimate, and more than enough to take bring equities to reasonable values. Because it is forward looking, the stock market has felt more pain than the general economy as it absorbs the potential of Fed rate increases even before they happen. The market always expects the worst and recovers later.

Technology stocks have lost the most, and Healthcare and Media have also suffered as medical care and stay-at-home lifestyles change from the lockdown. Energy has been the biggest winner, with gasoline prices skyrocketing due to severely limited domestic production. Gasoline prices are currently 2X levels of the beginning of the year, now over $115/barrel for oil and nearing $5.00 for gasoline, making energy the biggest contributor to inflation. Food prices have also increased significantly, with farmer’s dependence on fuel, feed, and transportation to market. Real estate prices are still very high, but home sales have begun to slow, as higher interest rates reduce mortgage demand.

The current recession message dominating the news cycle is overly negative. Despite the fear of too heavy a response to inflation, there are reasons to be optimistic about a potential soft landing.

Inflation is certainly present in the economy, but we believe there are signs of leveling.

• Employment is positive, Unemployment has fallen to 3.4% from 14.8% in 2 years.

• Real business sales, adjusted for inflation, are up, showing resilient consumers

  and manufacturing. Companies are still posting strong profits.

• Industrial Production has been consistently positive, supply chain problems have

  been largely overcome.

• Increased wages have kept pace with inflation, helping consumers absorb the

  increased costs of living.
  Taken as a whole, these factors do not indicate an imminent recession.

  After a market correction, the S&P usually trades 8% higher in the first month following the market bottom, continuing to 24% higher in the following months.
  Longer term, many believe, as we do, the markets will be higher in the next year or two.

  Inflation

  The pandemic was a stark lesson on how foreign outsourcing can pinch our domestic supply chain, creating shortages of raw materials and finished product. As stimulus cash hit consumers bank accounts, that cash fueled inflation as consumers spent more than they ever have.

  “Inflation is always and everywhere a monetary phenomenon. It is always and everywhere a result of too much money, of a more rapid increase of money, than of output. Moreover, in the modern era, the important next step is to recognize that today the governments control the quantity of money so that, as a result, inflation in the United States is made in Washington and nowhere else. “
  Milton Friedman

The massive government stimulus programs enacted during Covid sent money directly to households in amounts that far exceeded the available supply of goods and services. Quite simply, people staying at home spent money on things that were not being produced and replaced. This is the definition of inflation...too many dollars chasing too few goods.

During Covid restrictions, working from home was the solution for many urban Millennials and GenXer’s. As their homes doubled as work and school, many renters and apartment dwellers sought houses away from large urban centers. An entire generation that once seemed unwilling to “settle down” joined the housing market as first-time buyers, taking advantage of low interest rates and moving to smaller cities, and rural areas. Demand quickly absorbed excess supply and soon buyers were chasing fewer homes, bidding prices up. The housing market remains strong, but decreased supply and higher mortgage rates are cooling the overheated market.

During the recovery from Covid, supply chain bottlenecks created shortages and drove commodity prices higher, but the energy squeeze added the most to inflation. All of us have felt the pinch at the pump, gasoline prices have nearly tripled over the last twelve months as increased regulation, decreased access to drilling sites, pipeline shutdowns, and a climate change focus have combined to decrease North American production, reversing US oil independence. The Russia/ Ukraine war did not cause the US energy crisis, but it has certainly added to it. Gas prices also impact food prices through increased farm costs and transportation.

While US inflation is 8.3%, there is hope that inflation may have peaked.

What is Inflation?

Inflation, as discussed in the media and government, refers to the “rate of
inflation” on an annualized basis. Economists measure a typical basket of goods and services that are common to most households and consumers (the index), price the basket, and then compare the price to the previous month or year. The current level of inflation is the change in the index (the basket) from a year ago. That calculation provides the annual “rate,” or rate of change in the consumer price index, which we refer to as “inflation.”

An inflation rate of 8.3% means that the overall cost of goods and services has risen by 8.3% over last year. However, it seems unlikely that prices will continue to increase at the same rate as they have during the past year. If homeowners’ equivalent rent, food, gasoline, energy, and healthcare costs were to level off, even at the current elevated rate, inflation will fall back to something closer to 2%.

As time moves forward, each month’s new inflation index will be calculated against already rising index levels. The result will be lower levels of the “inflation rate” even though the cost of goods and services remain high...they just are increasing further. For this reason, we believe that inflation may have already peaked, even if prices remain at levels.

Deflation

The media is alarmed with inflation and its impact on families and businesses, creating a narrative of fear. This fear describes a period of swiftly rising interest rates designed to “cool down” the economy, but more likely putting the US into a recession.

However, this scenario might bring not only reduced inflation, but deflation... prices moving to lower as economic activity tails off and spending slows. While still strong, some business leaders are preparing for the slowdown, issuing lowered forward guidance.

The setting for deflation may already be here. Commodity prices, in particular lumber, which was one of the first commodities to soar during Covid, has already dropped by more than 50%. Transportation costs are easing with more ships and trucks moving goods and home sales are slowing.

Energy prices, the primary inflation driver, should moderate as the global economy begins to slow. Further, if Russia decides it has achieved its goals in the Ukraine, and/or the US government decides to refocus domestic production, we could see a significant retracement in oil prices.

The following chart shows how inflation usually returns to the mean (the red line). Unless inflation spirals out of control for an extended period due to war or currency devaluation, the inflation rate will abate as prices settle in and become entrenched or moderate over time.

The Pendulum of Emotion

One final word on the current social and economic situation. In looking back through history, sentiment and mood affects economic decisions. Confidence and despair, the opposing poles of emotion, provoke many of us to make rash decisions that later seem overly optimistic or negative.

The recent volatility in the markets provides a moment where we can act rationally in the fact of an emotional event. Fear of the big price swings can drive some investors to liquidate their portfolios and move to the sidelines, to be holders of cash. Panic selling accumulates as investors let fear override rational analysis. Moving to cash seems like right thing, but precisely when you make the decision to liquidate is very important.

If you can have the foresight to get out of a crazy market before the damage accumulates that is a very good thing. Picking a spot to re-enter is less difficult if you’ve avoided losses. But unless your crystal ball is very clear, the correction can hit quickly and severely, making the decision to liquidate positions expensive by taking losses after the downturn. Holding cash does not recoup those losses and rushing back in to buy once the mood improves can lead to “selling low and buying high.”

We came into 2022 having anticipating a correction and holding half our positions in cash. This helped mitigate losses once the correction came. We reentered the market near the end of March, which with hindsight may have been a little early. Either way, we have a fundamental belief in the strength of the market, even in the face of interest rate hikes and inflation. As long-term investors we avoid the urge to over trade and overreact, instead choosing to ride out the waves of emotion by focusing on the underlying strength of the positions our clients hold.

The chart on the next page requires a little explaining...the peaks represent moments when fear and negative expectations are at their highest. The troughs represent positive expectations that often lead to excess.

Since 1958 Consumer Confidence has always returned to an even keel, around zero, shown in the chart in the middle of the field, running left to right.... much like a pendulum that swings back to the middle. Negative events in this inverted chart show up above the midpoint, each is labelled. Note how each of the crisis; recessions, crashes, and pandemic show an abrupt reversal as negative expectations give way to recovery and optimism.

In short, we see the pendulum of emotion beginning to swing back.

We hope you and your families have wonderful summer break. God bless you,
Ed & Claudia