Three Key Thoughts:

1. Sticky Inflation

2. Desperate Russia

3. Nowhere to Hide

Sticky Inflation

In March and August of this year, the US stock market rallied on the hope that inflation was beginning to come down. If true, this would let the Federal Reserve pause its aggressive program of interest rate increases. Both times, investors were disappointed as inflation reports continued at a high level. More recently, expectations about inflation have stayed high and markets have plumbed new lows for the year.

Inflation from housing costs and labor shortages are likely to remain sticky for a while as we are chronically in short supply of housing (relative to the demographic need) and labor (as our population growth hasn’t been sufficient to keep up with the demand for labor). Throw in high energy prices driven by our abandonment of energy independence and the war in Ukraine, and you have a very difficult set of inflation drivers for the Fed to address.

With longer term interest rates having risen alongside short-term rates, 30 year mortgage rates are now over 7%. This more than doubling of rates on new mortgages has frozen the residential home market on both sides. Buyers, already stretched by high prices, can’t afford the monthly payments demanded by higher rates. And potential sellers are reticent to list because prices have softened and, more importantly, they don’t want to exchange their low cost mortgage for a high cost one on a new home.

We are just starting to see the impact of higher rates in other parts of the economy, as it usually takes 6-12 months for Federal Reserve actions to work through the real economy. This time, that effect may come sooner and more severely given the speed and magnitude of Fed actions. Ironically, it seems that the public has already anticipated this outcome. They are pessimistic about the current economic situation and do not expect inflation to stay high. The Fed wants to make sure their expectations stay that way.

Desperate Russia

Much has been written about the shockingly poor performance of the Russian military in its invasion of Ukraine. Putin tried to keep his “special military operation” outside the view of the average Russian citizen but the battlefield failures made it necessary for him to initiate a conscription to replenish his troops. This hastily arranged draft sent many scurrying to exit the country but more importantly brought the military failures so far into stark daylight.

Predictably, and with Putin’s approval, hard line supporters have called for a major escalation of the war effort, claiming Russia itself is under siege. Of course, harsh treatment has been in store for those who protest or resist the draft. However, it is far from clear that Russia has the ability to escalate in a sustained way with traditional weaponry. Trained troops, equipment, transportation and weaponry are already very stretched with refreshment prospects uncertain. This leaves Putin in a desperate situation, making him both unpredictable and dangerous.

In addition, we believe he has played his energy card poorly. By cutting off natural gas supplies to Europe under the guise of pipeline “maintenance” and “leaks,” he is forcing Europe to adjust to alternatives very quickly. And they will never return as customers. Putin is then forced to sell oil and natural gas at discounted prices to China and India, neither of which is pleased with Putin’s war. With China’s economy already struggling, they hardly need Putin trying to economically cripple their largest export market, Europe.

The late Senator John McCain once labelled Russia “a gas station masquerading as a country.” Many other commentators have modified that quote to call Russia “a gas station with nuclear weapons.” Putin’s dream is to re-establish Russia as a great world power. Where he will take that quest from here is difficult to guess but it is clear that his gamble on taking Ukraine has not paid off.

Nowhere to Hide

The stagflation situation we find ourselves in now is not good for any financial asset. We are cautious about US stocks in the short-term as we don’t think that estimates of corporate earnings yet reflect the further slowing in the economy to come. With the Federal Reserve likely to keep raising rates through year end, bond prices will remain under pressure. And cash is a loser to still-hot inflation.

In short, there is no good place to hide.

If there are shreds of optimism, they are that (1) the Federal Reserve is likely to pause the rate hikes at year end to take stock of where the economy is and that’s only a couple of months away and (2) markets typically bottom well before the economy does.

Investment Implications

“When you’re going through hell, keep going!” Often attributed, perhaps incorrectly, to Winston Churchill, this quote is nonetheless apt advice for our current situation. We are investing clients’ cash in very short-term bonds to take advantage of rising rates. And we continue to evaluate stocks of companies we believe will thrive long into the future. With China’s economy staying weak, Europe dealing with energy shortages and high inflation and the US dollar likely to stay strong, we have significantly reduced investments in international stocks.

We don’t know when the situation will change for the better, but we are confident that it will. The US economy is still fundamentally strong, with advances in technology and health care spurred on by the lessons learned during the pandemic. Ultimately the forces of entrepreneurship and innovation will get us back on a solid growth track.