Precarious Expectations

Friday Reflection | September 16, 2022

When our expectations are met, we often experience a reassuring sense of predictability; when they aren’t, we feel unsettled. In financial markets, investor expectations directly influence market prices. When investors expect a company or industry to be more productive and profitable in the future, demand increases, and prices are pushed higher. New information that upends prior expectations can be disorienting and lead investors instead to push prices lower in the short-term while they adjust to a new status quo.
 
For the second time in less than three weeks, the stock market rallied on an expectation of positive news regarding inflation but was ultimately disappointed. A few weeks ago, it was Fed Chair Jerome Powell who dashed hopes of a “Fed pivot” at his Jackson Hole speech, and this week it was a hotter-than-expected CPI report that frustrated expectations of a swift decline in inflation. Equities declined sharply following this news, abruptly reversing the rally that had been building and forcing investors to update their expectations.

There were three inflation reports released this week that all generated the same conclusion: Inflation is more persistent than markets had hoped. In each report – US CPI, UK CPI, and US PPI – the core inflation reading that excludes food and energy was stronger than expected. This implies that inflation is broadly distributed throughout the economy rather than solely being a problem in food and energy prices. For most consumers, this comes as no surprise given that the price of virtually everything (cars, restaurants, airfare, insurance, housing, etc.) is materially higher than it has been in recent memory. Still, the 11% decline in gasoline prices at summer’s end had created a tentative optimism among investors that exacerbated their sense of reversal.
 
The main inflation problem remains that too much money is chasing too few goods. The money supply in the US was around $15.5 trillion in January 2021; expansive pandemic stimulus has brought that much higher to nearly $22 trillion today – a nearly 50% increase. When we’ve discussed the low-interest rate and easy money policy of the Fed, that’s what we’re talking about. In order to reverse this trend, the Fed is now raising interest rates to force many businesses, potential homebuyers, or other borrowers to put plans on hold as the cost of financing rises.
 
An improvement in the supply of goods would also help push prices downward. The challenges of the global supply chain have improved recently, but manufacturing and distribution costs remain a barrier to increasing supply. The Drewry World Container Index, which monitors the dollar cost for a 40-foot container, has fallen sharply from over $10k in 2021 to around $5,400 now; that remains nearly three times the pre-pandemic cost of $1,800.¹ Things have improved but they haven’t yet returned to normalized levels. While it’s possible that inflation has already peaked, there continue to be macroeconomic forces keeping prices from declining at the pace investors were expecting.

Looking forward, the next major catalyst for financial markets is next week’s Fed meeting, when they will share their latest thinking on the economy and additional rate increases. The market has become increasingly focused on the level at which policymakers will end rate increases, known as the terminal rate, and there’s growing anxiety that the Fed will raise rates by more than originally expected. Expectations are increasingly being recalibrated in real-time, with equity markets reacting to every twist and turn as the Fed charts a path to historically more normal interest rates. Our expectation is for continued near-term volatility in the stock market, with the silver lining of stronger yields on bond and money market funds as rates continue to increase.
 
The 2-year US Treasury note now yields 3.9%, up from 0.7% at the start of 2022. Rates on some money-market funds, CDs, and even some bank savings accounts have hit 2%. Yields have climbed this year and could continue rising as central banks raise interest rates. We have confidence in the long-term benefits of stock ownership despite their recent declines, but it is also refreshing to see fixed income yields reaching historically normal levels for the first time in 15 years.

Investors – and people broadly – too often expect that the status quo will continue indefinitely. When the market is rallying, the expectation is that it will keep soaring to new highs and investors downplay risk factors. Inversely, when markets decline like they have this year, investors start predicting financial collapse and focusing on every negative storyline. Reality is far less linear.
 
It can be helpful to remind ourselves that the S&P 500 was just under 3,400 in early 2021. Even with this year’s sharp declines, the stock index is still up 16% in the past two years and is up 50% over the past five years. In January 2020, the Case-Shiller Home Price Index was 214, versus 308 currently.² That’s nearly 50% appreciation in home prices in just over two years – so even if prices decline further from current levels as expectations shift, there have still been net gains for most homeowners. Markets – stock, bond, and real estate – can change course rapidly and there are measurable benefits for investors who balance historically-rooted optimism and a timeframe that extends well beyond the present moment.

Resources

¹ World Container Index – September 8, 2022 Drewry UK

² S&P/Case-Shiller U.S. National Home Price Index FRED – St Louis Fed