Monthly Outlook: August 2022 

Markets enjoyed a solid bear market bounce in July. U.S. stocks rallied 9.2%, international stocks were up 3.4%, and even bonds rose 2.4%. This was the third rally of 5% or more since the market downtrend started in January 2022. The other rallies proved to be short-lived, and we expect this one to be, too, unfortunately. Even with the July bounce, markets remain downtrending with U.S. stocks down 14.0%, international stocks down 14.6%, and bonds down 8.2%, YTD. For investors that haven’t reduced their risk and trimmed stocks, we’d recommend selling this rally.

The July rally was a bit odd considering the weak economic news that was released. GDP for the second quarter fell -0.9%, following a -1.6% decline in the first quarter. Although two consecutive quarters of declining GDP is only a shorthand estimate of recession and doesn’t confirm one, it is a good clue that the economy is slowing, and a recession is likely coming. Furthermore, inflation remains sky-high, with the latest CPI reading of 9.1% and PPE reading of 6.8%, the highest level since 1982. The Federal Reserve (the Fed) will have no choice but to continue to tighten monetary policy to try to squelch the inflation spiral. This will further slow the economy and makes the July market bounce even more likely to fail.

Supply * Demand = Price

The temporary optimism for stocks in July seems to be predicated on some faulty logic. Put simply, it goes like this: If the Fed hikes interest rates to, say, 3.25% by year end (from 2.25% today), that will surely cause a recession, and they’ll have to then lower interest rates very soon after. The stock market seems to be looking through the next six months and anticipating lower interest rates and stimulus. This may be too optimistic.

Prices for all things are explained by a simple formula: Supply * Demand = Price. If supply goes down and/or demand goes up, the price will rise. In extreme cases, prices will rise quickly enough to register as problematic inflation. That’s the situation we have now. Supply chains were broken during COVID, and supply of labor is down due to who-knows-why. Demand for “stuff” and experiences is way up due to pent-up COVID shutdown, and demand for labor is up because stimulus money has the economy booming. This has led to a 40-year peak in price inflation. It’s really not a mystery, and it should not be a surprise to anyone, least of all policy makers. The Fed and Congress, both, poured massive amounts of stimulus into the system in response to an unexpected pandemic. The economy yo-yoed between shutdown and boom in a matter of two years. Getting the economy back to normal and price inflation back to 2% from the current ~8% level may prove to be a harder nut to crack than normal.

What if Tighter Policy Lasts for Longer?

Already this year, the Fed has raised the Fed Funds rate from 0% to 2.25% to tighten monetary policy. They’ve been clear that they intend to do more, and the Fed Funds rate will likely be 3.25% by year-end. It’s starting to slow the economy by weakening demand. Higher interest rates make borrowing for houses, cars, credit cards, etc., more expensive. Additionally, corporate earnings, generally, are weakening, and are expected to soften further. But will such policy be enough to bring inflation down from 8% to their 2% target? What if it only brings inflation down to 5%? How much more will the Fed have to do? Maybe they don’t raise rates much more than 3.25%, but maybe they keep rates high well into 2023? Remember, to crack inflation, supply must increase and/or demand must decrease. My biggest inflation concern is how to squelch cost of labor inflation. It’s a major cost for every business, and unless supply of labor increases or demand for it declines, wages are likely to stay high. I don’t see Federal Reserve policy changing this in the next few quarters.

We don’t have to be accurate economists to be great investors. Market prices reflect the meeting point of all buyers’ and sellers’ estimate of value, blending all the data and opinions in the universe. We can, and do, simply follow the long-term price trends for each market, and invest accordingly. Even with the monthly zigs and zags in the markets, the price trends remain down in 2022. It’s only sensible, then, to stay protective and alert. Inflation will pass, but not soon.