The Message on Inflation and Rates Has Not Changed, even if Hope Springs Eternal
After a terrible first half of the year, investors got too negative, setting up a big summer rally. Stocks lost 15%-30% in the first six months of the year (depending on the index) with the S&P500 (big companies), the Russell 2000 (small stocks), and the Nasdaq composite (mostly tech stocks) all getting hammered. The sell-off was sparked by the Fed’s pivot to a more restrictive policy (higher interest rates) and concerns about consumer spending following a year of free money distributions. However, the stage was set for a rebound as investors became too bearish, as we outlined in a June client video. Spending did crack but it didn’t collapse. Earnings weren’t apocalyptic. Gas prices peaked and the summer sun started shining. As stocks rose, the market narrative followed, and talk circulated about inflationary problems fading into the past and expectations for a kinder, gentler Federal Reserve in the future. From the end of June until last mid-August, stocks jumped 8-18%.
The Dragon Has Not Been Slain
The problem is still that inflation is too high, and lower demand is likely the only fix. Inflation has been running at 40-year highs in 2022. The original source of the inflationary lift-off was the Covid19 panic, which disrupted supply chains, added costs, and spurred a massive overaction from the U.S. and other governments (both the lockdowns and the fiscal and monetary policy responses, in our opinion). Regardless of what you may think on those topics, it’s clear that supply became constrained, and demand was augmented, fueling the price increases that continue today. Some good news is that the supply side of the imbalance will most likely eventually resolve itself. Demand, on the other hand, remains elevated. This extends to the labor market, where there are not enough workers. Unfortunately, the tight labor market has now become the biggest contributor of inflationary pressures. Businesses are experiencing rising operating costs. And these companies are passing the costs back to consumers by raising prices for products and services.
Reducing Demand Requires Breaking the Labor Market
This is the message the market heard from Jerome Powell on Friday at Jackson Hole. During the sunny summer rally, investors told themselves a story about inflation peaking, the economy holding in, and interest rate increases tailing off in the foreseeable future. Some reports in the media even suggested that a few intrepid investors were looking forward to rate cuts. This fantasy narrative went down the drain at Jackson Hole. In remarks that were quite clear and reasonably concise (you can watch roughly 8 minute talk here) the Federal Reserve Chairman outlined the need to reduce inflation (or restore “price stability” as he put it). Further, he appeared to accept that lower employment and weaker economic growth would likely be required to get the job done. The Dow dropped 1,000 points as investors digested this, and then left their desks to head out for the weekend in resignation.
What happens next? Our sense is that investors need to do another round of considering the implications of higher interest rates for longer. The market has to price in higher unemployment and slower economic growth that the Federal Reserve suggests are required. A big challenge is trying to determine the time horizon to get “price stability”. Is it six months or 18 months? We haven’t the foggiest idea. We doubt many others will either, at least initially. We also expect the Fed Chairman’s words to reinflate (pun intended) the of discussion a possible “policy error.” A “policy error” is a cute way to allude to a terrible recession provoked by overly aggressive interest rate hikes. As you have probably guessed, none of this should be positive for stock prices.
The Level of Uncertainty of the Future Does Not Change. What Changes is the Perception of Uncertainty.
Perhaps we’ve presented a dire near-term outlook, but our investment approach is not based on this. Summer may be over, and the summer stock rally of 2022 is probably history. Rising interest rates are not positive for stock price performance. However, we remain cognizant of our inability to forecast both big-picture macro factors and the movement of the overall market, which is also a function of shifting investor mood.
Have you ever read that stocks were down due to high levels of uncertainty or that stock prices were rising due to “fantastic visibility”? In both cases, we think investors were fooling themselves. Our view is that the future is always equally uncertain. This is because the source of uncertainty is not found in today’s conditions. It is the unanticipatable events or changes in conditions that have yet to occur.
Investing is an exercise in managing uncertain outcomes.* Yes, you can be certain about some things in the future. The sun will rise in the East. Politicians will keep telling lies. The Green Bay Packers will remain the only publicly owned NFL team. The direction of the economy and capricious investor attitudes on the other hand, are largely unknowable. One of the biggest mistakes you can make when investing is to sell stocks when perceived uncertainty rises and buy them back when everything appears all clear. (Another mistake would be to believe that crypto currencies have any value at all, but we’ll leave that discussion for another letter.) Our approach to investing is to acknowledge uncertainty, and to have a plan that accepts this reality. Here’s our plan: We don’t “own the market” but instead invest in high quality individual companies. We don’t attempt to swap in and out of sectors based on a desire to get “defensive” or to position for economic growth. Instead, we own companies with flexible and durable business models. We don’t try to outthink the smartest people out there. We entrust our capital to the best management teams and rely on these individuals to make good decisions and lead their businesses through dynamic economic conditions. Lastly, (and this is the hardest part) we try to invest in great companies at advantageous prices and hold for the long-term.
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
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John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
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