Now two weeks into the year’s 4th quarter, I have identified a couple of reasons for the current market conditions. It really boils down to two fundamental issues:
"Transitory" was the word of the moment. Inflation would be transitory. The experts said so. The basis for this claim always seemed a little flimsy to us. To be fair hindsight is always 20/20.
Warren Buffet likes to say, “The rearview mirror is always clearer than the windshield.”
By the end of 2021 however, it became self-evident to many and eventually even the Fed too, that inflation would not in fact prove transitory. The Fed did not leap into action but would soon start raising interest rates in an effort to reduce the money supply. It did so for the first time back on March 17th, 2022, raising its Fed Funds rate from the prolonged historically low of 0.0% - 0.25%, a full ¼ point to 0.25% - 0.50%.
Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
This succinctly describes what happened in March 2020. Everyone went home. Output declined and the money supply skyrocketed. The chart below helps to illustrate this. The chart shows the 30-year history of the growth in M2, the money supply, as indicated by the black line, versus inflation, represented by the red line. The table below the main illustration shows a longer monetary history dating back over 150 years.
To further your understanding of the chart, the money supply (M2) is defined as the money stock, which includes currency, coins held by the non-bank public, checking accounts, savings accounts, and money market shares.
Encouragingly the above chart shows that the Fed has successfully reduced the growth in the money supply to historical growth rates. It has achieved this by adopting a more restrictive monetary policy.
Remember as recently as March of this year the Fed maintained its Fed Funds rate at 0.0%. In a rapid succession of interest rate hikes, the Fed has now increased the rate to 3.0% – 3.25% and will likely continue increasing rates two more times this year until the rate is > 4.0%. The Fed next convenes its open market committee to vote on interest rates November 2 – 3 and many expect yet another 0.75% increase in its rate.
So, if the Fed has successfully reduced the money supply, it has failed to slow the inflation rate. This is not terribly surprising because monetary policy operates with a three – six-month lag. From the time the Fed executes a new interest rate increase, to the time it impacts the real economy, it takes at least three months, if not longer. The Fed last raised interest rates September 22nd. The soonest it will impact the economy would be around Christmas and many economists argue that its full effect will not be felt until spring begins next year. Six months ago, the Fed Funds rate was only 0.0% - 0.25%.
The Fed has been trying to catch up to the economic reality of historically high inflation. Its more restrictive monetary policy will eventually have its desired effect resulting in lower inflation rates, but it will take time and patience.
We suspect that inflation has peaked and in the coming months we will see evidence that inflation is trending down. This will prove beneficial for stocks and a new rally in the market will begin. This will occur well in advance of the Fed achieving its desired inflation target 2.0%.
Quality companies that are resilient to the economic cycle will return to favor as inflation falls even if it results in a weaker economy. The stock market leads the economy. By which I mean that the market will decline in advance of an economic recession and its recovery starts before the economic recovery begins.
Over the long run, we know that there are times when our companies may fall out of favor for a period of time. As the time horizon increases, those periods appear to be minor speed bumps along the companies' climb to higher prices.
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