October 2022
Stocks and bonds continued their 2022 rout in the third quarter. The S&P is now down about
25% for the year, with the bond market down about 15%. Covid in early 2020 was similarly
scary, with the S&P down 32% from peak to trough. We survived that episode; our pulse and
blood pressure will recover this time too.
Mostly because of supply chain issues, inflation in the West is going to remain high. Central
bank rate policy is better suited for influencing demand, so bringing inflation down via higher rates will work, but slowly.
Here’s why. If you’re a saver, you like that extra interest on your cash in the bank. As a result,
you and millions of other savers are demanding/buying marginally less “stuff.”
If you’re a borrower and you want to buy a house, a car or just add to your credit card balance, you may be slowing your rate of purchases. Higher interest rates “crowd out” discretionary spending in other parts of your life. Scaled up, this is what whole countries are about to deal with in order to make interest payments on their treasury bonds.
Those are both demand examples we all relate to. The biggest supply issue we face - getting more people to work - isn’t directly affected by interest rates. More labor supply would ease transportation, semiconductor and food processing, all of which are experiencing serious labor dislocations and thus higher prices.
Despite the Fed’s goal of bringing inflation down to 2%, borrowers like inflation, because it
devalues their existing debt. So in some sovereign circles, there is an incentive to keep inflation above 2%. And a structural element for equity investors to remember is that high interest rates attracts money into the bond market. In this sense, higher interest rates are a good thing because bonds are now an asset class that pay a decent return.
All of this said, a bounce higher in stocks and bonds is coming. There is so much pessimism
priced in to both. While inflation will likely persist, I think the worst of it is behind us, and the
Fed can’t raise rates every time they meet. I think by the end of this year they will announce a
pause, to give the economy a chance to absorb their rate hikes.
If I’m right about the pause and effect, this is not an all-clear to buy and hold tech stocks. Higher rates have yet to hurt profits growth - which they will - and companies will cut jobs to manage costs (even though labor supply remains an issue). Therefore I’m still cautious over the next year.
Here’s a chart of the S&P 500 looking back at the past 26 corrections. 2022’s magnitude is a little worse than usual. While we’ll recover, we shouldn’t assume a steeper than usual recovery.
