Where is the Fed's Peak

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Continue reading

Hard or Soft Landing?

 

Economic growth spiked coming out of the pandemic trough in 2021 with the aid of aggressive fiscal & monetary support. Late in 2021 that growth began to cyclically slow down leading to volatility in the first half of this year followed by sizable rallies and selloffs. The selloffs have been exacerbated by geopolitical shocks, tightening monetary policy, and inflation. The rallies have been characterized by optimism that these sources of contention are showing signs of dissipating amid record low sentiment in equity pricing. At the center of these contentions is inflation. High inflation is typically an offshoot of strong economic activity and loose monetary policy. Symmetry implies that a slowdown in economic growth should coincide with a peak in inflation which would be a welcomed respite for investors allowing the Fed to lighten up on rate hikes. This “dovish pivot” was the root of the 17% rally in the S&P 500 in mid-June through mid-august, but the crux of this optimism is that slowing economic growth risks a recession and the inflation we are experiencing now is unique in many ways. In response to this Fed chairman Powell’s recent comments at Jackson hole sent equity markets lower after this dovish pivot never materialized. On the contrary Powell's speech was short, but explicit in relaying the central bank’s commitment to fighting inflation even at the risk of recession...

Continue reading

Where is the Fed's Peak

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Continue reading

Where is the Fed's Peak

Inflation data continued to surprise to the upside with last week's CPI reading shocking markets and lead the Federal Reserve to announce another 75bps rate hike yesterday. The fed funds rate is now in the target range of 3% to 3.25%. In our opinion inflation has likely peaked but remains elevated enough that a quick dovish pivot by the central bank is not in the cards. You'll remember from our note last year (here) that when the Federal Reserve begins tightening policy and raising interest rates it is essentially the economic equivalent to a punch bowl being pulled away at a party. While we were not surprised that the Fed was tightening policy we have been surprised by the speed of policy change. For perspective, at the beginning of the year markets were pricing in a federal funds rate at sub 1%, now futures markets are pricing in a rate above 4% for 2023.

So now that we have embarked on a changing policy journey, where does it end?The truth is I don't think even Chairman Powell knows the answer as to what the terminal rate will be in a year. Like mentioned previously the market sort of does this for him by pricing in the terminal rate years ahead using futures contracts. Still, the procedure for central banks has always been more of a guess-and-check process where they begin raising rates until something in the market forces them to reverse course. On our chart today I plot some of these events and you can see they are wide ranging as far as which area of the market is most affected and ends up defining the tightening period. But one thing is common amongst them: most are pockets of excess where prices became irrational. Also notice how many of these are relatively illiquid or obscure with many taking place in emerging or debt markets...

Continue reading

Q3-2022 Quarterly Newsletter

More Pain To Endure

There is no doubt that this has been one of the most difficult years in recent memory for many investors. Nearly every equity index has fallen below the definition of a traditional bear market, a decline of 20% or more. Equally difficult has been the performance of the bond market which is supposed to insulate portfolios from market volatility. Even commodities, which started the year strong with heightened geopolitical activity, have begun to roll over. Crude oil has fallen -25% during the third quarter of 2022 and -35.7% since its March peak. Under restrictive Fed policy to mitigate heightened inflation, we will have to endure the pain until the Fed completes their mandate of price stability.

What has been behind the weakness in the market is above average inflation and a major shift in Fed policy. Nominal GDP has been very strong, up 8.5% in the first quarter and up 6.6% in the second quarter. After inflation though, real GDP is trending negative. Inflation, as measured by the Consumer Price Index, has come down from its peak of 9.1% in June of 2022 but still remains up over 8%, well above what the Fed considers its “neutral” rate of around 2.5%. In response to stubbornly high inflation, the Fed Funds rate has been increased five times so far in 2022 to a range of 3.00% to 3.25%. We anticipate two more hikes before year end which will leave the Fed Funds rate at a target of around 4.5%. We anticipate Fed policy may be able to transition sometime in early 2023 depending on the inflation data...

Continue reading

..
Continue reading

Market Valuation and Volatility

 

With the dramatic compression in valuation multiples this year we can now start to plot the current positioning of the market versus historical averages to gauge whether or not equities are attractive. On the graph above I have the forward 12 month P/E ratio of the S&P500 which currently stands at 17.6x and represents a level of 4,029. Overlapped on the chart I have 5, 10, and 15 year average multiples along with corresponding S&P 500 prices...

Continue reading

The Fog of War

The situation with Russia/Ukraine remains fluid but we wanted to follow up our note on the ‘Turmoil on the Eastern Front’ from the beginning of the invasion. In that note we showed the historical playbook for geopolitical events, and looking back the market has behaved remarkably in line with those precedents up to this point. But we don't think the situation is completely behind us and want to reiterate that historically what happens after the initial recovery mostly depends on what conditions were like going into the crisis. In today's case that was inflation and changing central bank policy. We continue to think that will be the dominant theme as we go into the second half of 2022.

For more on the geopolitical situation please see Schwab’s latest market perspective below:..

Continue reading

Staying Home

 

Geopolitical tensions continue to boil with the Russian invasion of Ukraine shocking an already inflationary global commodities market. Rumors of progression in ceasefire negotiations have boosted markets today but regardless, the economic fallout from the sweeping sanctions will likely last for some time. In our last note we outlined from a high level what the market behavior was during past episodes of similar geopolitical turmoil. We also reiterated why having operating cash set aside and being able to ride out volatility is essential to long term investing. But just as important is understanding what you own and making sure the assets are fundamentally strong...

Continue reading

Turmoil on the Eastern Front

After 18 months of very little volatility a cascading series of events including the escalation between Russia and Ukraine have reverberated throughout markets causing our first 10% percent drawdown in large cap stocks since March 2020. I'm not going to try to predict the path of military actions in Europe but I can try to put into perspective what the economic impact might be from what's taking place in the region.

Geopolitical events by their nature are difficult to predict and tend to be short lived, although there are certainly exceptions.Outside of the commodities sector, Russia is a marginal player in the world economy accounting for only 1.3% of global GDP, and Ukraine makes up an even smaller portion. US exposure to Russia in terms of total trade is a very low 0.1% of GDP. The EU on the other hand sources roughly 1.5% of their total goods trade with Russia. The main exposure is that commodities are a global market with Russia accounting for about 10% of global oil production and the EU has become ever more dependent on imports for energy. EU imports have long represented over 90% of its oil consumption, while the natural gas import share has increased from roughly 50% in 1990 to also over 90% today. By contrast, the US has moved from importing over 50% of its oil & petroleum during the 2000s to being a net exporter today. So in theory the first order effect from rising energy prices should be modest to the overall US economy. Still, the second order effects of a shock to the already tight global energy market is what could be disruptive...

Continue reading

Black Friday Special

Markets underwent a volatile session today on news that the WHO is monitoring a new covid variant detected in small numbers in South Africa called B.1.1.529. The new variant is purported to contain multiple mutations with increased antibody resistance and rattled markets on a thinly traded day with several of the cyclical & travel related parts of the market getting hit hardest.The development of rising covid cases is a risk to markets but the trend of the world economy recovering from covid is still intact even as new variants create speed bumps in the process. The Delta variant created a hiccup in the recovery earlier in the year but the economic risk ended up being minimal. With winter approaching I would guess that the world will continue its rolling two month cycles of rising and falling covid cases with a combination of antivirals and boosters eventually smoothing infections similar to the flu.

The WHO has said it will take weeks to understand how the new variant may impact transmission or react to vaccines. But for some perspective, South Africa still has very low vaccination rates with only 41% of the population receiving the jab. In most of the developed world vaccination rates are greater than 70%. Also, only ~ 80k tests per day are being administered in South Africa which means the sample size will need to be much larger before data is concrete. And while the new variant is worried to be more transmissible, death rates in South Africa are still very low which is encouraging . We’ll see if that holds in the coming weeks...

Continue reading

Abundance of Shortages

 

Covid has disrupted supply chains in two major ways: surging demand for imported consumer goods in the west, and a decline in workers required to maintain and operate these supply chains. Over the last twenty years supply chains have relentlessly been pushed towards efficiency with the adoption of Just-In-Time(JIT) inventory management in addition to the integration of global component sources. This Evolution has dramatically increased efficiency but has come at the cost of fragility. Covid constantly flipping the on/off switch on these supply chains has exposed this weakness. Shipping is the nexus of the issue. It usually takes 40 days to transport a container from a factory in China to a store in the US. At the moment it takes 73 days meaning goods ordered today may not arrive by the Holidays. Consequently, price of shipping has jumped. Both the Shanghai Shipping Exchange Containerized Freight and the Baltic Exchange Freightos Container indexes are reading at historic highs. Just recently the port of Los Angeles announced they are going to start running at 24 hours a day to ease the cargo backlog but this won't solve the problem overnight. ..

Continue reading

Evergrande & Debt Limit

A few weeks ago we sent out a letter followed by a note conveying that after an exceptionally strong 18 month stretch of performance in markets with little-to-no volatility we would be transitioning into a period where market price action would normalize and volatility would likely rise. However, we still see long term equity market performance remaining strong supported by the fundamental backdrop.

That volatility came to fruition as several cascading news headlines have come down in the last week beginning when Evergrande, a large property developer in China, announced that it would likely not be able to pay its financial obligations. Evergrande is widely reported to have around $300bn of liabilities, own 1300 real estate projects in 280 cities and is associated with 3.8million jobs per year. So it’s reach is wide and because of this the fear was that it would have a bleeding effect throughout markets. Because of China's opaqueness it is really hard for outsiders to gauge what is truly happening inside the country but I can give at least my view on what the fallout from Evergrande will be. I think the Chinese government will allow Evergrande to fail but use the country's trillions in reserves to limit the contagion of Evergrande’s liabilities. This will begin with containing the domestic financial risk in China to make sure the collapse does not become systematic. However, I doubt the Chinese government will be as benevolent with foreign holders of Evergrande debt. This view is supported as Chinese high yield bond indexes spiked but investment grade indexes barely moved on the Evergrande news. This indicates that investors in adjacent Chinese debt products do not expect the contagion to escalate into a widespread credit crisis. Also, the nature of China’s centrally planned economy limits the flow of capital outside the country and Chinese investors in Evergrande expect to be reimbursed...

Continue reading

Where Do We Go From Here?

Incredible to think about, but the S&P 500 has advanced over 18% year-to-date and roughly 30% over the last 12 months. From the post-pandemic low last March equities have rallied over 100%. I made the graphic above before the recent 2% sell-off, but nevertheless equities have bounced back much faster than any post-recession period in history. What’s more is that this rebound has been absent of virtually any volatility. The S&P 500 has notched over 45 all-time high closings so far in 2021 while going over 10 months without a 5% pullback. 

Recently our President sent out a letter conveying our premonition that markets would be undergoing a “transition period” whereas they would adjust to peak growth rates & liquidity, and also to reinforce why our investment strategy and philosophy is well positioned to move into this new phase (His letter is available here). When stepping back and taking into account the big picture of equity markets performance in the last 18 months we think it would make sense for markets to digest this strong performance and for volatility to increase. But despite this, looking forward earnings are projected to be strong and while perhaps tightening, liquidity will still be abundant and characteristic of past early tapering periods (see our note on this here)...

Continue reading

Taxing Times

 

Earlier this year stories started to break that the Biden Administration was planning to raise the capital gains tax rate on wealthy Americans to 39.6% and recently whispers are floating around that the new rate could be even higher. Rumors of rising taxes usually invokes an anxious response by markets especially after a strong run like we have had. But the effect to the overall market from the capital gains hike may not be as significant as people think as it will only affect a minority portion of today’s equity accounts. In 1965 80% of US corporate equity was owned in taxable accounts. Today only roughly 30% is owned in taxable vehicles with much of the US holdings shifting to tax deferred accounts which are not affected by capital gains taxes. Foreign investment has also eaten up a large share of domestic equity holdings as the US runs ever growing trade deficits...

Continue reading

Government Spending & Mid-Year Economic Review

Inflation continues to be the hot topic in financial markets and is shaping up to be a defining macro story of the next decade. One aspect of the inflation debate which we did not touch on in our Inflation Fixation note is what about the monetary and fiscal stimulus? US Government spending in response to fighting Covid was the highest since World War 2 at over 30% of GDP with more spending in the pipeline. The spending is high in a vacuum but it is also coordinated throughout the World by both Central Banks and Governments. What’s more is we have a new Presidential regime which has made spending a pillar of its social policy signaling that austerity is probably not in the cards.

Could this combination of a hesitant Fed, aggressive stimulus injection, and ambitious future spending goals signal that the Fed will be behind the ball on curbing inflation? Or will the structure of the economy and a calibration of supply chains revert the World to the muted inflation regime of the last decade?..

Continue reading

What Happens When the Punch Bowl is Taken Away?

 

Maybe some would say a good problem to have when considering where things were a year ago, but a primary risk to markets now is that the economy is overheating. We have made note of the inflation readings that have jumped meaningfully over the past several months, but why could this signal a risk for markets? Because it raises the possibility of Central Banks pulling back some of the stimulus which has helped support markets since last March. In response to the inflation jump Fed officials have been adamant about portraying the price spikes as transitory. But at the same time have begun to discuss the possible tapering of asset purchases leading many investors to bring forward their expectations for the first rate hike. In our view this will be the key source of volatility for markets in the second half of the year, particularly in August during the Feds annual Jackson Hole meeting where Chairman Powell is likely to signal a tapering of the Feds bond buying program...

Continue reading

Inflation Fixation

If you have tried to buy something like a car or washing machine lately you probably know firsthand about the challenges of lean inventories & price pressures and are not surprised by the surge in inflation readings that have filled media headlines. Inflation is not only salient because it affects businesses/consumers but also because of its effect on interest rates, and therefore asset prices. But inflation is also an economic phenomenon in the sense that it is maybe the most discussed financial topic but also the least understood by forecasters when applied to real world developed economies. In our January 2021 Economic Outlook we highlighted runaway inflation as a key risk for the economy in the New Year, but also why the long-term picture is not as clear.

The view by the Federal Reserve and one which we largely share is that inflation will be transitory driven by supply chain bottlenecks …  but transitory can feel like a long time. When you essentially turn off & turn back on the World economy it will take some time to find balances. Just like the economic data stunned us during the lockdown, the same is happening now with reopening. Very aggressive fiscal and monetary policy has led to a burst in reopening and many parts of the supply-side of the economy are simply trying to keep up. The hope is that shortages will start to ease as supply catches up to demand, but this won't happen overnight. We think we are at least several quarters away from the economy feeling more balanced. If we had to step out and make a forecast on inflation it would be one of phases: 1.) temporary burst in inflation as shortages from shutdowns drive up goods prices and reopening supports services pricing 2.) softening of inflation as economic growth rate peaks in second half of year and supply chains relieve themselves of bottlenecks 3.) labor market pressures push core inflation modestly higher at a faster pace than pre-covid due to wage inflation...

Continue reading

For Stocks, Time Really is Money

One principle of investing that we constantly reiterate because we believe it is so foundational is the concept of keeping a long term mindset in the capital markets. This is especially difficult in today's world that is rife with instant transmission of information and fast money strategies revolving around SPACs, Crypto, and reddit “meme” stocks. In fact it almost feels inhuman to be indifferent to the constant hurling of strong opinions easily transmitted through social media and instead see the big picture. But history has proven time and time again that the most effective strategy to growing wealth is to purchase shares of strong businesses at reasonable prices and then simply let time and compound interest do its work. Most American fortunes were earned via ownership of strong businesses for many years. 

 ..

Continue reading

The Armageddonists

Market drawdowns and Bear Markets are a reality when it comes to investing in the equity markets. Part of the reason equity holders receive a higher long-term return over ‘safer’ investments such as bonds is that they take on additional risk and the likelihood that their investment will be negative over stretches of time. Of course no investor wants to experience their investment losing money but this year illustrates perfectly why sticking to a plan and staying invested while owning proven enterprises with strong balance sheets is the prudent approach. This fact of investing is nothing new but the rise of social media and the competitiveness for media headlines since 2010 have given way to a flood of negative market calls which naturally appeals to human negativity bias and our survivorship instincts. This appeal strategy has worked in part because the flood of calls followed two of the deepest bear markets since the great depression: The Tech Bubble & Global Financial Crisis.

Of course, just as there is inherent risk with being invested in the equity markets, there is also risk in not being invested.This is through the opportunity cost of trying to time the markets by jumping in and out of investments or dramatically drifting away from asset allocations due to “Armageddonist” media headlines. For example, $1 shifted from equities to bonds in 2014 in response to mega-bearish commentary would have underperformed equities by roughly 40% as the S&P 500, propelled more by earnings growth than by multiple expansion, rolled on...

Continue reading

Most Recent Blog Posts

Connect With Us

 

Covington Investment Advisors, Inc.
301 E. Main Street
Ligonier, PA 15658
Phone: 724-238-0151
Fax: 724-238-0148
Email: covington@covingtoninvestment.com

This website uses cookies for navigation, content delivery and other functions. By using our website you agree that we can place cookies on your device. I understand