Have you ever known somebody who frequently states the obvious? Their statements might be superfluous and really not necessary; as if they like to hear themselves talk or simply feel it necessary to contribute to the conversation. A slang term for such a person would be Captain Obvious. A few years ago Hotels.com even ran an ad campaign centered around a fictional Captain Obvious who still has many humorous memes floating around the internet. Often the economic reports that receive so much attention and move the markets in the short-term do just that – state what we already know is occurring in everyday life. A great example of this was the Consumer Price Index (CPI) report on inflation last week, which simply confirmed what most of us are experiencing with inflation.
The stock market showed promise to begin the week and some people were thinking the worst may have been behind us, but those hopes were, yet again, quickly dashed later in the week. Fears over continued inflation sent markets lower Thursday with Friday being even worse after the CPI report on inflation remaining at the highest levels in 40 years. When you break out the inflation report, much of it was attributable to higher energy costs, especially gasoline. It was therefore no surprise the University of Michigan Consumer Sentiment Index reached its lowest recorded value, comparable to the trough of the 1980 recession. This index measures personal financial outlook, which worsened with 46% attributing negative views to inflation; a number only exceeded once since 1981. Numerous surveys are showing that consumer sentiment and financial outlook are quickly deteriorating due to fears over rising inflation and higher energy prices.
In response to the higher than expected inflation reading, bond yields spiked pushing bond prices lower. The bond market is already experiencing its worst year ever and not expected to improve. Fixed income is not providing the same type of diversification is has the past 40 years so it is time to consider other alternatives as diversification to equities, especially if you are looking to maintain your income stream. Eventually higher bond yields will lead to some investment opportunities but if inflation is over 8% and bond yields are in the ballpark of 3-4% you are still losing purchasing power.
Energy Prices are High!
Stating the obvious to anyone who has had to fill up their car with gas recently or uses natural gas in their home, energy prices are high and continue to climb. As was previously mentioned, the CPI report showed that inflation was driven primarily by higher energy prices since the cost of petroleum products affect most goods produced, either as a direct input or through the cost of transportation. With inflation remaining stubbornly high, it is expected the Federal Reserve will raise short-term interest rates another half percent at their meeting this coming week and continue on this same path at the two subsequent meetings in July and September. In theory, more restrictive monetary policy and higher interest rates should lead to lower consumption and demand, however it is doubtful energy demand is going to significantly subside over the next several years and therefore there is fear Fed will have little power to rein in inflation. And in the meantime, our economy will be hampered by tighter monetary policy. This is not a good combination.
Eventually alternative energy sources could alleviate the demand for fossil fuels but it will take many years for this to occur on a large scale. Since supply is not keeping up with demand and demand is expected to continue to increase as the economy expands, the only way for prices to drop is to increase supply. What is hindering domestic supply now are federal government policies regarding drilling leases and limited refinery capacity. Until restrictive government policies are eased and/or there is a thawing of geopolitical tensions, which seems unlikely, we can most likely expect higher energy prices for the foreseeable future.
The most watched event of the coming week is the Fed meeting, but as was mentioned earlier, it seems a half point rate hike is a foregone conclusion so there are likely to be few surprises to move the market. The Producer Price Index (PPI) will be released Tuesday, which measures wholesale prices before goods are sold to consumers and therefore tends to lead CPI. The PPI has shown annual price increases of greater than 10% the past few months with elevated CPI numbers being reported in following months. We do not expect it to be any different this time. A lower than expected PPI report does have the potential to give stock markets a boost but we would not count on it. Retail sales for last month, which have become a key focus of late since it gives an idea of the state of consumers, will be released on Wednesday but they will most likely be overshadowed by the Fed meeting later in the day.
Historically there tends to be added volatility at the end of June since it also marks the end of the quarter, but markets tend to settle down afterwards into the later summer. Since it was such a dramatic pullback in the stock market last week, we could see a short bounce this coming week. However, we remind our clients that instead of focusing on the short term, we encourage you to remain focused on your long-term objectives. With the expectation that bond yields will continue to rise, we continue to think the stock market is the best place to be invested even though we expect further volatility. Commodities are currently working well, but it should be cautioned commodities can be very volatile and have the potential to drop in value quickly. Case in point: lumber prices which have fallen 60% since March on expectations for lower demand due to a decrease in new home purchases.
There are many factors affecting the markets currently, as there always are, so take a step back and look at what is happening. Market downturns generally provide great buying opportunities which often times look obvious in hindsight. Instead of waiting for the future to look back, this is a good time to consider the present and how to best position your portfolio. We are here to help you ensure your investment are properly positioned for what lies ahead.
Have a great week!
Nathan Zeller, CFA, CFP®
Chief Investment Strategist
Please contact us if you would like to review your individual financial plan or learn how the TaxSmart™ Retirement Program can help you.
Office phone # 952-460-3260