The Problem with Inflation... Halfway into June and the persistent pressures that have defined markets in 2022 continue unabated. The cast of influencing characters remains the same – many we have touched on in prior monthly updates. With rekindled selling pressures across most major assets, focus has shifted squarely back to the primary issue that has catalyzed this year’s downside – inflation. These days you’d be hard-pressed not to hear about the inflationary difficulties plaguing nearly all aspects of the global economy. This past year, we have all noticed the steady creep of prices across a wide spectrum of our daily lives – from gas prices to groceries and everything in-between. Confirming our anecdotal experiences, these trends are evident in today's broad inflationary measures that are now reaching generational-high levels across all of North America:
When examining the current inflation, the conversation usually begins by addressing the contributing role of COVID support policies followed by an array and buzzwords like “money printing”, “stimulus”, and “supply chains”. Most if not all of these variables have played a part in catalyzing the current inflation. All in all, it comes down to this: for the last two years too much money has chased too few goods across an impaired global manufacturing system. If like for me, this dynamic elicits the visual of the supply and demand charts from economics courses of years past, then the outcome of this dilemma bears little surprise – price goes up. While linking the problems described above to the current inflationary pressures is intuitive for most, understanding the link back to the markets and understanding why it has been driving such sustained downside is less so. You may be familiar with the saying “a dollar today is worth more than a dollar tomorrow”. In finance, this relationship is known as the time value of money and is aimed at illustrating how inflation can erode the value of money over time. A good illustration of this phenomenon is the cost of a can of coke in the 1950s relative to its cost today.
The rise in broad inflation metrics over the last year, has permeated into all aspects of the economy, affecting corporate sales and margins, as well as curbing consumer spending as cost pressures exceed wage growth. Translation: an increased risk of slowing economic growth. The other side of the coin is how the lenders respond to these conditions - as they demand higher compensation to ensure returns exceed escalating inflationary pressures. In other words, higher debt service costs and, you guessed it, slower economic growth. Last but not least, we can’t forget the influence of central bank policy in trying to tame inflation through restrictive actions. With their influence on short-term interest rates and bank reserves, central banks are increasing the cost of debt for businesses and consumers in an attempt to reduce demand and lower prices. On-trend, the unavoidable impact of these actions is slowed economic growth. Year to date, stocks, bonds and other assets have continuously re-priced the risks of persistent inflationary forces and their adverse impact on growth. This has resulted in one of the worst starts in history for both stocks and bonds, rendering modern portfolio diversification and risk management practices ineffective at cushioning the impact of the market decline. This is clear in the following illustration of balanced portfolio performance year to date:
As we move through the summer months and into the fall, global investors are likely to remain squarely focused on the inflation story; its impact on corporate earnings growth, central bank policies aimed at cooling it, and whether the economy will remain resilient or tip into a recession. Despite some early signs pointing to pockets of inflation cooling (below), a hot summer travel season following two years of postponed plans has added new pressures that will likely keep data noisy for the short term and muddle the inflationary outlook until the fall.
While this may cause continued market volatility over the summer months, we believe that given time, this latest episode will also subside and market headwinds will give way to tailwinds as the next economic expansion begins. While corrections, bear markets, and discussions of recession are investment outcomes that we would all prefer to avoid, the fact remains that these are normal parts of a functioning market. This fact is illustrated below and shows investors who've stayed the course during history's major corrections have more than made up for any short-term losses through subsequent recovery and bull markets.
