September 2022

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Following the Great Financial Crisis, global economies entered a lengthy era of financial repression, characterized by extremely low interest rates.  Traditional asset allocation frameworks required adjustment because current income was so paltry.  Financial assets benefited tremendously from the low interest rate policy regime.  In 2014, concerned about the inflationary potential of excessive liquidity, the Fed embarked on a gradual process of policy “normalization” that was interrupted several times, most recently by the pandemic in 2020.  Monetary and fiscal policy support during the acute phase of the pandemic was orders of magnitude larger than during the Great Financial Crisis.  In effect, COVID extended the era of financial repression well beyond original expectations.

Thus far, the post-pandemic era has been characterized by uncoordinated economic and health policy, periodic supply chain disruptions, unreliable data, and consumer behavior modifications.  These factors contribute to wide variations in economic forecasts.  Disagreement over the state of the economy contributes to fierce debate over policy.  Some believe the enduring impact of the pandemic and associated policies will be persistent high inflation.  Others argue removal of liquidity will engineer a recession, characterized by deflation.  Acknowledging a greater threat from inflation, the Fed has led other central banks in terms of tightening monetary conditions.  The era of financial repression is now officially over.

According to several convincing studies, supply chain disruptions accounted for 40 – 60% of post-pandemic inflation.  Consumer hoarding exacerbated shortages, and numerous companies misjudged inventory needs.  However, recent indicators confirmed that resolution of bottlenecks was alleviating cost pressures.  The growth rate of rent increases has declined sharply in several major metro markets.  Despite the war in Ukraine, crude oil prices have returned to levels that existed at the beginning of the year.  Other data confirm a sharp decline in global manufacturing activity.  These and other data contributed to the widely held perception that inflation peaked over the summer.

Market participants expected confirmation of peak inflation in the August CPI report.  In addition, the market had priced in moderation of rate increases at the end of 2022 with a “pivot” to rate cuts by Q2 2023.  Instead, the August CPI report was worse than expected with data that suggested peak inflation remained elusive.  The Fed addressed the report with an aggressive commitment to taming inflation and recession as an acceptable outcome.  The markets responded violently to the hawkish posture and quickly re-calibrated a higher endpoint for rate increases.

The stock market has not been the only casualty of tighter policy.  In fact, long maturity bonds have performed worse, and few asset classes have been spared from tighter liquidity conditions.  Gold and precious metals have failed to serve as effective inflation hedges.  Tighter policy also contributed to the fastest decline in home affordability in history as the national average on 30-year fixed rate mortgages rose from 3.30% on 1/3/2022 to 6.83% on 9/30/2022.

As we look forward, however, we note that, for the first time since 2007, cash and bonds offer attractive yields.  Income strategies no longer require an over-allocation to dividend paying equities.  Municipal bond yields are extremely competitive on a tax equivalent basis.  Market- and survey-based indicators confirm long-term inflation expectations remain anchored.  While we acknowledge the probability of recession has risen substantially, the principal cause of this year’s market volatility is the rate normalization process.  We believe the Fed is approaching the end of the cycle, and in the event, we expect volatility will decline.  For these reasons, we urge investors remain opportunistic and focused on long-term strategies.