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Seeking Signposts in Unsettled Terrain
Plus October Market Report

John Gorlow | Nov 18, 2022


A soaring market is not always enough to erase fear. We witnessed that earlier this month, when a stupendous one-day rally raised the S&P 500 by over 800 points but did little to quell investors’ concerns about inflation, interest rates, or recession. We live in highly unpredictable times. With slurries of unsettling news flowing into the markets from all directions, what can we read in the turbulence?

Markets rose steeply on November 10th when Consumer Price data showed that prices rose more slowly than economists had predicted. The reaction was stunning, with the S&P 500 gaining 5.5%, its biggest single-day jump in more than a decade (excluding the wild swings of Spring 2020). The Nasdaq climbed 7.4%. The yield on the two-year Treasury note dropped from 4.628% to 4.324%, and the benchmark 10-year yield fell from 4.149% to 3.828%, their biggest one-day declines since 2008 and 2009, respectively.

The cause of the rally seems obvious. If inflation cooled down, the Fed could end aggressive interest-rate increases, and stocks and bonds could rally in a big way. But that may be wishful thinking. Analyses of current price pressures and the history of inflation cycles suggest a different story, says Randall Forsyth (Barron’s, 14-November 2022). Forsyth references a paper by Rob Arnott and Omid Shakernia of Research Affiliates, examining data from 14 advanced economies going back to January 1970. When year-over-year inflation rises above 8%, as has happened with the CPI this year, it doesn’t recede quickly but tends to accelerate 70% of the time. When inflation crosses that 8% threshold, it becomes more intransigent, requires more restrictive monetary measures to budge, and hangs around for up to a decade. The silver lining: there’s a 30% chance this won’t happen, according to the research.

And yet, Arnott and Shakernia warn, “We dismiss that possibility [of high, persistent inflation] at our peril.” Forsyth adds that “the exuberance with which stocks and bonds greeted the latest CPI reading indicates that they’re dismissing history. The Fed evidently is, too.” The bond market seems unperturbed, he points out. The “break-even inflation rate”—the difference between the nominal yield on Treasury notes and the yield on comparable Treasury inflation-protected securities (TIPS)—has moved lower in recent months. Earlier this year the markets were expecting the consumer price index to average about 3.5% over the coming five years. Now it has slid below 2.5%.

Perhaps we’re just weary of thinking things will get worse, even as global problems compound.

Welcome to the Global Polycrisis

Whether you’re a glass half-empty or a glass half-full kind of person, you can’t help but feel some dismay over the growing array of crises piling up on the global front. Adam Tooze, a professor and Director of the European Institute at Columbia University, points to an interesting phenomenon called a “polycrisis,” which he defines as “a problem [that] becomes a crisis when it challenges our ability to cope and thus threatens our identity. In the polycrisis the shocks are disparate, but they interact so that the whole is even more overwhelming than the sum of the parts (Financial Times, Opinion, 29-October 2022).”

We’re seeing that now, as so many economic and non-economic issues are intertwined, and therefore not easily addressed. These include “pandemics, closing factories and overloading hospitals, drought, floods, mega-storms and wildfires and threats of a third world war; each crisis is hard enough to parse by itself,” Tooze writes.

Lawrence Summers describes the current situation as “the most complex, disparate and cross-cutting set of challenges that I can remember in 40 years.”

We can see how some problems spiral into others: cheap money fueled growth, which in turn fueled inflation, which made central bankers raise rates to cool down prices. Higher rates beat up the markets and now threaten to tip the global economy into recession. And then there is war to contend with in Ukraine, and its impact on inflation and the world economy. A slowdown in China. A melting tech industry. And of course, a polarized U.S. electorate that can’t agree on solutions to anything. You get an idea of how the problems spool together until the ball of yarn becomes too big to unravel.

In a recent Barron’s interview (14-November 2022), Ray Dalio shares three ideas about the key forces driving today’s uniquely challenging issues. “One is the big debt levels and debt increases that central banks have been supporting by buying a lot of debt with the money they are printing. A second is large internal conflicts within countries between populists on the left and the right. This conflict has big implications for taxes, how the wealth pie is divided and how our system works. A third is conflicts among countries over wealth, power, and ideologies. We’re seeing that now between Russia and Nato, China and the U.S., and other countries.”

None of these could be called a small problem. And yet, are we powerless to fix things? The standard line for a while now is that big tech will lead the way through with brilliant, innovative solutions. It’s as though no one else needs to have agency if we believe this to be true. But tech is having its own meltdown moment. Still, “Modern history appears as a tale of progress by way of improvisation, innovation, reform and crisis-management,” says Tooze. “We have dodged several great depressions, devised vaccines to stop disease and avoided nuclear war. Perhaps innovation will also allow us to master the environmental crises looming ahead.”

I like the wisdom of Stephen Pinker, a professor of psychology at Harvard University, who advises a different way of understanding all the dire predictions. “Journalism is a non-random sample of the worst things that are happening on earth at any given time. When you look at the world through the lens of data, rather than events, it looks much more positive,” he says (Financial Times, 23-November 2022).

Perhaps. We’ll give Tooze the last word on the polycrisis, and hope that he is wrong. “The more successful we are at coping, the more the tension builds. If you have found the past few years stressful and disorientating, if your life has already been disrupted, it is time to brace. Our tightrope walk with no end is only going to become more precarious and nerve-racking (FT Opinion, 10/29/22).”

And Then There’s (Maybe) A Recession

Since we’re talking about uncertainty and seemingly intractable problems, let’s touch on the possibility of recession. Has the market already discounted a recession? Is it priced in? Is it here already? How long will it last?

At Cardiff Park we stay away from the prediction business and let others read the tea leaves. This month we summarize thoughts from an opinion piece by Ruchi Sharma, Chair of Rockefeller International (Financial Times, 6-November).

“Economists tend to think in small incremental steps, missing big turns in the story, which helps explain why their consensus view had not forecast a single U.S. recession since records began in 1970—until now,” Sharma writes. You can almost hear the laugh in his next line: “For the first time, economists as a group not only expect a recession in America in the next year, but give it a very high probability, more than 60 percent. Given their record, it’s worth asking whether the consensus is, in fact, unlikely."

He describes the kind of supporting evidence we would need to see for “the unexpected scenario,” that is, no recession in the coming months. Inflation would have to decline rapidly, the Fed would back off from further tightening, and supply chain bottlenecks would resolve to lower inflation faster than expected. We’d also see “cargo shipping prices plummeting, delays at ports shortening, and the Fed’s ‘supply chain pressure index’ coming down sharply. China’s economy is in a funk and is exporting slower inflation to the rest of the world. Goods inflation is decelerating with prices for everything from used cars to energy now in decline.”

And yet, Sharma continues, many anticipate that the Fed will follow the playbook of the early 1980s, raising rates aggressively “and averting an inflationary wage-price spiral by inducing a recession.”

But is that really needed? Sharma believes that “…for now America’s economy still seems far away from recession territory. Weak growth in the first half of this year vanished in the third quarter, when US GDP grew at an annual rate of 2.6 percent. Disposable incomes are keeping pace with inflation, encouraging healthy growth in consumer spending. Spending on travel is stronger now than on the eve of the pandemic.”

Adding to that, he points to corporate capital expenditures that are growing much faster than business revenues and earnings, and a very low unemployment rate, despite all the Fed tightening. “None of this is what one would expect on the eve of a recession,” Sharma concludes.

And it’s always possible that we will be treated to happy surprises on the upside, including peace in Ukraine or a warmer than usual winter that doesn’t throw Europe into an energy crisis. (Recall our previous discussion about a polycrisis and how current economic issues intersect with disparate global events.)

In the end, Sharma turns to the markets as the best predictor of a recession. “Going back to the second world war, the U.S. stock market has typically fallen at least 20 percent and bond traders have always pushed short-term yields above long-term yields in the months before a recession. Both of those market signals are warning of a recession now, so to picture alternate outcomes may be magical thinking,” he concludes.

The Long View

We have no way of knowing which of many possible outcomes is most likely. No one has been able to reliably identify major shifts in economic cycles in real time, and a bull market could begin at an unlikely moment. There’s an adage that markets are like a bellwether, falling before the economy notices things have soured, and rising while the economy is still in the doldrums. As I write this, markets are trying to rise; we’ll see if that lasts.

Since 1928, the first month of a bull market has, on average, produced a 15.2 percent gain; for the first three months, the gain has been 31.6 percent, according to Bespoke Investment Group (Jeff Sommers, New York Times, 21-October 2022).

Markets are fickle. It is a wearying and taxing waste of time trying to predict their next move. In fact, market movements should have very little bearing on your peace of mind. Here’s why: We have constructed your portfolio to complement your financial structure, hedge your financial liabilities, and move you toward specific investment objectives with high-confidence outcomes in mind.

Your liquid portfolio is only one component of your total financial structure. Our approach to wealth management brings all factors of your financial life into consideration to build a highly tailored portfolio, taking risk where appropriate to support the precise timing of your essential spending and discretionary objectives.

Portfolio returns are important, but if you become overly stressed with what the market is doing in the middle of a steep or prolonged downturn, remind yourself that what we are really doing is managing towards outcomes. In other words, immunizing your risk of failure to safely reach the place you are heading, and the goals you have set. Periodic returns are just one subset of that total picture.

Enjoy your Thanksgiving holiday and stay well. Count your blessings. I am thankful for my wonderful clients, who know how to stay the course and are not easily swayed by good or bad news. That said, let’s hope for good news and positive outcomes in the months and year ahead.

October Monthly Report
Courtesy of Avantis Investors

After plunging in September, global stocks rebounded in October. Expectations for a pending slowdown in the pace of monetary tightening contributed to the rally. Meanwhile, Treasury yields continued to climb, and bonds delivered another monthly loss.

Despite still-high inflation, rising interest rates and mixed earnings and economic data, the S&P 500 Index gained more than 8% in October. Recession concerns led to market speculation that the Fed may reevaluate monetary policy.

All sectors of the S&P 500 Index advanced in October. The energy sector was the strongest, up nearly 25%, while communication services was the weakest, up 0.1%. The technology sector gained nearly 8%, even as several large, high-profile companies reported disappointing earnings.

Following a first-half decline, the U.S. economy grew 2.6% in the third quarter, largely due to energy exports. However, the GDP report showed consumer and business spending weakened amid high inflation and rising interest rates.

Hopes for a shift in central bank policy also contributed to gains for non-U.S. developed markets stocks, which rallied but underperformed U.S. stocks. Emerging markets stocks generally declined for the month, largely due to weakness in China’s equity markets.

With inflation at a record high, the European Central Bank hiked interest rates another 75 bps, bringing borrowing costs to their highest level since 2009.

U.S. inflation eased slightly in September to 8.2%, but core inflation rose to 6.6%. Against this backdrop, U.S. Treasury yields continued to climb, and bond returns declined.

Fixed-Income Returns

Elevated inflation and expectations for the Fed to continue raising rates through year end pushed Treasury yields higher in October. Most bonds posted declines for the month.

The Bloomberg U.S. Aggregate Bond Index declined 1.3% in October, as all index sectors posted losses.

Soaring mortgage interest rates and lack of demand continued to weigh on the MBS sector, which underperformed Treasuries and investment-grade corporates. Meanwhile, high-yield corporates tracked the U.S. stock market and rallied for the month.

Municipal bonds declined modestly for the month, but they fared better than Treasuries and taxable investment-grade bonds.

Five- and 10-year inflation breakeven rates rose in October, and TIPS rallied. TIPS outperformed nominal Treasuries, which declined and underperformed the broad bond index.

Inflation and rate-hike expectations continued to push Treasury yields higher. The 10-year Treasury yield jumped 22 bps to 4.05%, while the two-year Treasury yield rose 21 bps to 4.49%. Accordingly, the yield curve remained inverted.

Headline inflation eased slightly to 8.2% (year over year) in September, while core inflation jumped to 6.6%. Rising prices for services (shelter, transportation, medical care) and new and used vehicles largely drove core inflation higher.

If you have questions or concerns about your asset allocation, or if your life circumstances have changed in ways that require a portfolio review, please contact me. I am here to help.


John Gorlow
Cardiff Park Advisors
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