Q2 2022: PFM Quarterly Commentary
“From compression comes expansion” was coined by technical market analysts who observed that periods of unusually high volatility typically follow periods of abnormally low volatility. Naturally, it’s during these times of heightened volatility (i.e., now) when investors truly appreciate the tranquility which preceded. Here we’ll cut to the chase: one need not be a market technician to recognize that 2022 has been a dismal year for investments at large. A little analysis can help illuminate and quantify the sheer volatility already experienced in these last six months and offer at least some insight on the path forward.
To begin, let’s first define volatility to be periods of persistent selling rather than the occasional news-driven decline. Specifically, we think a reasonable metric would be rolling five-day periods of the S&P 500 that register a five percent decline. And to keep this analysis contemporary, we will begin with 2015. The first two years, 2015 and 2016, saw only three such instances and each were all clustered in August and January, respectively. Remarkably, 2017 did not showcase a single incidence, a fact that we highlighted on several occasions in our market commentaries that year. In 2018, volatility returned with a vengeance, primarily in the fourth quarter and driven by the Federal Reserve’s tightening efforts. That year notched twelve of these five percent decline events. Investor serenity returned in 2019 with only one observation in August. Unsurprisingly, volatility in 2020 exploded higher as a direct result of the Covid-19 pandemic and the year notched sixteen occurrences. The compression/expansion pattern continued with a zero-volatility year in 2021. Marching right along we find ourselves at the halfway point of 2022 and fourteen incidences have already been logged – you can see why we conveyed the message early in the year to fasten your seatbelts in expectation of a bumpy ride.
The point of this exercise is twofold. First, we wanted to demonstrate that aside from several intermittent event-driven drawdowns, investors have largely enjoyed a recent prolonged period of positive investment returns accompanied by historically low volatility. While delightful to experience, this lengthy stretch of tranquility removed the mechanism that normally punishes excessive risk taking and created complacency, thereby fostering speculation in certain investment areas that became the hallmark of the last bull market: unprofitable technology companies, SPACs (Special Purpose Acquisition Companies), cryptocurrencies, and NFTs (non-fungible tokens). Second, we wished to share that this year is on course to experience more downside volatility than any in the previous eight – and that includes 2020, when COVID emerged as a worldwide threat.
So, you’re probably wondering: what has caused the worst six-month start to the S&P 500 in sixty years, the steepest decline in the NASDAQ since the tech bubble burst two decades ago, and placed Treasury bonds on track for their worst year ever? If you follow our commentaries closely, you’ll already know that the answer is inflation and the country’s inability to stymie it. In our last quarterly letter, we explained that the Federal Reserve cannot rely on traditional rate increases to quell inflation due to the current level of the country’s indebtedness and the planned increase in debt over the next decade. If the Fed were to raise interest rates to a level commensurate with that of the last inflation crisis, we pointed out that the government’s finances would be decimated due to interest payment obligations alone, not to mention impact on the financial health of corporations and individuals.
Unfortunately, the Fed has another emerging problem – growth is slowing. Historically, monetary tightening has occurred during periods of positive growth; however, Gross Domestic Product (GDP) was -1.6% in Q1 2022 and the Federal Reserve’s own predictive model (called GDP NOW) calculated -1.0% growth in Q2 2022. Despite the country most likely being in a recession already, the Fed is supposedly embarking on its most aggressive tightening efforts in more than a generation. Unlike most in our industry, we’ve cast a dubious gaze on the Fed’s tightening roadmap ever since it was initially announced. Our analysis indicated that the Fed had one arrow left in its quiver and that was to relentlessly communicate their plan to tighten monetary policy – but importantly – never actually bring that plan completely to fruition. In effect, the Fed would aggressively cause tightening more by words than by actions. This interpretation may amount to a distinction without a difference, but to the contrary, this approach anchors short-term interest rates at near record low levels while leaving the door open to reverse course to stimulate growth without losing all credibility.
With traditional inflation-fighting tools unavailable and most inflation being sourced at the supply side of the economy, the Fed’s remaining tactic is intended to weaken growth just enough to reduce aggregate demand in hopes that inflation will fall as a result. The outlook of this approach is questionable at best and opens the door to the very real possibility of something worse: stagflation. Stagflation is when inflation persists at a stubbornly high level while overall growth stagnates. As we have all been experiencing for some time now, high inflation is uncomfortable enough when the economy is relatively robust and the unemployment rate low. Inflation would quickly become intolerable should growth continue declining accompanied by an increase in joblessness. With the economy tipping into recession and inflation rising ever higher to an annualized 8.6%, clearly the Fed will look to avoid stagflation at all costs. To us, the increasing possibility of stagflation means that the Federal Reserve will be unwilling to raise the Fed Funds rate to 4.50% (currently 1.75%), even though Jerome Powell has repeatedly stated this intent. To that end, we anticipate the Fed will announce the premature end to its tightening plans in the coming months. While this view may lie outside the consensus opinion and stand in direct contradiction to the Fed’s long-standing narrative, the Fed Funds Futures market (a financial instrument used by large financial institutions to wager on the direction of Fed policy) is now pricing in interest rate cuts beginning in Q1 2023. At least for now, some participants in the financial markets agree with us.
It can be difficult to keep a positive perspective when markets are falling sharply, but keep in mind that they are inherently and inexorably cyclical. While uncomfortable, this period of high volatility will eventually pass and lead once again to calmer days – with patience and perseverance we’ll reach the other side together.
Peak Financial Management
Additional information, including management fees and expenses, is provided on our Form ADV Part 2, available upon request or at the SEC’s Investment Advisor Public Disclosure site, here. With any investment strategy, there is potential for profit as well as the possibility of loss. We do not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. Past performance is not a guarantee of future results.