Markets remained volatile over the last month as economic growth continues to remain resilient in the face of persistent inflation, tightening credit conditions, and price surges in energy and food commodities. Consumer sentiment, an economic indicator that considers people’s feelings toward their current financial health, the health of the economy in the short term, and the prospects for longer-term economic growth, has turned negative in recent months, adding to market volatility.
According to the University of Michigan’s Consumer Sentiment survey, the decline in sentiment is “largely driven by continued negative views on current buying conditions for houses and durables (goods), as well as consumers’ future outlook for the economy, primarily due to concerns over inflation.” Negative consumer sentiment has pushed stocks and bonds into oversold territory, which has increased the potential for a near-term rally in both asset classes. However, it is our view that a near-term rally should not be misinterpreted as an “all-clear” signal for the markets as inflation and monetary tightening conditions remain headwinds going forward. While we may have seen a peak in headline inflation, the Federal Reserve interest rate policy is still far below the neutral rate, requiring continued interest rate hikes to normalize policy. As a result, the resilience of the consumer will continue to be tested.
Inflation – A Global Issue
In recent months we have discussed how the Federal Reserve has started to tighten monetary policy in an effort to combat inflation. However, inflation is not just a domestic issue. Other developed world economies and central banks are also grappling with the impact of inflation and rising energy costs exacerbated by the ongoing war in Ukraine. As global economies continue their recovery from the COVID-pandemic, global central banks have exercised caution when it comes to restricting monetary policy. Central banks have not wanted to risk their country’s economic recovery by raising interest rates and dampening demand, but rising inflation is forcing them to adjust course. Policymakers are becoming more “hawkish” so as not to lose their inflation-fighting credibility.
We have seen a meaningful rise in bond yields as investors react to rising inflation fears in US Treasuries and G7 bonds (see chart right). Christine Lagard, the head of the European Central Bank (ECB), announced they would end their net asset purchase program and said, “it is appropriate for policy to return to normal settings rather than those aimed at raising inflation from very a low level.” Interest rate policy is far from restrictive at current levels, but we will continue to monitor these developments.
Surging Energy Prices
The US is the world’s largest producer of oil, followed by Russia and then Saudi Arabia. One of President Biden’s first acts when his administration took office was to curtail oil and gas production on federal land, sending oil prices higher. To make up for the shortfall needed for the expanding US economy and increased demand for oil, the US bought and imported Russian oil. Oil prices were pushed even higher as Russia’s invasion of Ukraine ended the US purchases of Russian oil, thus further limiting supply. Oil is in everything, and nothing moves without energy. The increase in oil prices has contributed substantially to inflation. Oil prices have climbed as high as $130/barrel, and natural gas prices have also surged. The national average for a regular gallon of gas is approaching $5.00, almost a two-dollar increase from a year ago. Diesel fuel, primarily used in the transport of goods, is nearing $6.00 (see chart previous page). Unfortunately, there doesn’t look like there is any near-term relief in sight as China’s economy continues to come back online and their demand for oil increases. This will put continued upward pressure on oil prices.
The housing market experienced an acceleration in home prices as interest rates remained at historically low levels over the past few years. Low-interest rates allow consumers greater purchasing power, but as interest rates rise, their purchasing power becomes diminished. This year we have seen that scenario unfold as the 30-yr fixed-rate mortgage has climbed sharply higher, crossing the 5% threshold. As a result of the upward move in interest rates, home affordability has declined. For example, assuming a 20% down payment, the rise in mortgage rates and home prices just since December amount to a 42% increase in monthly payments on a new 30-year mortgage for the median new home.
As a result of the rapid rise in mortgage rates, housing (a historically interest-rate sensitive sector) has started to show signs of cooling. Home inventories (how long it would take to sell the current inventory at today’s sales pace) have increased to 9 months from the record low reading of 3.3 in mid-2020. This will have a cooling effect on home price growth, but price moderation could be moderate with a limited supply of homes. Additionally, homeowners that have refinanced their mortgages at historically low rates will be less willing to put their homes on the market, thus further limiting supply.
Despite higher interest rates, the demand for new homes remains very strong. Builders have been ramping up construction activity to help meet demand. The total number of single-family homes under construction is currently at the highest level since 2006. Strong housing demand and household formation growing since the pandemic will support home prices and rents going forward. Strong rent growth and the anticipation of a further decline in homeownership affordability may keep housing demand more resilient than usual in the face of rising mortgage rates.
Chart of the Month
For some investors, prolonged periods of market volatility or economic uncertainty can make it more challenging to “stay the course.” This month’s chart depicts the importance of staying invested over long periods of time and avoiding trying to time the market.