I thought it appropriate this week, since we're experiencing rising inflation akin to the 1980s, to channel my inner hair-band. One of the last great acts of the hair-band era was Guns N' Roses, with their super tight leather jeans and strong guitar rhythms.
Their 9-minute song "November Rain" hit the charts in 1991. What is less known, however, is that the song was originally written in 1986 and was considered for edition to their debut album "Appetite for Destruction." In fact, according to former bandmate, LA Guns guitarist Tracii Guns, Axl Rose began working on the song as early as 1983 - therefore it qualifies as my hair-band inspiration. You can actually listen to the piano demo recording of "November Rain" as it was being considered for their debut album (click here). The song reminds me of the state of the markets - two people (investors and the Fed) have accepted that their relationship has come to an end, but neither has the strength to admit it.
"Nothin' lasts forever
And we both know hearts can change
And it's hard to hold a candle
In the cold November rain"
Let's look at what we've seen so far this week and how the the market & the economy are constantly changing...
Nothing Lasts Forever. Investors continue to "buy-the-dip," which is why the decline in markets over the past 5 months has felt somewhat calm. In 2020, at the beginning of the pandemic, the VIX (volatility) spiked 3x in just two weeks, ultimately increasing 550% at the peak on March 18th, 2020. This year, the VIX saw an initial spike of 90% in February, only to settle down below the original lows of the year by the end of March and has increased but not reached the original high of February 24th.
Meanwhile, the S&P 500 Index has sold off 19% from peak to trough this year. Equities have bounced around, but have yet to reach investor capitulation. This phenomenon is due to investors buying the dip. You can see in the chart of S&P 500 movement that approximately 19 times over the past 2 years investors have bought the dip. The problem - investors have continued buying the dip as the market has sagged. The trend, until January of this year, has been a rising market in light of the various dips. That is no longer the case with rising inflation, rising interest rates, and lack of confidence that the Fed can achieve a "soft landing." Expect investors to continue in this practice until we see either the VIX (volatility) or the TED Spread (panic) spike in a meaningful way. While markets may see a relief rally, it's likely to be short-term in nature, meaning there could be pain for investors ahead.
Hard To Hold A Candle. As we noted last week, there are cracks in the system that are starting to emerge and there are similarities to previous pre-recessionary periods. The key element now holding everything up is the consumer. Retail Sales for April came in this week as expected (+0.9%), but down from last month (+1.4%). However, consumer behavior is changing. With gas prices hitting fresh 10-year highs ($4.61/gal national average), retailers passing along inflationary costs, and interest rates now affecting mortgage applications, consumers are actively changing their behavior.
The lower-income households are adding to Revolving Credit (credit cards), as we pointed out last week, at a record pace. Excess cash has declined as the Savings Rate is now below the historical average. What's equally as telling is that Consumer Staples had been holding up well versus Consumer Discretionary, until just recently. At the end of the 1st quarter, Consumer Staples were up 1.53% while the Consumer Discretionary sector was down 20.85%. As of yesterday, Consumer Staples is now down 9.75%, compared to Consumer Discretionary down 23.64%. The consumer has been shifting to essentials and, perhaps, some of those essentials are now being pared back to the bare minimums.
Why - because prices everywhere are rising. Even for the lower-income households that go out to purchase a hamburger (not exactly steak tare tare), the average price has increased more than 10%. Each element of a hamburger, not including the rising costs of eating at a restaurant (wages, utilities, insurance, etc.), has increased with the supply chain disruptions and rising inflation overall. Of the 500 S&P companies who have reported Q1 earnings, 85% have cited inflation as a major concern moving forward.
When consumers substitute a hamburger purchased at McDonald's for a sandwich made at home, then the economy begins to slip into recession.
Cold November Rain. The reason many economists and investment banks are now doubtful of the Fed achieving a "soft landing" has to do with the massive stimulus pumped into markets and the lack of response from the Fed until recently.
When we look at what was spent by the government during the pandemic and how much the Fed purchased assets, the numbers are staggering. The six primary laws that funded pandemic relief totaled $5.4 trillion. For some perspective, government spending is typically 17% of U.S. GDP, which is roughly $4.4 trillion. That means that stimulus spending during the pandemic was 120% of the typical annual government spending.
The Fed increased its balance sheet by $4.7 trillion, which when combined with government spending, means total pandemic stimulus was more than $10 trillion. This caused consumer demand during the pandemic to remain high while supply was limited due to the shut down and restart. Inflation, as a result, has run rampant. Meanwhile the Fed "pretended" that inflation was "transitory" and failed to keep the economy from running hot. Now, the market simply doubts the Fed. To complicate matters more, there's uncertainty around the Fed's ultimate response. Is 75 basis points on the table or not? Is a "soft landing" possible or not? The way the Fed has been speaking lately, who knows.
Financial Planning Note of the Week: With the possibility of recession increasing, clients with financial plans that call for major home improvements, major discretionary purchases (vacation home, new car, etc.) or other purchases that are not immediately necessary, should be warned of the potential for recession. Any major purchases that can be postponed should be pushed off into the future. This is the time when most consumers doubt the likelihood of a recession and keep spending as if everything will remain normal. Consider halting major purchases for the time being. What's the worst that will happen? The recession doesn't happen and you have plenty of cash to proceed with a planned purchase? Better to be in that scenario than the alternative - made the major purchase at peak prices only to see a recession hit and earned income get squeezed.