In the event you have watched the news lately and noticed stock prices have been struggling, here are some of the reasons and what we might expect moving forward.
Stock markets usually decline for one of two reasons. There is either a crisis or a correction after a run up. There are also several factors that influence the price and direction of stocks. Let’s break it down into smaller pieces to help explain the current situation.
The Fed & Inflation
The Federal Reserve has two mandates. The first is to keep inflation in check and the other is to achieve full employment. The generally accepted level for full employment is an unemployment rate somewhere around 3.5%.
The Fed has three levers it can pull to accomplish its mission. The first is by raising or lowering the Fed Funds rate, a short-term interest rate. The second is increasing or decreasing the money supply. The third, and lesser known, is setting bank reserve requirements (we’ll leave that one for another time).
In 2008, the Fed has lowered the short-term rate to zero. Since the pandemic, the Fed has ventured into new territory with a tremendous increase in the money supply. More specifically, it has been adding about $240 billion per month to the money supply. More could be said on that, but we’ll leave it there for now. The bottom line is this, the Fed has had an easy monetary policy in place for quite a while. But change is coming. The Fed will discontinue all additional stimulus (i.e. $240 billion per month) by the end of March. It will also begin to raise its Fed Funds rate immediately after that, with an estimated 4-7 rate hikes over the next 12-18 months. Thus, the Fed is changing its policy from an easy policy to a tightening one.
Why is the Fed changing its policy? Because inflation is hitting levels not seen since 1982. However, inflation is a function of supply versus demand. When demand is strong and supply is weak, prices rise. That’s the case now. Hence, the Feds actions are designed to slow demand. Unfortunately, the Fed cannot do anything about supply, which is where the current problem resides. This is why there is a concern that the Fed will go too far and cause a recession. If it slows demand too much, especially if the supply chain problems correct, a recession is a strong possibility. The Fed has a very difficult task since we no one knows exactly when the supply chain issues will resolve.
Russian Aggression in Ukraine
Despite Vladimir Putin’s comments about staying out of the Ukraine, Russian troops marched across the border this morning, causing some panic in the global financial markets. Putin would like to resurrect the power of the old Soviet Union, and expanding its territory seems to be his preferred method (hint: Crimea in 2014). Most believe Putin’s actions are intentional and well calculated. For example, as a result of the Russian incursion, oil prices have spiked. Why is this important? Russia is one of the world’s largest producers of natural gas and oil. Both comprise a major portion of Russia’s income.
How much will Russia’s actions affect the financial markets? It depends on how far Putin intends to go and how long it lasts. In any event, the problems will be felt more in that region of the world than in the United States. Nonetheless, the U.S. and the U.K. have already levied sanctions on several Russian banks and a few wealthy individuals. Enough geopolitical banter.
Although Russia’s aggression has caused stocks to head lower, I’m more concerned with the actions of the Fed than with Putin. The financial markets have routinely overacted to events, and I believe the Russian reaction is another such instance. We’ll know soon enough.
Now that interest rates are normalizing and the Fed is removing the punch bowl, the party may indeed be nearing its end, but rest assured, there will be another party emerging at some point. The question is: How long will stocks struggle? Unfortunately, no one knows for sure. What we do know is this, stocks are a great way to profit from the economic strength of America and will reward those who stay the course. Thus, at this point, it may be best to ride it out, raising a little cash for buying opportunities, and keep a watchful eye on the Fed, inflation, and of course, on Putin.