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Why Economic Volatility Isn't Going Away

Strategas Economic Outlook

When COVID‐19 arrived on U.S. shores more than two years ago, we shuttered the economy almost completely in an attempt to limit transmission and keep hospitals from being overwhelmed.

To combat this freeze, government officials enacted unprecedented fiscal policy (including stimulus checks and enhanced unemployment insurance) and monetary policy (such as zero percent interest rates and bond purchases). And in many ways, these policies were successful. With the support of these programs, U.S. consumer spending recovered quickly and the Covid‐19 recession was one of the shortest ever recorded.

However, given today's overheated economy, some have begun to argue that the programs were too successful. Because of the pandemic limitations and income‐replacement policies, spending on goods skyrocketed while spending on services cratered. This created a major backlog in global supply chains (which were already challenged by COVID‐19 lockdowns) and drove up prices for goods substantially. Perhaps the best example of this is the approximately 60% increase in used car prices we have seen since the summer of 2020.

Though this has been a challenging period, much of this could be explained away by pandemic‐specific issues that we expect to revert back to normal as COVID‐19 fades. The problem today is that after a year of these imbalances, inflation is starting to seep into other, "stickier" components (ones often set by contract, like rents and wages). Inflation expectations are also rising, which can be a troubling, self‐reinforcing mechanism – if you expect prices to rise in the future, you might stock up on something today, further contributing to inflationary pressure. Sticky inflation is a far more challenging problem to address.

Even further, the recent spike in commodity prices (particularly oil) is compounding the issue. Energy shocks are a brutal one‐two punch: they drive up inflation in the near term, but can have devastating longer‐term effects as well (i.e., if the shock is sustained, it will eventually destroy demand and drive up unemployment). Energy is also an input cost for food production, transportation, manufacturing, and more – as energy prices rise, other industries will likely be forced to raise prices too. As long as there are geopolitical disruptions abroad, commodity volatility seems likely to continue, especially given the constraints on traditional energy production.

This all puts the Federal Reserve in a very difficult position, as they attempt to lower inflation without choking off the economic recovery and the strength of the labor market. Their first goal is to get from emergency policy (0% for their benchmark Fed funds rate) to a more neutral setting of 2‐3%, and they have already laid out steps to get there over the next year or two. They should also begin to let their balance sheet decline (which has grown to around $9 trillion from around $4 trillion pre-pandemic). Higher interest rates make borrowing more expensive, which could mean higher mortgage rates, higher auto loan rates, higher variable rates on credit cards, higher cost of capital for U.S. companies, and on and on. So there could be plenty of downside as the Fed intentionally tries to slow economic growth.

Taken together, there's little doubt the Fed has the tools to contain inflation – the question is just how aggressive they will have to get. And with domestic labor markets overheating, central banks cannot "wait and see" like they might have in other periods of global uncertainty. In the end, inflation should peak sometime in 2022, but getting back to the Fed's target level of 2.0% will remain a substantial challenge.

In addition to being a major economic issue, rising prices are also a political quagmire during what should be a contentious midterm election cycle. For the first time in many years, polling suggests that the U.S. population is more concerned with inflation than unemployment. Case in point: A recent AP‐NORC poll showed 68% of respondents said that they are "extremely concerned/very concerned" about high gas prices impacting their family finances. This is notable because there is a strong inverse correlation between a president's approval rating and the cost of gasoline, and sure enough, the president's approval rating is the single biggest determinant of the midterm election outcome. The White House‐Congress party combination has changed in seven of the last eight federal elections, and with energy prices elevated, it seems likely to become eight of nine this year.

Aside from the headline political volatility, midterm election years are historically much more volatile for the stock market as well. The average S&P 500 intra‐year decline in midterm election years is 19% as compared to just 13% in the other three years of the presidential cycle. We believe this is because

1. Presidents know they usually lose seats in midterm elections, and so they try to motivate their bases with populist policies that are often anti‐growth, and

2. Investors begin to grapple with the uncertainty of a new political party taking over.

However, this volatility has also often led to great buying opportunities. Stocks have historically been up one year from the midterm market bottom by an average of 32%, and in addition, the S&P 500 has not declined in the 12 months following a midterm since 1946.

Ultimately, higher interest rates and inflation remain near‐term headwinds. During times of heightened volatility, it is worthwhile to zoom out and focus on longer‐term opportunities, the strength of one's financial plan, and the resilience of our markets in the face of past crises. Trust in your Baird Financial Advisor through these trying times; a brighter future awaits.

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