Monthly Market Update: She is tossed in the waves, but does not sink

Tue 15 Feb 2022

A hawkish Fed has sent volatility spiking, marking one of the most memorable weeks in forty years. On average, for the past five days the S&P 500’s gap between the day’s highs and the day’s lows hit 3.4%. Since 1982, only 2% of all five-day periods have been more volatile.

The most important thing for investors, right off the gate, is that “third standard deviation” events are not tradeable. These are high frequency markets turbo charged by high-powered computers and no amount of analysis, technical or fundamental, has the slightest predictive value. It will, in hindsight, but not now. Gurus will fall and others will emerge after this, but right now forecasters are mostly shooting in the dark. We are in uncharted waters. Consumers are always pricing in more inflation than actual, core goods inflation. The fact that real inflation numbers have caught up with expectations, shows how much momentum prices have right now.

Surveys suggest that consumer are more afraid of the Fed than trust it.

To be certain, after last week, markets are pricing in five rate hikes until the year’s end. Still, if the Fed was serious about beating inflation with rate hikes, it would be so far behind the curve that it would take a significant escalation of hawkishness to even begin making a difference in inflation expectations. But it isn’t. Record global debt loads simply don’t allow for 10% rates. Neither do traders who have learned to rely on the Fed increasing the supply of money every time they felt insecure in the past decade. They would drive the S&P down three thousand points before allowing for money to cost that much.

The Fed is trying to keep wage growth down, by being hawkish enough to lower consumer inflation expectations. Fast-rising consumer inflation expectations suggest that half-measures fool no one. The Fed could either support markets or fight inflation. It chose to do both, which means it chose to do neither.

In other words, the worst has happened: We have runaway inflation, and the Fed is out of ammo. So inflation will have to work itself out. Either underlying demand remains sluggish and eventually we retreat to inflation commensurate to “secular stagnation”, plus some “Green Inflation”, or we inflation momentum takes a life of its own, like it did in the 70s.

Volatility will have to work itself out too. Currently we are experiencing sharp market gyrations, as investors take profit from popular pricey stocks and wait to see what happens next.

“Fluctuat nec mergitur”. Parisians said of their in the 19th century. “She is tossed by the waves, but does not sink”. We don’t think this sort of turbulence forebodes the end of capitalism. We believe, instead, that we are experiencing the long-awaited return of non-Fed-driven markets, where supply and demand were not dictated by one indicator, but many. The waters will be turbulent. Some will find themselves overboard, most likely due to lack of liquidity (ironically). Some will jump ship and wait, only to buy again when the bulk of good news has been priced in. Not losing is not the same as winning, however. Inflation is a well documented phenomenon, and some assets, like equities or real assets tend to win out. Those investors who believe that the boat won’t sink and trust that the money they pay to their asset managers are well spent, may well experience a lot (more) volatility, but they will, probably, have the most prosperous journey.

George Lagarias, Chief Economist