Private Client Letter – October 2022

In our Midyear Update I observed “the current market environment is about as challenging as any I can recall in the past 40 years” and three months later this remains the case.  Inflation continues to be the dominant challenge as the Federal Reserve has surged their hawkish rhetoric along with the fastest interest rate tightening cycle in the past half century.

The Fed raised the federal funds rate by 75 basis points to the 3.00% - 3.25% range during its September meeting, the third straight three-quarter point increase and pushing borrowing costs to the highest since 2008.  The so-called dot plot showed Fed officials are forecasting that interest rates will likely reach 4.4% by December and rise to 4.6% next year.

Ironically, just one year ago at the September 2021 FOMC meeting, Chairman Powell and other Fed members expressed absolutely no concern for inflation at precisely the time commodity prices were spiking.  Now, as the very same commodity prices are rapidly declining, the Fed sees nothing but stubborn inflation that will require further tightening through 2023.

After completely missing the clear signs of surging inflation a year ago, the Fed has now moved to the other extreme in what is proving to be the most aggressive rate hike cycles in history just as deflationary forces are taking hold in our economy.  Wharton professor, Jeremy Siegel, recently commented “calling this poor monetary policy would be an understatement”.

The chart above clearly demonstrates how aggressive the Fed has been once they realized inflation was an actual problem.  Now they have overcorrected by raising rates at a faster clip than just about every Federal Reserve in history.  

With so many policy mistakes over the past two years it is fair to ask, what does Clearwater Capital know that everyone else doesn’t?  We aren’t claiming clairvoyance and our crystal ball is as faulty as any.  But what we do have is discipline and an unwavering commitment to data.  We have always highlighted facts over feelings and when the facts changed, so would our outlook.

Regular readers of our commentary are aware of our view that the surge in M2 money supply that began in 2020 was the spark that triggered rising inflation about a year later.  The August reading for M2 money supply was virtually unchanged and the six-month rate of change just barely avoided moving into negative territory for what would have been the first and only time since the early to mid-1990s. 

The Fed was very slow to see the inflation problem which showed up in surging M2 growth in 2020, and they are being very slow to see that inflation fundamentals have improved dramatically this year.  There is currently mounting evidence that inflation pressures are receding.  

Non-energy commodity prices have already broken to the downside after a strong inflationary runup.  Oil is down over 25% in the past four months.  Commodities prices are well off the previous highs and many now are back to pre-covid levels.

The ISM Prices Paid index provides more graphic evidence that inflation pressures peaked months ago. The index, which reflects the percentage of respondents reporting paying higher prices for inputs, was 87 as of last March, and has since fallen to 52.5.

ISM Prices Paid Index

Meanwhile, supply chain bottlenecks are clearing up rapidly, thus facilitating the supply of goods, and in turn tending to lower their prices.  For example, the Baltic Dry Index (an index of shipping costs in the eastern Pacific) has fallen by 72% since its peak last October.  Where there used to be over a hundred container ships anchored off the coast of California waiting to unload, there are now just a handful.

The Fed has pledged to be data dependent when considering further rate hikes.  If the current deflationary trends continue, we believe the Fed might soon signal a shift in policy by considering a 50 basis point move in their next meeting, as opposed to the rapid succession of 75 basis point hikes we have seen.  Any such pivot would likely trigger a surge in investor sentiment, along with equity prices.

Warren Buffett's co-pilot, Charlie Munger, once famously said:  “We earn superior long-term returns by doing the smart thing - keeping perspective - during challenging times.”  Let’s hope the Fed heeds this advice and does not tighten monetary policy more than may be necessary to rein in inflation.

If the Fed does go too far, the likely outcome would be a difficult recession in which corporate earnings estimates would come down by 10%, or more.  While the S&P 500 currently trades at a very reasonable 15.5x forward multiple, analysts have not yet adjusted 2023 earnings forecasts.  If that begins, valuations will not be as “cheap” as they may currently appear. 

As investors try to sort out the Fed’s next move, technical levels in the equity markets are receiving a lot of attention.  The primary focus for investors remains the lows set in June—3,636 for the S&P 500 and 11,037 for the Nasdaq-100.  These levels also happen to coincide with each index’s respective 200-week moving average, which has historically served as the approximate bottom of every bear market since 1971 except for three: 1973, 2001 and 2008.

It is important to note that the markets broke those lows on the final day of trading in September before rebounding sharply on the first day of trading in October.  If these levels of support hold, equity markets are likely to rally further into October as this bear market attempts to find a sustainable bottom.  If these support levels do not hold, we would likely see another move lower.

The most important economic report coming in early October will be the employment report.  Should the job market not show signs of softening, the Fed’s hawkish posture would be reinforced, as would their efforts to continue to fight inflation with further rate hikes.  If new job creation comes in lower than expectations, the Fed may have room to think about a pivot.

As I mentioned at the beginning of this letter, “the current market environment is about as challenging as any I can recall in the past 40 years”.  We believe it is possible for the Fed to navigate a soft landing, however the risks of a policy misstep appear to be rising.

Please let us know if you have any questions or concerns.

John E. Chapman

October 2022