Tumultuous, volatile, painful; pick any number of synonyms for “challenging” to describe market and portfolio performance in the last year, and you’ll see any advisor nodding along in agreement. As the banking sector reverberates from widening fault lines created by aggressive Fed policy, it’s worth looking back over the last year to see how inflation concerns have played out so far.
Last March, Nationwide surveyed 2,000 consumers across all generations to see how worried they were about inflation. The youngest generation (Gen Z) reported the least amount of strong concern — not surprising given the years of runway still in front of them for retirement income — while Boomers and Gen X, who likely worked or remembered the last period of inflation in the 1970s, reported the highest levels of concern with retirement right around the corner.
The environment when the survey was conducted was tense. In March 2022, inflation took off, rising 8.5% compared to the year earlier, the fastest 12-month rise since December 1981. It came on the heels of February’s 7.9% CPI year-over-year increase and was primarily driven by enormous gains in energy prices (up 32% y-o-y in March 2022).
Cue the first Fed rate hike on March 17 of 0.25% from the zero rates it dropped to at the onset of the pandemic in 2020. One year later, and as of the beginning of March, there have been eight consecutive interest rate hikes that have raised rates from 0% to between 4.5-4.75%, wreaking havoc on markets and bonds and taking an increasing toll on several sectors of the economy.
Cracks in the Foundation?
A handful of banks have collapsed recently, and the Fed has stepped in to offer additional short-term funding via the newly created Bank Term Funding Program for banks underwater or struggling from the unrealized losses carried on balance sheets created by the environment of rapid interest rate hikes. It’s a major indicator of stress lines in segments of the banking sector, particularly for mid-tier regional banks, and markets responded in force.
“Last week was a reminder of the underlying pessimism of institutional investors, along with the fragility of the market,” Mark Hackett, chief of investment research for Nationwide’s Investment Management Group, said of the equity sell-off that happened on the heels of the bank failures. Volatility in both equities and bonds was pronounced as fear of bank contagion gripped markets.
“As has been the case since the beginning of last year, bond investors are exhibiting greater signs of emotion than the equity market, which is unusual during periods of uncertainty,” Hackett explained.
So What About Inflation?
Inflation spiked to 9.1% in June 2022 and has been on the decline ever since, but that descent slowed in the first quarter of 2023. The CPI print for February was 6.0%, rising 0.4% month-over-month, and core CPI that detracts energy and food gained 5.5% year-over-year and 0.5% month-over-month. Inflation is proving to be stickier than markets had largely anticipated in services and could become more entrenched in goods in the coming months.
The Atlanta Fed tracks what they call the sticky-price CPI, which is made up of a weighted basket of items that are either flexible and can rise and fall rapidly or are sticky and rise and fall slower — the two categories are determined by how often prices are changed for each item. Flexible measurements include prices on things like gas, used cars and trucks, clothing for adults and older children, food, and accessories, while sticky-priced items include car insurance, recreation, communication, transportation costs, rent, medical care, and more. It’s a different and clever way to look break apart CPI in a way that might provide better forward-looking indicators.
According to the Atlanta Fed’s estimates, since December, the flexible portion of CPI has inverted with sticky CPI for the first time in over two years, with flexible drives of inflation continuing to fall while sticky inflation components maintain their upward trend. It tracks alongside the persistent, historically low unemployment numbers and resilient wage gains in the first quarter of 2023 that could mean sticky inflation on the services side in the coming months.
Add into the mix supply chains that have flagged the bloat that has happened in inventory in the last six months as pandemic undersupply swung sharply to oversupply and the exponential increase of full containers and warehouse space being held long-past due dates by companies with already overfull shelves. As containers sit past the grace period, they incur increasing fees, and with no easy or quick resolution in sight, the fees are likely to keep adding up and be passed on directly to consumers in the next quarter or two, creating stickier inflation once more on the goods side.
… And Portfolios?
The traditional 60/40 portfolio had a historically terrible time in 2022. At its worst, it was down about 20% as equities and bonds plummeted in the face of soaring inflation and aggressive rate hikes. A portfolio that invested in the S&P 500® for its equity portion and the Bloomberg U.S. Aggregate Bond Index for the fixed income portion would have closed the year down about 16%, the second worst year for a traditional portfolio since 1976, according to Vanguard, the worst was a 21% loss during the Financial Crisis of 2008.
It turns out that the fears that investors felt the shadows of at the beginning of March 2022, captured in Nationwide’s survey, were fully realized over the year. There was almost nowhere to turn for refuge last year, with stocks and bonds moving in correlation, falling together in a rare move for markets that simply couldn’t overcome the pressures of aggressive rate hikes on bonds alongside the inflation impact on equities.
It remains to be seen where the economy and markets go from here, and advisors continue fielding difficult questions from clients regarding any number of risks and portfolio expectations after last year’s underperformance. Concerns range from if a recession is on the near horizon and how long the Fed will hike/hold rates to the newly added concern regarding if the strength of supportive measures by the Fed will be enough to uphold the banking sector.
Underneath it all is the uncertainty about how persistent inflation will actually prove to be and the ghosts of investment income fears made manifest last year.
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