One of the many things I have learned over a lifetime in and around financial markets is that the more you feel something to be true, the most important it is that you take a step back and add some context to your feelings. Recently, I have been feeling a sense of impending doom, as I am sure have many others, so I am taking a step back to see if my feelings are justified. The results are somewhat reassuring.
The fear comes from the fact that the year seems to have started with a big drop in the market. It seems like every headline is about another bad day, and every nascent bounce back is snuffed out during high-volume trading days. There are good reasons for that fear, reasons that themselves create an atmosphere of dread.
The Fed declared their intention to tighten, and the bond market is preparing for that. Yesterday, the 10-year yield hit a level over 40% higher than it was as recently as December 3. Even off a low base, that is a big move in just over a month. The era of free money, when stocks were the only game in town, is coming to an end, but that is long overdue. However, rates are rising at a time when omicron is rampant, Putin is busy saber-rattling, inflation is proving persistent, and the supply chain is still broken for many companies.
But, if you look at each of those factors individually and with some perspective, no one of them is actually that worrying.
Sure, a 40% move in a normally very liquid and therefore somewhat stable market like the 10-year in one month is big enough to make you sit up and take notice, but take a look at a 40-year chart of 10-year yields and a different picture appears:
If anything, that suggests that yields are still low, even compared to the “new normal” levels that followed the 2008/9 recession. Rates are climbing, but historically speaking, this looks more like a welcome return to normalcy and therefore a sign of economic health than anything to worry about.
The omicron surge in Covid-19 has some people questioning whether that economic health can be maintained, but the new variant only has a really dramatic impact if it, or any subsequent mutation, causes the kind of shutdowns we saw in the spring of 2020. That isn’t happening. Omicron doesn’t seem to respect vaccination status or immunity from previous infection, but it does generally cause milder symptoms than previous iterations of Covid. There are more infections with a lower percentage of them resulting in hospitalization or death. That means the number of severe cases is around the same, but also that there are a lot more people who have had it and recovered. The infectiousness and resistance to antigens make it scary, but data indicate it is yet to have a big negative impact on the economy and that will probably stay the case.
The Russia problem still has potential to come to a head. Indeed, I rated it as one of the biggest risks this year in several New Year pieces. However, as a Ukrainian friend pointed out over the weekend, Russia has been “amassing troops” at the border for eight years or so, so this is nothing new. From a purely economic perspective, it only becomes a problem if Putin launches an all-out attack, or if European countries or the US decide that the gradual erosion of Ukrainian sovereignty that has accompanied those troop movements over the last eight years has gone too far . So far, neither of those things have happened, and nothing much has changed.
Inflation is a worry, of course, but there are two reasons to believe that it won’t have a major, lasting, negative impact on stocks. The first is that the rate hikes the Fed is signaling are in response to inflation. History suggests they will be effective in slowing it down, while starting from such a low base suggests that they won’t cause a sudden reversal of growth. The second is that inflation means higher nominal asset prices in general, and stocks are assets. The real “value” of those assets may be eroded by inflation, but their prices won’t.
Last and by no means least are the supply chain disruptions that we have heard so much about recently. They are real, they have an impact, and they will influence growth for a short time, but they are also temporary by nature. On a global scale, higher wages will bring more labor into the market and higher shipping and other transportation rates will attract more capital to those areas of the economy. The inevitability resolution of these temporary dislocations is what makes capitalism the best economic system yet devised by humankind, and it is reasonable to assume that Adam Smith’s “invisible hand” will do its thing here as it always has in the past.
Of course, none of this means that the current selloff is over. Even if the problems themselves look a lot less scary with added context, the fear that they spawn is enough by itself to push stocks lower still over the next few weeks. Looked at in that context, however, the pullback is nothing new, nor does it look right now as if it will be particularly durable. So, while some defensive adjustments to portfolios may be warranted, now is not the time for drastic moves.
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