(April 28th, 2023)
By (Berk Ozcan, Equity Analyst)
Edited by (Ascanio Cicogna, Head of Research)
What is Inflation?
Inflation is the sustained increase in broad price levels of goods and services, leading to a decrease in the purchasing power of a currency. For an investor, grasping the concept of inflation and its driving factors plays a crucial role in making the right decision. Various methods exist to measure inflation, such as Consumer Price Index (CPI) and the GDP deflator. In the United States, the Federal Reserve (FED) is the central authority responsible for managing inflation and price stability. The primary objective of the FED is to maximize employment, stabilize price levels and manage long-term interest rates. The policies implemented by the FED to achieve its objectives have a complex yet critical relationship with financial markets.
FED’s Recent Decisions to Fight Inflation & What to Expect
Inflationary pressure has been a major concern in the US especially with the COVID-19 outbreak and its aftermath. The disruption in the supply chain during world-wide lockdowns has resulted in an inflationary pressure, the 12-month inflation as of September 2022 was 8.2%. Unexpected events such as Russia invading Ukraine and ongoing disruptions in the supply chain have resulted in price shocks. The expectations of the time were, as Mr. Powell stated, that “these one-time increases in prices are likely to have only transitory effects on inflation,” but they turned out not to be transitionary. After realizing that inflation is not going anywhere, the FED has been increasing interest rates and following a quantitative tightening policy in order to fight inflation and slow down economic growth. As of the 17th of March 2022, the FED has increased fund rates to nearly five percentage points. It is important to keep in mind that before taking such measures, the FED was buying billions of dollars of bonds to stimulate the economy. In June 2022, US inflation was at its long-time peak at 9.1%. The reckless monetary policies followed by the FED has created a time of volatility, wealth disparity and unpredictability. On March 22nd 2023, the Federal Open Market Committee announced their latest press release anticipating “that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”
Figure 1: USInflation (CPI)
Source: OECD Library
The efforts of the FED to bring inflation to a stable two percent level against the recent banking crisis and financial stress raises the odds for a recession. The FED’s discount window has jumped to 153$ billion dollars in March indicating the liquidity strain on banks.
Figure 2: Total Borrowings from the Federal Reserve
Source: U.S Federal Reserve
Note: Shaded areas indicate U.S recessions
On the 3rd of April, S&P Global Manufacturing Purchasing Managers Index (PMI) released their latest survey and adjusted US PMI to 49.2 in March, up from 47.3 in February. After the 5-month decrease in PMI, the new release indicated that the decrease in manufacturing eased, but weak demand is still a reality that challenges producers.
Conclusion: Summary
The volatility and controversial policies implemented by the FED have resulted in inflationary pressure. Conventionally, rising interest rates have a negative impact for equities. Higher interest rates result in higher borrowing costs which will hinder corporate growth. After the FED’s latest announcement, we have seen a slight decrease in NASDAQ Composite and the S&P 500. Despite the conventional belief, both have been in the positive territory so far in 2023. The NASDAQ-100 Index, heavily technology focused, has outperformed the S&P 500. Tech stocks seem not to be affected by the recent banking crisis around the world. The decreasing inflation and expectations that the FED might end its campaign to raise the interest rates have resulted in a rise in tech stocks. As inflation goes down, we are yet to see whether the latest implemented policies will have a smooth landing or trigger a recession.
As uncertainty and inflation take over the markets, investors should also keep an eye on gold. Historically, gold has proven itself to perform relatively well during inflationary periods. The precious metal has been rising towards record highs as the U.S currency and bond yields weaken. I believe gold could be a strategic investment considering the current situation we find ourselves in.
Citations:
“Federal Reserve Open Market Operations.” Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/monetarypolicy/openmarket.htm.
Federal Reserve Press Release. 22 Mar. 2023, https://www.federalreserve.gov/monetarypolicy/files/monetary20230322a1.pdf.
News, Breaking Market. “US S&P Manufacturing PMI Final March 2023 Full Report Https://T.co/reec1sm3b3.” Twitter, Twitter, 3 Apr. 2023, https://twitter.com/financialjuice/status/1642886159687712769.
“Prices - Inflation (CPI) - OECD Data.” TheOECD, https://data.oecd.org/price/inflation-cpi.htm.
“Total Borrowings from the Federal Reserve.” FRED, 28 Mar. 2023, https://fred.stlouisfed.org/series/BORROW#.
LEGAL DISCLOSURE:
The projections or other information generated by BSTA regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. As such, BSTA does not assume any legal responsibility for actions that may have been taken by readers associated with any investment projections made by the members of BSTA. There are risks associated with investing in securities. Investing in stocks, bonds, exchange traded funds, mutual funds, and money market funds involve risk of loss. Loss of principal is possible.
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