It Gets Worse Before It Gets Better

Sometimes Wall St. gets so involved in the details that it misses the forest for the trees. And then there are times when we are brought back to the simple basics and that happened this week in a webinar from DoubleLine Capital founder, Jeff Gundlach. Here is the simple reality that is often missed because it has been here for so long – markets, whether it is stocks or bonds or cryptos, have been riding a wave of central bank liquidity. That is now ending as central banks around the world have already begun to ‘withdraw accommodation’ (read: raise interest rates and/or reduce their balance sheet). If you think that these actions will not affect global markets, think again. The only question is when (or if) central banks pull the plug on these rate hike plans and begin to shove money back into markets. Until then, we expect a choppy stock market at a minimum with chances for a meaningful decline increasing. Stay invested, but stay cautious. Think value stocks and dividend paying stocks as the preferred places to be in the stock market. Despite oil prices above $80, we believe energy stocks can continue to perform well as the lack of capital spending in the industry is leading to production declines that cannot be quickly reversed. That would translate into higher energy prices, as well as additional inflationary pressure.

The Punch Bowl

Ever since the Great Financial Crisis of 2008, central banks around the globe have taken extraordinary measures to push liquidity into financial markets. Globally the actions taken were to 1) push interest rates down and 2) directly inject liquidity through a process called Quantitative Easing, or QE. Don’t let the term scare you, QE is a fancy term for a simple action… the Federal Reserve (or other central banks in other countries) simply buys bonds in the open market. When they buy those bonds, they, of course, need to pay for them, which is a direct injection of new money into financial markets. Think of QE as ‘the punch bowl’.

Now, the Fed and other central banks, are raising rates, or are telegraphing that they will soon raise interest rates and they will begin to reduce their balance sheet. This is just another fancy term that says they will start to sell the bonds that have been purchased via QE. That of course, means that the buyers need to pay the Fed for those bonds, which removes money from the financial system, and is known as QT (Quantitative Tightening). Think of QT as ‘taking away the punch bowl’.

Asset Returns Under QE

The chart above shows the returns of stocks (red), bonds (purple) and commodities (blue) since 1994. Note that at the time of the Great Financial Crisis in 2008, the returns of all three asset classes were roughly the same since 1994. That’s when QE first hit. The connection between QE and stock market gains appears obvious to us. At a fundamental level, it is difficult to imagine that reversing 13 years of this uber-accommodative monetary policy will not impact markets, particularly stocks.

We suspect that the choppy start to the new year is the first bubble popping as young growth companies with no income or cash flow have already been taken to the wood shed. As the advertised rate hikes and QT get closer, we suspect that this choppiness will extend into the more established growth stocks that have wavered recently, but not declined very much. When that happens, the broad indexes begin to reflect the change more clearly.

The economy still looks strong and that could forestall any correction for a while, but growth is expected to slow through the year while QT is ramping up. We believe that leads to more difficult days ahead.


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Disclosures:
Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio.
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By: thinkhouse