2nd Quarter 2022 analysis.
The worst first half of the year in 50 years, and there is room for more pessimism because we have not seen the top in the inflation numbers or the Consumer Price Index (CPI). Until we see some relief in the bottom and top-line inflation readings, the market will continue to test investors to the downside. The key to navigating these markets is diversification and patients. The diversified portfolio has helped the average investor avoid the pitfalls of the next best thing! I am not immune to typical human behaviors of chasing returns and being overconfident, but I continue to learn new reasons to stay diversified. Individual stocks that were hot are now the black sheep of the market. We see headlines of Cryptocurrencies going bankrupt and upstart technology companies looking for chapter 11 protection. The second quarter of 2022 has been challenging for any investor, and I imagine all have been humbled if they are individual stock pickers.
I have started calling our current bear market the sleight of hand recession. The recession that no one will admit until it is too late. I believe 2022 has been a recession for the main street and the average person for all of this year. Inflation tends to affect lower-income families first, and high oil prices affect all prices and demand. One demand not subsiding is the need for more airline employees and travel-related employee wage increases. We all feel that urge to leave the nest and explore, which is why the airlines must raise travel demand estimates. There seems to be too low morale in these flight crews and insufficient patients among travelers. These are pandemic-related issues, and these things will pass as we adjust to the new normals. I am in this crowd of would-be travelers, and I am not surprised there is high demand. Pandemics have a way of creating a universal cabin fever.
I will now reflect on the only thing that matters for our current market. INFLATION! Headlines everywhere read of inflation and gas prices all point to one glaring issue. How did we get here, and what is our path out of this mess? Looking back at the last quarter, we can observe a few things and see if there is something to show us that the worst might be over.
We first look at the inflation numbers to see how bad it has gotten.
As you can see from the graph, we had not experienced this kind of increase in inflation before many young adults were able to drive. If you look further in time, you can see how the current inflation mark measures up to the past.
Areas of note in this graph are the 1970s and 1980s; inflation was still much higher than our current readings of 8% to 9%. Notice also that there is a high correlation between significant world events and rising inflation. Our present inflation is similar to a few other times, particularly the 1946 rise in inflation. The 1946 inflation was caused by pent-up demand from soldiers returning from war. The world underwent significant changes, and the war sped up the industrial revolution. Economies are becoming more complex, and the supply chain is starting to be analyzed for the first time as new nations look to gain a competitive advantage. The good news was that the inflation of the mid to late 40s was short-lived, and not until the 70s would inflation become an issue again. The similarities are with the demand and supply of goods. As our factories went from war machines to automobiles, it took time, and hard to buy a car for a while. Today we have supply chain issues similar to these times but for different reasons. Chip shortages and good shortages today are not from a small war in Eastern Europe or a world war but from the lack of manufacturing workers from the Chinese pandemic oppression. The deficits are coming from a two-year pandemic that halted the production of anything. I see this all being transitory similar to the late 40s, and it is only a year before things return to normal. The time frame for this, like the 40s, would put us into the beginning of 2023 before we see a full recovery. Supply chains are not repaired overnight, which unfortunately takes time and is hard on portfolio returns. As China has finally passed its Zero Tolerance Covid policy, we can see that our current inflation might have peaked, and we see our workforce (China) return to full strength.
The other inflation that we all are feeling is from the gas pump. Today’s gas prices are higher than in the late 2000s as there was a fear of peak oil production and demand at all-time highs. Here are some charts that show your fuel cost and the relationship between the last energy crisis.
Why are gas price margins so high, and why are we paying more at the pump, but our crude supply costs are not as high. The reason is that the oil and gas industry was hit hard for over a decade, and they need to recover some capital. The energy industry has as many ups and downs as any other industry, but there are a few differences with the energy industry. Energy is leveraged and hedged so that the companies can withstand the peaks and, more importantly, the troughs of an economy. The energy industry also has to fund projects over decades to get profits, and this extended time frame increases the variability risks associated with debt instruments. I see this as the industry’s big push before consumers change their preferences towards vehicle selections and lean toward electric.
What are some other forms of inflation and their impact on the economy? All commodities have some degree of correlation, and for our research, we consider all commodities as one asset class, not individual industries. When corn goes up, so does oil, and vice versa. I think the worst is over as far as inflation goes because we see all commodities coming down as demand destruction takes hold, as seen in this chart:
And to leave this on a positive note, I want to point out a chart initially written by Ben Carlson and then reposted by another famous blog writer Josh Brown. All bear markets end, and returns are typically positive one year later. There are always exceptions to the rule, and markets could be headed for a more challenging time for longer, but I am not in this camp for many reasons. The employment rate is too high, people are spending money on travel and experiences at a record pace, and the banking industry is preparing for a significant downturn. One thing to note on the returns chart is that no matter how bad the recession, it only takes 3 three years to recover.
As inflation seems to be peaking and our CPI numbers stop climbing, we could see relief in the capital markets and possibly a rally in equity prices. The key measures to look forward to this next quarter are CPI readings and Gasoline future pricing. CPI readings in July and August will tell the story and change the market direction based on the numbers. Gas prices will continue to fall this summer as the peak of demand for the summer is behind us, and the cost of crude stabilizes. 2022 is the year of inflation, but it can only last so long. The economy always returns to the mean, which is now just a matter of time. How long we all need to wait is unsure, but history shows us that even bad times don’t last forever.
Chief Investment Officer
AAM Fee Only Financial Planning and Investment Advisory, LLC
July 20, 2022