In times like these, it is hard to see any way out of the endless stream of bad news and the stock market’s downward spiral. Is this part of the normal ebb and flow of economies and markets, or has there been a fundamental change that will usher in a new era? It is impossible to know the answer to that question in real-time, but today’s exercise will focus on getting back to some semblance of normalcy in the financial world. What does that look like, and how do we get there?
Most things in finance can be simplified into a simple supply versus demand equation. Without having to take an Economics 101 course, changing one or both sides of the equation will affect the price of the good or service in question. Think about the exorbitant prices people are willing to pay for popular sporting events or the hottest Christmas toy – a classic case of demand overwhelming the available supply. On the flip side, the discount bin at a department store represents oversupply related to current demand. Our present inflation predicament is a result of abnormalities in both supply and demand.
Oil, especially in its refined gasoline state, is the most visible sign of our inflationary environment. Not only do we feel the pain when filling our tanks, but gas station signs are a daily reminder of how bad things have gotten. The hydrofracking process allows this country to bring more supply to the market rather than being dependent on foreign supply, at least in theory. The current push for renewable energy has left oil companies at odds with the current administration, affecting how much supply can be brought online. Oil companies are also showing a greater desire to return their windfall profits to their shareholders rather than spending more money to find more wells to drill. As we are currently learning, increasing the supply is not a matter of flipping a switch. The situation is compounded by the Russian sanctions to take their massive supply off the market with seemingly no end in sight. Industrial necessities and consumer behavior drive demand for fossil fuels. After two years of being stuck at home, people are itching to get out and travel (and willing to pay up for the gas that supplies their vehicles). The path forward in energy will likely be a combination of increased supply in some form and a change in consumer behavior.
COVID policies caused a seismic shift in our consumption habits. In normal times, our take-home pay would be spent on a combination of goods and services. When the ability to participate in experiences like going to a restaurant was eliminated or reduced, we spent more money on things. We redid our houses or bought new ones. We bought some more toys to keep us occupied. Oh, and we were given some free money to do with as we pleased. This severely disrupted supply chains, which caused limited supply trying to meet massively increased demand. As we normalize, the shift back to services should cause current inventories to be marked down, which will hopefully slow that section of inflation.
At the center of all this is the Federal Reserve. If they were driving a car that was the economy, they zoned out while listening to their favorite song and just now realized they were going double the speed limit. As a result, they are hitting the brakes much harder than they would generally prefer. Slamming the brakes signals to the stock market that the era of easy money is over and that corporate earnings will be harder to come by. As a result, investors are selling their investments to adjust to this new reality.
So how do we get out of this mess? It starts with inflation beginning to normalize through some of the channels mentioned above. We are a long way away from the Fed’s target of 2% inflation per year, but signs that we are slowing the advance will give them the flexibility to at least relieve the pressure applied to the brakes. Until that happens, the ride will continue to be bumpy.
Author: David Rath, CMT, CFA
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