Many stock market indexes declined yesterday in response to the August inflation data released early in the day. The Department of Labor reported an 8.3% year over year increase since August 2021 and an increase of 0.1% for the month of August[1]. These numbers were not wildly off from expectations and were a decrease of 0.2% from the July figure and 0.8% lower than the June figure. However, the decline in inflation was less than expected. 

The result was a repricing of many stocks – although not back fully to the most recent low. Bloomberg’s Robert Bland explained this morning “While the magnitude of Tuesday’s equities rout was impressive, the S&P 500 only reversed most of the gains made in the previous four sessions. The lack of a surge in the VIX index -- known as the “fear gauge” -- suggests that the selloff was a recalibration of those expectations rather than panic selling.”[2]

I continue to reiterate the fact that stock prices communicate one thing – expectations for future earnings. Prices go up in the short term if earnings are expected to be higher in the future. Prices go down in the short term if earnings are expected to be lower in the future. Fed Chair Jerome Powell was clear in his August 26, 2022 speech he and his team intend to take forceful action to bring inflation down to their 2% target and will continue to do so “until we are confident the job is done” [3]. 

It would require a very creative interpretation of his remarks to get the idea they are winding down the rate hikes and even more so that we’re going to see a reduction in rates anytime soon. However, that’s apparently a notion some investors bought into over the past week and many stock prices had seen moderate increases the previous four trading sessions. Yesterday’s inflation data apparently corrected that thinking and brought expectations back into line with our present economic reality. 

I recently finished listening to an audiobook version of J.R.R. Tolkien’s The Hobbit. I got more out of the book this time through having lived more life since first reading it in middle school. Three things I took away from the story are applicable for the present moment.

1. We don’t always get to choose the journeys we go on.
2. Most difficult journeys are usually longer than we want them to be.
3. No matter how much we wish we could go back when we face challenges, moving forward with courage and resolve is the way to survive.

Our economy is on a journey of our own creation though not necessarily of our choosing. The government shutdowns and fiscal stimulus in response to the COVID-19 pandemic deeply distorted the US economy in ways we are still trying to fully understand. I continue to follow the insight of economists like Brian Wesbury at First Trust[4] who maintain that inflation is caused primarily by too much money (measured by the M2 measure of money which includes financial assets held by households like savings, CDs, money market funds, cash, checking accounts and other demand deposits) circulating in the economy rather than supply chain constraints as many politicians are claiming. 

The M2 measure of the money supply grew 24.8% in 2020 and 12.4% in 2021. It had grown at a 6.2% annual rate in the ten years leading up to COVID. The money supply has increased in the last two years at rates which had not been seen since World War II. That is not easily or quickly undone. Inflation is more likely to continue to be elevated until that excess money has been wrung out of the financial system which may take years. We are most likely going to be on this journey for longer than we want to. 

I agree with Brian Wesbury’s analysis and expect markets to have periods of volatility (trending both upward and downward) but overall remain within a relatively fixed range around the current levels. We may see short term rallies like last week again and corrections like yesterday back down until there is clear evidence inflation is fully under control or the Fed changes course due to some new shock to the system. 

It is especially important to stay focused on your financial plan at times like this, maintain sufficient cash reserves to prevent having to sell equities unexpectedly and not be lured off course either by fear or a temporary sense of relief. The safest course is to move forward with courage and resolve until we reach the next phase of the journey.

For additional information on how the Fed’s actions may impact markets, see this recent article from Kathy Jones, Managing Director and Chief Fixed Income Strategist for the Schwab Center for Financial Research.