A world of uncertainty awaits us

Volatility and uncertainty are not uncommon in the stock market and the economy. But that is even more so now. Inflation is running hot, wages aren’t keeping up, tech earnings are slowing down, and rates are creeping higher. Those are the things we know, and because the equity markets are forward-looking, it makes sense that these things are largely already priced into stocks. And yet we’re still waking up to sharp volatility and ugly down days. Welcome to my world.

The Fed raised rates last month and created a glide path for reducing its balance sheet over the coming months. The increase in interest rates from a range of 0.25 to 0.50 percent to a range of 0.75 to 1.00 percent was telegraphed well in advance by the Fed, and everyone knows how to evaluate higher overnight rates. Prime rate and other lending rates will move higher, short-term financing will be more expensive, and a subset of consumers who buy on credit won’t be able to purchase as much as they could before. As for the shrinking Fed balance sheet, that’s a bit trickier.

We have exactly one data point to use when forecasting how this will play out—the Fed’s balance sheet reduction in 2018–2019, and even that was a bit different. Leading up to that period, then-Chair Janet Yellen said, “shrinking the balance sheet should be like watching paint dry,” implying that it should be a slow, modest program that didn’t affect the markets. Whether the operation led to the market volatility in late 2018 is up for debate, but the Fed soon reversed course after letting just $750 billion roll off over the course of more than a year.

This time, the Fed will be aggressive, as it plans to reduce the balance sheet by $47.5 billion in June and July and then by $95 billion per month after that. All of which adds up to more than $1 trillion per year. No one knows exactly how stocks will react as the Fed quickly drains liquidity from the bond market, but I suspect it won’t be pretty.

As Western nations ban Russian exports and cut off Russian banks from the financial world, we’re making the decision to suffer through commodity shortages at home to inflict pain inside Russia and to cut off some of that country’s funding. The shortages will show up as inflation, which doesn’t fall equally across populations. Notice that I wrote “will show up” because many of the shortages haven’t happened yet, especially in the soft commodities, such as wheat. Countries from Brazil to Egypt are making emergency plans for wheat, fertilizer, and palm oil. The shortages will go well beyond natural gas and oil and likely won’t end soon.

Russia has used thousands of precision-guided munitions and has lost dozens of aircraft, none of which can be replaced without Western technology. As the Russian military runs out of such hardware, Putin likely will use less-sophisticated weaponry, which will lead to more civilian deaths and greater Western resolve to ostracize the nation.

And then there’s China. Because China stockpiles commodities, controls prices, and currently has severe COVID lockdowns in place, we can’t know in advance what effects inflation and rebounding domestic demand will have on the Chinese economy and its exports. The lack of visibility, or a working model of how this will play out, leaves investors looking for any sign as to what lies ahead.

Any one of these variables (Fed balance sheet runoff, Russian invasion, and severe Chinese COVID lockdowns) would give equity investors fits. The fact that they’re happening at the same time is turning a potentially volatile investing environment into something that could be much worse—a big stock market sell-off. I’m not expecting that, but I do believe that the recent decline in the markets has a little further to go before it’s over.

Of course, nobody knows for sure what will happen. International bond investors might buy up U.S. debt quickly enough to stop rates from zooming higher. We might arrive at a diplomatic solution with Russia and avoid the worst of the global shortages ahead. And China might ease its COVID restrictions at such a pace as to not cause widespread economic harm. Any one of those would certainly be helpful. We’ll soon see. For now, we’ll keep a close eye on the news and wait for the economic clouds to part a bit before making our next move. In today’s environment, cash definitely is a friend. Thanks for reading.