“If a company is paying higher prices, they have one of two options,” explained Lowe. “They can either pass it along to the consumer – which is by and large what is happening – or they can absorb the higher prices. But that erodes margins for companies and ultimately impacts earnings. Our expectation is that margins will generally hold up but may drop off a little bit.”
Lowe said that inflation becomes more dangerous when people start to expect it to continue and change behaviors, which may start a cycle of inflation. “Our view is that it will stay higher than it has in the past but will start to ease as supply chains unclog, which could be a year-long process. The market expects that the Fed will be successful at dampening inflation and that supply chain shortages will ultimately ease, and demand will also decline.”
Worker shortage
With 11 million job openings but only seven million unemployed people in the work force, the current labor shortage has increased wage pressure, which translates into inflationary pressure.
“A lot of people left the labor force during the pandemic for a variety of reasons, along with this massive wave of retirement,” explained Lowe. “This labor shortage is concerning for the Fed because what you don’t want is a wage-price spiral. You don’t want inflation embedded into wages to start a cycle of price inflation. I think this will ease over time as people come back to work, which we’ve seen in recent jobs reports. As more people return to work, that should ease wage pressures.”
About half of the states in the U.S. have raised their minimum wage in the past year, which could potentially drive further inflation, although a higher minimum wage may be a moot point in many cases since companies have had to raise wages to attract workers.
“I think the minimum wage issue is kind of taking care of itself,” said Royal, “because you can’t find anyone to work for $15 an hour, much less under $15. We did see an increase of about 0.3% in the labor force participation rate, which is good news because the solution to the wage price spiral is to get more people in the work force.”
Fed actions
The market anticipates about seven rate hikes this year, beginning in March with at least a quarter point hike. But exactly how fast the Fed raises rates will depend on how the economy is doing.
“One complicating factor this year is that inflation is a huge political issue because of the mid-term elections,” explained Royal. “The Fed is not supposed to be subject to political pressure, but they may feel forced to tighten more quickly than they otherwise would because of the political pressure.”
“The Fed has two basic tools – rates and the balance sheet,” added Lowe. “Through the pandemic they were buying treasuries and mortgages. That’s going to end in March. And then they’re going to start shrinking their balance sheet – quantitative tightening. That will also work to push up rates.”
Globally, there has also been a sea change, with European yields expected to climb from negative rates to positive rates over the next year. “This is a global phenomenon,” said Lowe. “Inflation is an even bigger issue outside the U.S. where countries are much more energy-sensitive than we are.”
Market volatility
Every recession has been preceded by an inversion of the yield curve (with short term rates moving higher than long term rates) – but not every inversion has led to a recession. While the yield curve has not inverted in the current cycle, that’s something economists are watching closely.
“The takeaway is that there is a lot of rate uncertainty and inflation uncertainty that has created volatility in the market,” said Lowe, “We had unprecedented monetary and fiscal support, providing a huge tailwind in the market, but that has lessened. With the training wheels coming off, that impacts every market.”
Despite the uncertainty and volatility of the current environment, Lowe doesn’t view the market outlook negatively. “Markets can and have performed well during Fed hiking cycles because the Fed is generally hiking when the economy is strong. So, we expect solid returns but more muted than the past two years when we had outstanding returns.”
Added Royal: “Since the 1990s, in periods when the Fed is hiking rates, the markets have typically dropped a little bit and then actually outperformed over time. If recent history is any guide, the next six months after a rate hike cycle could be challenging, but long term, it could be a good time to be in equities.”
Stock market prospects
Different types of stocks can lead the market during different periods in the economic cycle. “During a recession, you have low growth, low inflation, maybe even deflation,” said Royal. “During those times, you want to be in defensive, low beta, low volatility areas, such as large caps, which generally carry less risk and less leverage than small caps.
![Small and mid caps: Learning from the experts [PODCAST]](/content/dam/thrivent/fp/fp-insights/advisors-market360-podcast/compass-insights-card-v1.jpg/_jcr_content/renditions/cq5dam.web.1280.1280.jpeg)
