Image: April was a brutal reminder that markets can go down in a fearful manner.

• Stocks and bonds fell during April as investors reacted to rising geopolitical tensions, weakening economic growth, disinterested central banks, and violent currency movements.
• Geopolitical tensions between NATO, Russia and China are disrupting the normal flow of trade, creating shortages and damaging economies.
• The US economy contracted in the 1st quarter as inflation rose to 8.5%, consumer sentiment soured, and new orders weakened. With the Fed about to raise rates, it is hard to come up with a positive outlook.
• Central banks continue to calmly watch inflation erupt all around them, ignoring their mandates to control high inflation.

Table 1: Performance update

Performance discussion

All major markets declined in April. As you look at the table above, it is a textbook example of how riskier asset classes like stocks underperform less risky bonds when there is a broad decline in the markets. Until this sell-off, bonds typically rose when stocks declined significantly. However, in the current environment of high inflation and imminent Fed rate hikes, bonds have been leading the markets down. The real shocker is that investment grade bonds have underperformed the S&P 500 year-to-date. That is not a good sign for future economic growth or stock market performance.

Problems everywhere

The world is surrounded with intractable problems.

Here in the United States, we just posted our first negative quarter of GDP growth in several years (-1.3% in 1Q2022). There is a trick to understanding this number, though. GDP growth is typically discussed and analyzed in "real" terms, not "nominal" terms. Just an fyi, REAL GDP = NOMINAL GDP - INFLATION. Nominal GDP dollars reflect prices we pay, wages we receive and taxes we pay. Adjusting for inflation tells us whether we are relatively better or worse off with these transactions. In the first quarter, Nominal GDP grew 6.5%, but inflation was 7.8%, so NOMINAL GDP 6.5% - INFLATION 7.8% = -1.3% REAL GDP. 

Several analysts recently stated that negative real GDP growth is ok because we still have positive nominal GDP growth. Just remember that during the 1970s, nominal GDP growth never declined, even in the depths of the 1973 and 1978 recessions. Please don't tell me negative real GDP doesn't matter. It matters a lot!

In Europe, the world watches in horror at the conflict in Ukraine. Russia is determined to take this territory, while Europe and NATO are resolved to support Ukraine's resistance. If the consequences were isolated to Ukraine, I'd be less worried. But Russia has been cut off from the world financial system, technically defaulted on debt, and cut off gas supplies to Poland and Bulgaria. Europe gets 50% of their natural gas from Russia, which was used to replace all those coal and nuclear plants they shutdown. If Russia shuts off the gas to Germany, it will be an economic disaster for Europe. Europe will go dark and there will be a deep recession.

China is busy trying to impose a zero-Covid policy on their country. Reliable news reporting is difficult in a country like China, but the reports out are troubling. Appartently, there is a massive shutdown of normal economic activity, shipping is backing up and factories are closing. China is forcing itself into a recession, it seems. This will drag down economic activity throughout Asia and create export product scarcity for the rest of the world. Conversely, this may create a negative demand shock for their imports of oil and other raw materials.

In the table below, you can get a sense for the low growth and high inflation nightmare plaguing the world.

Table 2: Key economic data of major regions (reflects most recent data which may be from 4q2021)

The US economy isn't doing so hot

Every discussion about the US economy begins with inflation. How high will it go? When will it turn down? Will it be "transitory" as the Federal Reserve promised last year?

The good news is that inflation will probably be transitory. The bad news is that it may take years to tamp it down again. Mechanically, inflation was created by the Fed as they created excess reserves for the economy after the financial crisis and then supported Congress when they created pandemic stimulus spending. The quantity of currency in circulation increased, so inflation increased. These effects are waning and lessen inflation support. However, there is a strong psychological aspect to inflation: food costs, wages and rents rise, but the price increases are sticky and do not go down easily. It is hard to know when inflation will fall, but it will almost certainly require the economy to painfully slow down. If you are interested in an excellent discussion about the psychological aspects of inflation, you can find it HERE.

There are some signs economic growth is decelerating. Besides the -1.3% GDP growth in 1Q2022, there are many indicators that US economic growth is decelerating rapidly. The University of Michigan sentiment readings which we've been posting for a while were prescient.

Figure 1: Surveys of current and expected new orders

Figure 2: University of Michigan consumer buying intentions still very weak

Figure 3: Index of supply chain tension still high here and in China

Central banks are sanguine, but not for long

Where are the central banks? Why won't they do something about inflation?

For now, they have done a lot of talking, but not much else to actually slow down our runaway growth and inflation. That is likely to change soon. Fed chairman Jerome Powell is on the verge of getting reconfirmed for another 4 years to lead the Federal Reserve. I assume once he is politically secure, policy will firmly change. 

There are some interesting indicators of future Fed policy. One of them is the simple correlation between the US 2-year Treasury yield and Federal Funds rates. You can see over many decades this relationship has been very stable with the 2-year leading the way. Figure 4 shows this relationship over the last 45 years.

Figure 5 shows this comparison over the last 10 years. It indicates short term interest rates are going to 3-3.5% quickly. I also put the consumer price index in there to remind you that even at 3.5%, if inflation doesn't fall, the Fed is still providing monetary stimulus by letting inflation run hot.

There is some discussion that the Fed will not raise rates because it will 1) hurt the stock market or 2) raise government interest expense and hurt budgets. This narrative ignores the political costs of high inflation. Voters hate high inflation, and the ruling party will get blamed no matter who's fault it was. You may cheat the voters today with inflation, but there will be a price to pay tomorrow. What this means is that the central banks are under enormous political pressure to solve the inflation problem.

The one problem with low interest rates is that the world's central banks have no dry powder to help the economy if we fall into recession. There are no interest rates to cut and quantitative easing has not proven help for the real economy. The age of central bank counter-cyclical stimulus may be over for now.

Figure 4: Federal funds rates follow the US 2-year bond regularly

Figure 5: Federal Funds may climb to 2-3% shortly

Figure 6: Implied path of short-term interest rates

If you think we have an inflation problem...

Inflation is bad in the United States, but at least we have a strong currency. If the dollar were weak, all our imports would be rising in much more in price, further aggravating local inflation.

Most of our trade partners, especially Japan, have let their currencies fall deeply compared to the dollar. With crude oil priced in dollars, the cost of energy is skyrocketing in these economies, further weakening them. These currency disparities are also a sign of systemic financial stress.

Incidentally, one of the primary sources of weakness in the US 1Q GDP was export weakness. Our overseas customers are experiencing price increases for the items they buy from the US from both inflation and a strong dollar. This is an example of how currency policy affects trade; the country with the strong currency loses exports which hurts their local economy.

Figure 2: Currency relative performance since 2010

How do asset classes perform in Fed tightening cycles? Look at 2018.

Assets behave differently in periods when the Federal Reserve is raising interest rates. In the table below, 2018 is highlighted because that is the last time the Fed raised rates and the subsequent decline in various markets was proportional to the underlying risk. Today, we see many of the same results as both stocks and bonds sell off and cash holds its value.

Table 3: Asset class returns by year

Our positioning in equities and bonds has been beneficial so far in 2022. We are underweight stocks, overweight precious metals, and overweight short-term bonds. Each of these choices has helped us stay ahead of the benchmarks this year and moderate the market's volatility for our portfolios.

In summary, geopolitical tensions are high, the global economy is slowing sharply, valuations are high, interest rates are about to rise rapidly, and the global financial system is under tremendous stress. We expect the markets to be very bumpy as we go through the coming months.

If you have any questions, please call me at 281-402-8284.

Sincerely,

Rob and Chris

Robert J Lloyd, CFA^®

President and Chief Investment Officer

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Lloyds Intrepid LLC (“LIWM”) is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from LIWM with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.