Depending which index you are looking at, the stock market is down 5 - 25% year-to-date May 26, 2022. Fixed mortgage rates have doubled and variable variable mortgage rates have almost doubled. These dramatic changes can be reasonably associated with the increase in the year over year inflation rate to high single digit territory, around 8%.
Inflation is widely considered a threat to stocks, bonds, and housing prices because it puts pressure on central banks to raise interest rates. Higher interest rates discount the value of future earnings, which are the basis of asset price valuations. So the question is, "where did this inflation come from and where is it going?"
I belong to a growing chorus of analysts who think this bout of inflation will be temporary, unlike the inflation of the 1980s, for at least three reasons:
Aging and Shrinking Demographics. Perhaps most importantly, the demographics of developed economies are aging and shrinking. The last time the central banks of North America, Europe, and Asia dropped interest rates to support the economy was after the great recession mortgage led meltdown in 2008. This stimulus included reducing central bank lending rates to 0 or close, as well as buying bonds in the open market to keep private interest rates down. The central banking community had only just begun to withdraw from these stimulative policies, by selling some bonds and raising some interest rates when the pandemic arrived, 12 years later! In other words, the economy has already been on life support for years. Normally that kind of stimulus would have created an inflationary boom, but the aging and shrinking demographics have been a force of deflation because of downsizing and deleveraging practices that appeal to us aging boomers. (Also note: technological advancements tend to reduce prices as well e.g. gas vs. electric vehicles.)
Receding Fiscal Stimulus. The pandemic stimulus was necessary but inflationary. No one knew how bad it would get or how many would be thrown out of work. What we did know was there needed to be jobs waiting when it was over, or there would be a depression. Consequently, the checks went out not only to those who lost their jobs but to everyone. Those who lost jobs quickly downsized, those who didn't strengthened their financial position and bought stuff. But that fiscal stimulus has all but dried up now and there are even some business loans that will begin repayments shortly in Canada at least.
Global Supply Chain Adjustments. The pandemic followed by the war in Ukraine on top of ongoing climate change disruptions have forced a number of shortages and associated supply chain adjustments. Some of these are permanent, but most are already receding after a period of adjustment.
The consequence of these three is that the high year over year inflation we have seen is likely to recede quickly. Indeed the month-over-month inflation rates in the US are already showing up around 4% annualized, half of what the year over year numbers have been. Once the pent up demand for travel gets satisfied even gas prices may come down.
Implications for Stock Investors
To make a long story shorter, a slower 2022 was predictable after the last 5 years of technology fueled super stock market growth. But it's very rare for stocks to fall so dramatically as they have on a calendar year basis. One thing is for certain earnings have not fallen overall, so stocks are 5-25% cheaper now than they were on January 1st. I believe that current stock prices will look like bargains, possibly as soon as year-end. It would be more ordinary than extraordinary to see stock market gains of 10% or more up from these levels by year-end, which would still mark a dismal performance for stocks historically speaking.
The Death of Bonds has Been Greatly Exaggerated.
The place of bonds in a long-term portfolio has been much maligned because the rates promised have been so low, and inflation has been so high. But if my thesis of falling inflation proves true, bond prices, which already reflect the impact if increased inflation expectations, will rebound nicely, and most government bonds will do well even in the face of prolonged crisis. Bonds remain an important part of a balanced portfolio even if they do shine best on rainy days.
Variable Rate Mortgages Remain Attractive.
Most five year fixed mortgage rates have pushed up to around 4% or more, while current Variable rates remain in the 2.5% range. Even with the anticipated rate hikes totalling 1%, the VRM rates will remain competitive with fixed rates. Add to this the possibility of a possible retreat from the rate hikes by central bankers in the next few years, and the average total interest paid by variable rate mortgage holders is likely to be substantially less over a five year term.
Although home prices have shown some declines in places where levels have run up dramatically, I believe it is more likely we will simply have slower turn-over and more balanced buying conditions (fewer bidding wars, longer condition periods) before we see substantial price drops in most places. House prices are notoriously "sticky" on the downside. Caveat: buyers must be careful in a transition like this as the bank may not agree with the value many sellers are asking.