Making Sense of Today’s Macroeconomic and Stock Market Landscape

Macroeconomic Context

In the past few years, Americans faced two extremely game-changing events: seeing a rapid spread in Covid-19 that shut several parts of the economy, eventually followed by the economy opening up as Covid-19 cases declined. Through the span of these events, macroeconomic phenomena like GDP, unemployment, and inflation became more volatile as Americans and their spending habits experienced a dynamic shift. 

The Global Supply Chain

As globalization has made our world more interconnected, companies have successfully developed intricate supply chains to optimize their business operations and offer maximum productivity. Now, a consumer can simply click a button on Amazon and expect deliveries within days, maybe even hours. This convenience, however, often hides the complexity of the supply chains from consumers. Behind the one-click online shopping, we have an ornate logistical relationship between numerous parties involving manufacturers, truck drivers, shipping companies, dock workers, and more. When the Covid-19 pandemic locked people down, they shifted to online shopping methods which put a huge burden on the existing supply chain. The supply isn’t able to keep up with the consumer demand thus resulting in shipping delays, overworked truck drivers and dock workers, and supply shocks. The reduced supply resulting from the increased demand that is burdening supply chains has led to an increase in raw material prices and labor shortage in many parts of supply chains. An increase in such prices result in decreased supply which equals increased prices. As the American economy is supposedly exiting the Covid-19 pandemic, the reduced supply and high prices reflect an economic phenomenon dubbed “stagflation”. 

Stagflation

According to macroeconomic theory, there are two components in an economy: aggregate supply (AS) and aggregate demand (AD). Aggregate supply represents the “total” supply within a given economy while aggregate demand represents the “total” expenditure for goods within the economy: consumer spending (C), business investment (I), government spending (G), and net exports (XN). The formula for aggregate demand is C + I + G + XN. Below is a chart representing a relationship between AD, AS, price, and GDP (the total final value of goods and services produced by an economy within a given year). 

The horizontally pointing arrow represents the “price level” the goods and services should be at while the vertical line represents GDP, defined above. Based on our understanding of supply chain issues, we see a decrease in aggregate supply with a slightly changed aggregate demand. 

We can consider AS0 as the aggregate supply before the pandemic and AS as the current aggregate supply with AD as the current aggregate demand. Based on this theoretical model, the overall price level has increased compared to the first “equilibrium chart” while the GDP has decreased. In an equilibrium economy, the price level and GDP are expected to increase proportionally, by 2% every year. 

Inflation

The concept of price level should be quite familiar to most: it is essentially inflation. Stagflation occurs when the economy is experiencing inflation, but the GDP or “output” isn’t keeping up with the inflation rate. The American economy is currently experiencing the highest inflation since the 1970s when the U.S. experienced stagflation, currently at 8.6% annually according to the Consumer Price Index (CPI). The CPI consists of a “basket of goods,” tracking the prices of a variety of products to determine the inflation rate. 

A combination of price increases throughout multiple products in different industries has contributed to a high rate of inflation in the U.S. Each product’s price increase has a different story. For example, gasoline companies are earning high profits after a volatile downward trend during Covid-19. As the economy is opening up, people are traveling to work and vacations, requiring more gas to fuel transportation. However, gas companies are limiting drilling largely due to worker shortages and increasing raw material costs, but also to keep their profits high and investors happy. The geopolitical scenario in Russia and OPEC’s limited supply make matters worse. Transportation is also getting expensive because of labor shortages. We see a common theme of supply chain issues, labor shortages, and increased raw material costs in nearly all products undergoing inflation. What can these price increases mean for the overall American economy and the stock market? 

The Fed and Interest Rates

John M. Keynes was a prominent British economist known for “Keynesian economic theory.” This theory called for moving AD to adjust the price level and output according to an economy’s needs. However, in stagflation, economists fear that increasing AD (AD+) to meet an economy’s potential output will cause more inflation. Decreasing AD (AD-) to meet an economy’s inflation goals will cause a decrease in output, possibly even enter into a recession. 

There are two main ways to change AD within the American economy: fiscal policy and monetary policy, which we mainly focus on. The Federal Reserve is the central bank of the U.S. responsible for ensuring that the U.S. has a healthy price level stability. In other words, the Fed is responsible for keeping inflation in control. The Fed changes AD by changing interest rates. Interest rates are the extra fees a borrower has to pay the lender to borrow money. There are different types of interest rates that the Fed controls, but the main idea is that they reduce interest rates to make it cheaper for businesses and households to borrow money so that they can spend more and increase AD. On the contrary, they can raise interest rates to make borrowing money more expensive, thus discouraging households and businesses from borrowing and spending, effectively reducing AD. As the Fed tries to control stagflation, it strives to accomplish a “soft landing” by reducing inflation to preferred levels while narrowly avoiding a recession. Another perspective represents the move as cooling down demand for supply to catch up. 

Affect on Consumer Spending and Recession Potential

The Fed recently announced that their main goal is to reduce inflation, even if they risk going into a recession. The inflation scene is dire in the U.S: despite the inelasticity of gasoline, sales by volume have decreased by 8.2% at gas stations because of price increases. If inflation stays at record levels, Americans might fall into a painful loop: workers demand more pay because inflation is eating into their salaries → businesses increase salaries but increase their expenses → they increase their selling prices to handle their increased expenses → cause more inflation.

Fed Chairman Jerome Powell recently announced interest rate hikes to near record high levels in recent years. The current interest rate is between 1.5-1.75% but the Fed’s target is 3.5-3.75%. These interest rate hikes seem to work. U.S. household spending has decreased because of inflation and higher interest rates, which indicates that the AD is decreasing. There was only a 0.2% increase in consumer spending in May, which is well below average. Moreover, mortgage rates are increasing creating an unideal environment to buy a house currently. Jobless claims are subtly ticking up while job growth is starting to decline. Retailers are starting to stock low priced items as consumers are putting big-ticket purchases on hold. 

With economists’ predictions and trends in consumer spending and other indicators like inventories and manufacturing growth, a recession is a likely possibility for the U.S. economy. Some institutions like the Atlanta Fed, investors, and economists argue that the U.S. has already entered a recession. 

The S&P 500 Bear

Macroeconomic changes as described above have significantly impacted the U.S. stock market. The S&P 500 recently entered a bear market, characterized by being -20% from a recent high. In fact, many indices are showing similar downward trends and volatility. Below is the price chart for the SPDR S&P 500 Index fund that closely tracks the S&P 500. 

The bear market can be explained by a multitude of factors: panic selling driven by interest rate hikes, a correction in high-growth tech stocks, and the anticipation of reduced earnings due to high inflation. The overall investor risk profile is shifting to becoming more risk averse during these times. 

Portfolio Management Strategies

In a traditional portfolio allocation strategy, it is recommended to have 60% invested in stocks and 40% in bonds. It is a diversification basics rule of thumb that many follow to balance out their losses. Currently, however, the average 60/40 portfolio is performing fairly poorly. It is unfair to sound the “death knell” on this strategy since most asset classes are getting hammered due to today’s macroeconomic environment. Holding cash isn’t the wisest strategy since it’s dropping in value by 8.6% every year. The best solution would be to passively maintain a diversified portfolio at this point: include a wide variety of stocks, possibly other alternate asset classes, and fixed income and safe haven securities. Seeing portfolios end every day in the red shouldn't discourage long-term investors from selling companies that they have faith in. Staying calm and perhaps “buying the dip” for some firms may be the move. 

Since panic selling has played a huge role in the bear market, investors, both retail and institutional will be on the lookout for the upcoming earnings season. If companies perform better than analysts’ low expectations, investors might slow down in their selloff. Discussions  around earnings calls can potentially help retail investors make better choices as they work to “truly” assess firms’ real value. Tech companies haven’t reduced their business investment much, so theoretically, it isn’t being affected much by the rising interest rates driving panic selling. Alternatively, energy companies’ stocks are booming because of their soaring profits. The market is driven by fear but if firms reassure shareholders that business isn’t as bad as they think, investors might jump the leap of faith and take a bullish stance on certain companies. Investors should consider the actual value of companies to make long term bets. 

On the other hand, some might consider gearing up for a rough or mild recession they feel is imminent. A popular avenue investors are flocking to are “safe haven” recession-proof stocks, companies like utility or consumer staples companies that are likely going to have constant demand regardless of a recession. “Defensive” blue-chip stocks are staying in the green as of now while high-growth tech stocks are falling day by day. According to a repeating pattern in history, one can expect the second half of this year to wrap up the year in green. However, pressures from the Fed and lowered consumer spending makes it hard to expect an overall robust bull market anytime soon. At this point, the American economy is at a tipping point between going into recession or narrowly avoiding it. It is hard to determine where the stock market is heading, so the best strategy would be to invest and hold in stocks you have faith in.