Patience Amidst Inflation
Stock market indices in the United States managed to climb higher this week as investors received news of incremental progress during peace talks in Ukraine and clear policy updates from the Fed. Despite these gains, progress has been uneven in the geopolitical sphere and in financial markets; we expect that pattern to continue. Investors are wading through a muddled landscape of data showing strong corporate earnings offset by rising inflation and interest rates, all while guessing at the long-term financial repercussions of the war in Ukraine.
Amidst this backdrop, one issue has remained clear: constrained inventories of various goods are keeping prices high and building frustration amongst consumers. The factors leading to short supplies of houses, food products, and barrels of oil are complicated, and resolution will take time and adaptation within the economy. Raising the benchmark US interest rate to 0.25% is a good first step and critically important — but also unlikely to create immediate relief.
A New Rate Cycle
While the initial rate increase may seem insignificant, the Fed also signaled intentions to continue to increase rates at each of their remaining six meetings this year. After the abrupt shift to zero percent rates and heavy stimulus in March 2020, this week marks a significant change in Fed policy — albeit one that they have been messaging to investors for months. Investors are expecting their target interest rate to reach 1.75% by year-end. That is low from a historical perspective, but a dramatic increase over the zero percent rates at the beginning of the year.
The Fed has a mandate to control inflation and raising the benchmark interest rate is one of their primary tools to accomplish that objective. Prices are currently running at four-decade highs, fueled by recent spikes in commodity prices related to the war in Ukraine and continuing supply-chain bottlenecks. Those forces are not within the central bank’s control and won’t be fixed by changes in interest rates.
For individuals, the impact of higher rates will be a gradual but steady increase in the price of money. While prices for food and gasoline are visibly increasing, so, too, are prices of mortgages, home equity lines of credit, and student loans. Long term, we think higher interest rates are essential for economic health. Higher rates allow conservative investors to earn interest on bank savings and bonds, and also rebuild the Fed’s capacity to support the economy by lowering interest rates during a future crisis.
Case Study: Housing Inflation
The price of real estate and rental costs in the Bay Area, and nationally, have continued to astound and frustrate both buyers and renters. The pandemic re-enlivened demand for single-family homes as people sought more space and flexibility for remote work, but the supply of available homes remains far below the level of demand. Meanwhile, homebuilders are reluctant to dramatically increase production in an environment of spiraling construction costs from lumber to labor expense. In the US, total housing inventory is down -15% over the past year, while prices have increased by +15% over the same time period. As rents continue to rise, there has been a pick-up in activity for new multifamily construction, building this new capacity takes time.
The decision by the Fed to raise interest rates was anticipated by the mortgage market. The average rate on a 30-year fixed mortgage has already climbed above 4.25%, far above the 2.65% in 2021. Now at their highest level since 2019, higher rates make homes less affordable even as rising prices for gasoline and other goods leave households with less money to spend. Despite this dampening factor, residential real estate prices remain high due to low existing inventory and are expected to stay high during the spring home-buying season.
Supply Chain Saga
Similar concerns exist elsewhere in the economy that inventory and supply is not keeping up with demand. The newest concerns arise from surging COVID cases in China that has led to nearly 18 million residents of Shenzhen facing new lockdowns that will last at least a week. Shenzhen is home to key manufacturing facilities, including Apple iPhone assembler Foxconn. Shanghai is also dealing with new lockdowns. For nearly two years, Chinese factories kept going as their “Zero-Covid” approach seemed to work despite precariously low vaccination levels, but that pattern may be shifting if these new waves aren’t contained.
Meanwhile, the price of oil — and gasoline as the tangible downstream product for consumers — has dramatically increased as a result of international sanctions imposed on Russia. US consumers have been quick to express their frustrations as higher gas prices raise the cost of travel, and begin to impact spending decisions. Until sanctions are lifted, which we don’t expect to happen soon, the global supply of oil will remain low and prices will remain elevated. Both of these issues — rising COVID cases in Chinese production hubs and suppressed supply of oil and gas from Russia — will eventually resolve themselves, but the timeline is unclear and consumers face higher costs in the meantime.
Looking at current headlines, the uncertainty in the landscape may appear overwhelming. There are references to WWIII and speculation about food shortages. While there is real tragedy unfolding in eastern Europe right now, there is always a myriad of risks to the global economy and interconnected systems we have built. The challenge for investors is to remain patient, with enough liquidity to match their needs, and avoid reactionary changes to your long-term strategy.
The inflationary pressures on consumers are likely to persist in the near term. By owning stock in high-quality companies that are able to pass these costs along to consumers, our clients benefit from higher prices through diversified portfolios. We understand this does not fully offset the frustration or concerns that can accompany higher prices at the grocery store or the gas pump, and that patience will remain key. As we look at past moments of heightened market volatility, remaining invested and diversified has provided the most resilient outcomes for our clients; and we expect the same to be true as we navigate through this new phase of rising interest rates.
 Existing-Home Sales Report, February 2022. National Association of Realtors
 Mortgage Rates Rise Above 4% to the Highest Level Since 2019 Barrons
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