By Michael O’Connor

They say history doesn’t repeat itself, but it often rhymes - at this point however, even the rhyming has stopped.

The pandemic policy changes have left us with skewed data figures, manipulated comp stats and a remarkably unfamiliar backdrop resulting in immeasurable uncertainty amongst investors across the globe.

During times like this, it is best to break complex problems down to their simplest forms and concentrate solely on the most crucial variables.

And the most crucial variables in this case are inflation and Fed policy.

An infinite number of potential outcomes are possible over the coming months, but all will be derived based on the aggressiveness of future Fed adjustments and the persistence of inflation.

There will always be risk

There is no perfect scenario here. The inflation we are experiencing is the by-product of an overheating economy.

The cumulative net worth of US Households is now almost $150 Trillion, $80 Trillion more than it was 10 years ago. The US labour market currently boasts two jobs for every one person looking for work, and corporate earnings jumped 35% in 2021, the largest increase since 1950.

Simply put, there is more money in the system than ever before.

The supply side issues have been well documented, but if inflation is to be quelled, then the demand side of the equation needs to be solved.

This is where the Fed’s tightening cycle comes in.

The Fed cannot improve supply issues, but they can negatively impact demand by dampening the labour market and decreasing the amount of capital in the systems through higher interest rates.

This tighter monetary policy is expected to bring inflation under control, but as the Fed increases the speed of rate hikes, the odds of economic contraction also increase.

In short, the goldilocks scenario of a gradual decline in inflation while maintaining labour market strength, household wealth and corporate profits, remains a pipe dream.

To strip inflation out of the system, a period of economic contraction is a necessary evil.

Crucially, this contraction does not need to lead to a crippling recession or anything of the sort. The level of contraction we experience will depend solely on the Fed’s ability to strike a balance between cooling inflation and maintaining demand.

Only time will tell if they can successfully thread the needle.

Jumping back in

Before declaring an all-clear for stocks, investors need to believe we are at the peak of policy tightening and inflationary pressure.

Certainly, we are seeing signs of improvement from an inflationary standpoint. For example, wheat prices are now lower than at the beginning of the war in Ukraine - another showcase of the unpredictability of markets.

With that said, one crucial paradox remains. Investors want interest rates to fall so stocks can rise, but any fall in interest rates is unlikely if stocks rally, somewhat capping the recent upside.

Make a plan

As always, I encourage a long-term focus. Investors will be better served focusing on the bull market opportunity on the other side rather than overemphasising what may be left in the bear market.

Those looking to take advantage of any potential upside need to get their house in order. You need to take the time to develop a clear picture of what your allocation will look like, create a watchlist of preferred names and know your entry points.

Scrambling together a plan after the fact is a sure-fire way to ensure you miss the very opportunity you were trying to capture.

Learn more at

https://www.theislandinvestor.com/