Yesterday (Tuesday) was the worst day for stocks since mid 2020 (when Covid lockdowns were being announced) because a higher than expected inflation number (CPI) spooked investors. And as the Fed fights aggressively to battle inflation (with interest rate hikes) some pundits believe the Fed is going WAY too far, and deflation is now the bigger risk.
Why is the Market Down
You’ve all heard the story: the Fed is hiking rates to slow inflation, but the side affect is that it also slows the economy (that’s why stocks are down this year—because the Fed keeps hiking rates aggressively).
Lagged Monetary Policy Affects
However, the big problem with interest rate hikes is that there is a long time lag before they actually impact the economy (for example 12 to 18 months). That basically leaves the Fed running blind as they keep hiking rates without yet knowing if their actions are working.
Is Inflation Transitory?
Making matters even worse, the inflation they are fighting may actually only be “transitory,” meaning it’s an after affect of Covid that will solve itself (as lockdowns, stimulus checks and extended unemployment benefits end and the temporary affects work their way through the system).
Deflation:
These two things (a 12-18 month lag and an inflation problem that may actually solve itself) now have some investors worried the Fed’s actions may now lead to deflation—an even bigger problem.
According to Investopedia, deflation is basically a decline in aggregate demand, resulting in lower prices. And it is caused by less government spending, stock market failure and tight monetary policies (higher interest rates).
Deflation may not sound bad, but it is actually really bad because it can eventually lead to high unemployment, and it can turn a bad situation (recession) into a worse situation (depression).
Jeff Gundlach and Cathie Wood:
Some famous investors are now calling for deflation as the bigger problem. For example, Billionaire 'Bond King' Jeff Gundlach says it's time to get more bearish on US stocks, as the risk of deflation is much higher now.
Jeff Gundlach says it's time to be more bearish on stocks and he sees the S&P 500 dropping 20%.
The billionaire "Bond King" told CNBC he now views deflation as the key risk to the US economy.
He advised investors to buy long-term Treasurys and said the Fed should slow its rate hikes.
Ark's Cathie Wood also calls Fed hikes a mistake and she prepares for deflation.
What Should You Be Doing?
As an investor, the current crisis always seems like the worst crisis ever. But the reality is that this too shall pass. As we wrote yesterday, investors’ emotional reaction to bad news is always much stronger than their reaction to good news. And the bearish argument always sounds more intelligent than the bullish argument.
In reality, this too shall pass. The market will get better. We are not in a deflationary environment yet (and we may not go into one either). Further, inflation will come down. The Fed’s aggressive rate hikes will achieve their desired affect of slowing inflation—and the market will get better.
Don’t do anything rash like ditching your long-term investment strategy because you read a bearish article on the internet. Rather, stay focused on your disciplined long-term investment goals. Your future self will thank you for it.