Signs that inflation may be moderating amid slowing growth fueled stocks to a sharp rally this week, lifting the benchmark S&P 500 back out of bear market territory. Nearly every sector in the index recorded strong gains, except energy. The Dow Jones Industrial Average surged over 1600 points last week finishing at 31,501—a gain of 5.4%. The technology-heavy NASDAQ Composite jumped 7.5% to 11,608. By market cap, the large cap S&P 500 rallied 6.4%, while the mid cap S&P 400 gained 5.1% and the samll cap Russell 2000 jumped 6.0%. 
The Federal Reserve is clearly on a mission to tamp down inflation. When Chairman Jerome Powell recently announced a 75-basis point rate increase, it was a bigger hike than what he projected in May and also marked the biggest rate increase since 1994.
In Chairman Powell’s words, “we are strongly committed to bringing inflation back down, and we are moving expeditiously to do so. We have both the tools we need and the resolve it will take to restore price stability on behalf of American families and businesses.”
Part of the Fed’s approach is to “front-end load” bigger rate hikes, in hopes that moving big and fast will solve the inflation problem sooner rather than later. But I’m not convinced the plan is going to work.
The reason is simple: inflation today is primarily a supply issue, and the Fed has no control over supply. Many would argue that years of easy monetary policy and massive fiscal stimulus programs created too much money and drove demand off the charts, a fair point. But these factors were more relevant in 2020 and 2021, in my view, and in normal times I believe the global economy could have absorbed this surge in demand.
But 2020 and 2021 were anything but normal. Excess demand was met by snarled supply chains, labor shortages due to the pandemic, rolling factory shutdowns across the world, clogged ports, and rising shipping costs, to name a few. The phenomenon in those years is what I like to call ‘inflation classic’: too much money chasing too few goods. Even if we removed U.S. fiscal stimulus from the equation, there still wouldn’t have been enough goods.
In 2022, the demand side of the equation is still strong, but the fiscal stimulus has largely run its course and monetary tightening is underway. What we’re facing now is uniquely a supply problem (again, too few goods) that the Fed can’t fully fix by ending QE, trimming its balance sheet, and/or raising the fed funds rate.
To make matters more complicated, just as the global economy was ramping back up, supply chain issues were starting to resolve, and spending was shifting from goods to services, Russia invaded Ukraine. The war clearly created major dislocations in the oil and gas markets, reducing global supply as many nations banned Russian energy imports. But the war also disrupted food supplies, fertilizer production, and further obstructed global shipping routes. Consumers around the world are feeling these inflationary effects, not just Americans.
Then the situation got worse. China implemented strict Covid-19 lockdowns across the country this spring, but most notably in the most populous and wealthiest city of Shanghai, where residents were confined to their homes for two months.
Manufacturing output and spending fell, and restrictions elsewhere in the country only added to the global supply problem.
The Fed cannot do anything to change these issues. Monetary policy can soften demand indirectly, by adjusting credit markets and making access to business loans and mortgages more costly, for instance. Eventually, the Fed could raise the benchmark fed funds rate high enough that it exceeds the yield on the 10-year U.S. Treasury bond, which could essentially shut off banks’ incentive to lend. That’s another way of saying that too many rate hikes could invert the yield curve. But we’re not there yet – the yield curve has actually steepened this year, which tells me the Fed has a way to go before choking off demand.
So, what does this all mean for investors? I think for one it means we can stop fixating on the Fed’s role and apparent power over inflation, which to me is much smaller and less significant than many think. The real focus should shift to the supply issue, and whether it gets better or worse from here. The outcome is key for markets.
Markets tend to move on surprises when outcomes are better or worse than expected. At this point, it feels to me as though everyone is expecting the worst, or at least expecting inflation to get much worse. And that lays the groundwork for a positive surprise.
The Week Ahead
The decline in commodities and interest rates last week generated some optimism on
inflation expectations and the pace of future rate hikes. But as Fed Chair Powell said
in his testimony, the central bank needs “compelling evidence” that prices are falling
and won’t ease off hiking rates until inflation is under control. That puts Thursday’s
U.S. PCE Price Index release in the spotlight, and consensus estimates point to a
second straight monthly drop in the core reading. A busy U.S. calendar also includes
durable goods, consumer confidence, trade balance and inventories, and personal
income and spending figures. The week closes with the ISM Manufacturing PMI
report. The oil and gas markets may react to the G7 meetings that began yesterday,
where global leaders will discuss measures to stabilize energy prices. The ECB will
host a forum on central banking in Portugal mid-week, another opportunity to hear
the leaders of the ECB, FOMC, BOE and others opine on monetary policy. Eurozone
inflation updates also appear with German CPI on Wednesday and EU flash CPI on
Friday. In Asia, the yen’s collapse has traders thinking the BOJ will relent and
eventually raise the ceiling on bond yields, with inflation statistics and business
surveys due on Friday. China delivers June PMIs to round out the week’s agenda. 
The Dow Jones Industrial Average ($DJI) was one of the very first indexes and
the most widely watched for many decades. More recently the S&P500 has taken
that throne since it’s a broader index and capitalization weighted instead of price
weighted. The Dow will always have its place and has held up better than most in
2022. All of the other major U.S. indexes entered bear markets this year with
declines of over 20%, but at Friday’s lows, the Dow had only dropped 19.75%. Rallies
last Tuesday and Friday led to a 5% pop for the week. The weekly MACD and RSI are still
below their down-sloping
trendlines, but the RSI did produce a bullish divergence that needs to be confirmed by price. Will the Dow dodge the bear, or is it just taking its time to get there?
Click on the Chart to Enlarge. 
Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.
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