Navigating Market Icebergs, Potentially Toward Calmer Waters

Over the last two centuries, at least 23 ships are recorded as having been sunk by icebergs, while many more have sustained damage. Most of these accidents occurred before the era of sonar, a time in which a sailor in a ship’s crow’s nest (sometimes two sailors, as in the case of the Titanic) would have to peer through the dark and foggy sky to try and spot the tips of icebergs before it was too late. Misidentifying even a small iceberg tip could be fatal, since 90% of an iceberg’s mass lies unseen beneath the ocean’s surface. Yet, if spotted early enough, ships would quite likely be able to navigate around the iceberg and into safer waters.

Over the years, while ships have grown larger, so have icebergs. The largest iceberg in the world, at about 80 times the size of Manhattan, broke off the coast of Antarctica just last year. And investors in 2022, encouraged by ever-more-sensationalist headlines, may be forgiven for thinking that the financial equivalent of Iceberg A-76 may be lurking in the markets today, waiting to sink an unsuspecting portfolio. Indeed, market uncertainty has recently grown more intense, particularly through a series of three developments: 1) an extremely strong January employment report, suggesting that higher wages are attracting people back into the labor force, but at the same time keeping the door wide open for policy tightening. Also, 2) inflation that has hit levels that were inconceivable just a few months ago, and 3) the Russia-Ukraine situation, and accompanying geopolitical tensions. While policy has stayed accommodative thus far, 2022 returns are reflecting these developments, including the potential for policy to aggressively change course. Oil and gold are the only major assets in the green this year, echoing the return pattern of 2018, another year in which real economy inflation was accompanied by financial economy deflation.

Inflation as a Market Iceberg

With the Federal Reserve (Fed) focused on inflation, and the market focused on the Fed, certain dangers do concern us. Energy prices continue to make new highs, propelled in part by geopolitics, while other commodities may also be well supported by a loosening of policy in China. This could prolong the raw material, cost-push inflation that has made its way into consumption baskets over the last year. At the same time, higher wages, which are usually a welcome development for an economy, look to be more correlated to broad prices than they have been in decades (see Figure 1), threatening a “wage-price spiral” that could keep inflation hotter for longer.

Figure 1: The correlation between wages and prices is picking up to pre-1980 levels

Sources: Bureau of Economic Analysis, data as of December 31, 2021, and Bureau of Labor Statistics, data as of January 31, 2022