Inflation Makes a Comeback
The high market volatility of the first half of the year continued in the third quarter as rising inflation, the Iran war, and rising interest rates combined to cause uncertainty in both the stock and the fixed income markets. Equity markets ended the third quarter with modest gains. Fixed income markets struggled as higher interest rates caused bond prices to drop across the board. So far, higher interest rates have not had a negative effect on the earnings of most companies. This, and improving data on new job creation, were about the only sources of good news for the quarter.
Lost in the torrent of news during the quarter is the fact that the U.S. economy just isn’t growing much. In the first quarter, GDP grew at an annualized rate of 2.1%. This dropped to just 1.5% for the second quarter. It looks like third quarter growth will come in just over 2%. Most estimates we’re seeing for the entire year are for growth of less than 2%. With inflation at 3.5% and the economy growing less than 2%, this is a problem. To combat climbing inflation, the Fed increased the fed funds rate by a quarter point in mid-September. More importantly, they indicated that more rate increases are likely. This is a big change in direction from the beginning of the year when they were expecting multiple rate cuts. The good news is that the Fed seems to be committed to reducing inflation. The bad news is that there is likely going to be some short-term pain to get that done.
A cautionary tale unfolded in August, as the hedge fund Situational Awareness collapsed, dropping by more than two thirds, and forcing a last-minute sale of their remaining assets to another hedge fund to avoid a total wipe out. This fund, managed by 24-year-old Leopold Ashenbrenner, was $45 billion at its peak, and invested in AI companies. He also took short positions in software companies. The fund put up spectacular returns in the past couple of years. Here’s the problem: when you’re getting huge returns, it’s because you’re taking huge risks. That, by itself, is not a problem, but that risk must be managed, and that wasn’t happening. Another problem is that the fund had 400% leverage. Bad idea. That leverage, combined with a concentrated portfolio, blew up the portfolio because two of its holdings moved against him in a big way. When two stocks moving against you in one day makes your portfolio collapse, proper risk controls are not in place. Hopefully Leopold has learned how to properly manage a portfolio. Hopefully the investors who gave him $45 billion have learned that incredible investment returns are not possible without also taking the risk of losing everything. As Warren Buffett famously said, “Only when the tide goes out do you discover who has been swimming naked.”
For the remainder of the year, we will be keeping a close eye on inflation, interest rates, and the GDP. Those three things will likely determine where the markets go from here.
Wabash Capital
