Shanghai Returns to Lockdown; Federal Reserve; Russia-Ukraine Conflict

China's "zero covid" policy has had a major impact on the global economy. The “mainland” is the world's largest producer of consumer goods and United States’ largest trade partner. Consumer spending accounts for 70% of US Gross Domestic Product (GDP). 

All the talk we’ve heard of supply chain “bottlenecks” by the Federal Reserve is a direct result of the strict and continued lockdown measures being enforced by the Xi administration. After lifting recent restrictions over Shanghai, lockdowns were forcefully reinstated just 24 hours after temporary hiatus.

The record high inflation experienced worldwide originated more than two years ago. On March 23, 2020, the United States Federal Reserve announced and implemented its largest quantitative easing (QE) program to date. Since then, its balance sheet more than doubled, rising from $4.1 trillion to just under $9 trillion in 24 months. As the Fed's emergency backstop artificially boosted demand, we saw total Money Supply (M1) increase a staggering 400%. 

These are not small numbers — they're alarmingly inflationary.

If you are curious why the stock market performed as well as it had since the United States first introduced pandemic-inspired lockdowns, to its easing of social restrictions, and into the end of 2021, the answer lies with the Federal Reserve. Trillions of dollars of the world’s reserve currency were printed through emergency Treasury Bonds purchasing programs, interest rates were lowered to near-zero, and the market was flooded with cash. 

After 18-months of highly “accommodative” monetary policy, the effects of inflation began to set in. The Consumer Price Index (CPI) has risen 8.1% — its largest increase since the 1980’s  period of “Great Inflation.” 

Keeping in line with its dual mandate of maintaining maximum employment and stable consumer prices, the Fed was forced to act before inflationary pressures would begin to spiral out of control. On March 17, 2022, the Effective Federal Funds Rate was raised from 0.08% to 0.30% — the first real increase to interest rates since December 2018. It also began reducing asset purchases and shrinking its balance sheet.

It took well over a year for the inflationary effects of the Federal Reserve’s highly accommodative monetary policy to spread across the global economy. Although the Fed has shifted course from quantitative easing to quantitative tightening (QT), we have yet to experience the full effect of the negative consequences of excessive economic stimulus. 

It is within reason to suspect that inflation, as measured through CPI, has yet to peak, and the problem will likely persist for the foreseeable future, regardless of the Fed's hawkish approach to combatting what it repeatedly said was simply “transitory."

Making matters even worse is the ongoing geopolitical conflict between Russia and Ukraine. Both countries are majors commodities producers and exporters. Russia is the world’s largest exporter of crude oil, refined petroleum and wheat. It exports significant amounts of semi-finished iron, nickel, and nitrogen-based fertilizers. Ukrainian exports include iron, steel, cereals, cooking oils, electronics equipment, plastics, and precious metal compounds.

A continued reduction in supply of vital commodities between these countries adds to the inflationary challenges the Federal Reserve is trying to manage. War, however, might be outside of its control.

The reduction of the supply of crude oil, as a result of war and domestic production restrictions imposed by the Biden administration, continues to take its toll on the price consumers are paying at the pump. 

Due to these factors, the price of crude oil will likely retest 2008 highs, or $145 per barrel, which will increase the cost of fuel a minimum of 23%. If this technical retracement plays out as we suspect, the national average of a gallon of gasoline will rise from $4.76 to $5.85. States like California and New York will soon be paying over $10 per gallon. 

Transportation costs will continue to cut into consumer discretionary spending more than it has since the 2008 Financial Crisis. 

(Remember: US spending accounts for 70% of its total GDP).

When firms like JPMorgan and Morgan Stanley are warning investors of trouble ahead, this is what they are referring to. It is important to take everything into consideration when evaluating the macroeconomic environment we find ourselves in today and could face in the future.

The recent sell-off in US indices set records dating back to the 1930s. "History doesn't always repeat itself, but it often rhymes." The stock market is an incredibly accurate measure of the probability of the occurrence of future events. As with all things, however, the future is never certain.