The economy continues to boom while the markets suggest a rocky period may be ahead. Forces are combining that will test the resiliency of the long running bull market at some point, as well as the Federal Reserve’s resolve. We see a possible analogy to the story in the film, The Perfect Storm.

The Economy

Real GDP increased at an annual rate of 7% in the last quarter of 2021. Adding inflation back in to that number means that the nominal GDP advanced by a rate of almost 14%. That’s smokin’. It appears that the Federal Reserve and government achieved their goal of bringing the economy back from the Covid depths. Perhaps they did it too well though, generating the highest inflation rate in the last 40 years as a by-product.

As might be expected, labor conditions have tightened as well, with February’s unemployment rate dropping to 3.8%, although the labor force participation rate is still below pre-pandemic levels. People continue to spend on real estate. Single family home prices are up 8.4% for the nation as a whole, since a year ago. However, as might be expected, housing affordability has dropped 21% as interest rates climbed in addition to the increase in basic home prices. Lower affordability will likely limit the rate of future gains.

The Markets

In November 2021, the Federal Reserve recognized that inflation was getting out of hand rather than being “transitory” as they had expected. This recognition prompted them to decide to slow the money “printing press” and warn investors that they intended to raise interest rates off the floor. The first rate increase was voted in March. Creating new funds to add to the money supply is also being stopped. Markets reacted negatively to these developments. Stocks dropped 12% , and 10-year Treasury bonds shed 8.6%. Stocks have recovered much of their loss at this point, but bonds remain close to their lows, which is to be expected, since bond prices fall when interest rates rise.

The Perfect Storm

The Perfect Storm is a film that tells the story of the last voyage of the Andrea Gail, a sword fishing boat that sailed out of Gloucester MA. It is based on a non-fiction book by Sebastian Junger.

A severe weather pattern, also known as the Halloween storm of 1991, was formed by Hurricane Grace colliding with a high pressure ridge over eastern Canada. At the contact point of the two weather systems, the cold air to the north met warm air from the south and created a rapid change in air pressure, resulting in strong winds and waves over the North Atlantic. The Canadian Hurricane Center recorded a 100-foot wave off the coast of Nova Scotia.

Despite knowing that a tropical storm was developing to the south, the crew of the Andrea Gail set out for one more trip to the Grand Banks to fish, because the catch of an earlier voyage was less than expected. The captain felt that the tropical weather system would not reach them in the fishing grounds. Unfortunately, after loading the hold with fish, their ice machine broke, so they could no longer keep their cargo cold. Faced with this dilemma, they decided to go back to shore to unload, but by then it was too late to escape the collision of the weather systems. The boat sank after being tossed about and damaged in the weather and was overturned by a rogue wave.

We have been writing for years in Outlook & Trends about how Federal Reserve policy of keeping interest rates low to stimulate the economy and reduce government borrowing costs has created significant overvaluation in the financial markets. Modern Monetary Theory adherents suggest this policy, as well as increasing government debt, are acceptable as long as inflation remains low. However, it was only a matter of time until inflation caught up.The Fed now recognizes that inflation is "very elevated" and “much too high”. It has decided to reverse the direction of monetary policy, reducing money-printing and vowing to raise interest rates. Higher interest rates are intended to slow economic growth and restrain inflation. Unfortunately, when the stress of any situation approaches its natural tolerance limits, it becomes much more susceptible to breaking under any small external influence. (Recall the proverbial camel and the last straw.) It is better not to push the limits to the extreme in the first place and operate in a range that can provide a safe harbor should it become necessary.

There is a parallel between this maritime story and the current economic environment. Just as Hurricane Grace had been forecasted and traveled northward for some time before reaching the Gulf of Maine, we have seen an overvaluation problem developing for years now. The mixture of valuation and rapidly appearing inflation has left the Federal Reserve with little choice other than to "head back to shore" without additional delay, by normalizing its balance sheet and raising interest rates.

The problem, however, may be that when the highest financial valuation (recently by some measures) in history collides with the highest inflation since 1982, unforeseen accidents can happen. Fed leaders may be confident that they can guide the financial ship, because high market values and inflation have occurred before. However, in the midst of what could be considered a serious, but not necessarily abnormal, economic condition, the Ukraine war and the possible additive effect of sanctions that overturn the global economic order cannot be discounted.

The economy looks like blue skies today from many people’s viewpoint, but instruments can give us a clue as to what is brewing over the horizon if we choose to look and take heed. Storms come and eventually go, but it can be risky to go out to get "one more load of fish" until the weather passes. Stock market valuations have been driven upward by FOMO (Fear of Missing Out) and low interest rates for a long time. It may still take a while for the storm to finally arrive, but it makes sense to take that time to prepare … to trim the sails, so to speak. Like the Andrea Gail, FOMO could leave us stranded, if not worse. Financial sailors should make sure they have an exit plan with an alternate course to safety.

The Perfect Storm only had two contributing forces. We currently have four, all converging at the same time. It will be interesting to see how this resolves. Whatever the resolution is, at some point it will not be business as usual. New strategies will be necessary to generate and maintain the value of funds for savings and retirement. If inflation is not brought under control quickly, loss of purchasing power can throw a wrench into the best of plans, particularly those that are based on continuation of historical average returns. The last 40-year period of declining interest rates and mostly rising stock prices has been fairly unique in our nation’s history. Change can be expected.

No one has a crystal ball that can accurately predict the future, but one way to address this question is through financial planning – to test alternative outcomes and answer the question, “What if”, and then adopt investment strategies and a lifestyle which will be successful and with which you are comfortable. LFM&P can help you with this process.