July 1, 2022
For the last
decade, the Federal Reserve and other central banks maintained
an accommodative easy-money policy. Likewise, politicians
have been following a spend-as-much-as-possible fiscal policy.
All things come to an end eventually. Over the years,
Outlook and Trends
has suggested that these policies
were likely to end in future inflation, and that the gross
overvaluation of the financial markets would eventually
normalize. That future appears to be now.
Last year, the Federal Reserve
predicted that inflation would be transitory as the economy
rebounded from the pandemic slowdown. Additionally, economic growth was expected to be reestablished as the country resumed
working and spending. Unfortunately that turned out to be
wishful thinking and the opposite has occurred. Inflation has
grown to an annual rate of 8.6%, while GDP declined by -1.6%
during the 1st quarter. Today’s Atlanta Fed’s
model suggests 2nd quarter growth
will also be below zero. The Conference Board’s Leading Economic
Index is lower than six months ago, and the University of
Michigan Consumer Sentiment posted the lowest reading since its
inception in 1978.
Employment is holding up, however. Businesses continue to have difficulty finding and retaining workers. Home prices have continued to gain. The Case Shiller survey reports an annual home price increase of 20.4%, while the National Association of Realtors data shows a 14.6% gain. Higher prices, coupled with higher mortgage interest rates have recently combined to result in a steep drop in home affordability.The overall picture suggested by these trends is an economy that continues to chug along, albeit with a loss of consumer buying power and reduction in the standard of living. Soothsayers suggest the potential for either a period of “stagflation” like the 1970s or a potentially a “hard-landing” recession is on the horizon. It is also possible that the Fed will declare success, reverse course, and re-inflate the economy when lack of economic growth becomes a greater political problem than inflation. The next chapter of the future story cannot be predicted, because it is largely dependent on unpredictable decisions by the small group of bankers, who make up the Fed’s Open Market Committee. Over the long-term, however, the cycle of increasing debt is likely to continue and eventually result in a predictably difficult outcome. (Read Ray Dalio’s Principles for Dealing with The Changing World Order if you are interested.)
stock and bond markets have continued their declines since the
beginning of the year. The S&P500 index is down 16.5% this
quarter and 21% this year. Treasury bonds, which normally
provide a cushion in a diversified portfolio by rising when
stocks fall, were down 4.6% and 10.5% respectively. The Fidelity
2025 target date fund, designed for safety in retirement
plans, fell 16.7% and 24.5% year-to-date. Our review currently
shows no asset classes that are rising over the intermediate
term. Even energy, the recent leader, has weakened. The only
minor exceptions are the dollar and higher rates shown by
money market funds and high yield savings accounts, but they too
are rapidly losing real, inflation-adjusted, value.
the financial crisis in 2008, governments have been propping up
the world economy by flooding the financial system with
borrowed money. In the beginning, such actions made sense as
they applied grease to a financial system that had seized up.
After the economic gears began moving again, the policies
continued, creating ultra-low interest rates, which people
used to refinance their homes and governments used to refinance
their national debt. There was also the stated purpose of
increasing the value of financial assets to create a “wealth
effect” which, in theory, prompted people to spend more, and
thereby support the economy.
time there were several half-hearted attempts at ending the
support. Each time, the markets threw a “tantrum”, and the
easy-money policy resumed with even more debt on the books.
Politicians love to give out favors of course, and policies
like the pandemic “helicopter money” handouts were justified as
a means to combat the COVID recession. Modern Monetary Theory
(MMT) was cited as a justification for this debt financing. MMT
proponents say that it is OK for a sovereign government to
spend as much as it would like, and take on as much debt as it
wants, because it can always print the money to repay the
debt. This thinking acknowledges, however, that the approach
will be limited by inflation. There was no inflation to speak
of in the last decade. There is now.
there is more political support to be lost now by the rising
specter of inflation than there is to be gained through
increased spending. The result was that the big-spending Build
Back Better bill could not be passed, and the Federal Reserve
has changed policy to increase interest rates and also to pull
back some of the excess money that it printed. The Fed has
loudly resolved to raise interest rates until inflation is
subdued. The question is whether inflation can be beaten down
without a recession. If it can, all is well, political pressure
will be relieved and the metaphorical can of debt may be
kicked farther down the road. On the other hand, Fed Chairman
Jerome Powell has acknowledged that recession may be an
outcome. If recession occurs, either the Fed will change policy
yet another time, or unemployment will rise, and we will be
back in another pandemic-type scenario producing a clamor for
more economic support. The 1970’s contained two of these
inflation / recession cycles. During the first cycle in 1975,
annual inflation rose to 12.3%. It was subdued when the Fed
raised the Federal Funds rate to 13%. The second cycle followed
6 years later after this rate was lowered to 4.5%. That
policy shift resulted in an even higher inflation rate of 14.7%
and another recession.
Then, just as
today, the period was preceded by an extended easy-money period
and stock market overvaluation. The FAANG (Facebook, Amazon,
etc.) stocks of the era were called the “Nifty Fifty”. The
dominant investment philosophy featured “One decision growth
stocks.” (Buying was the only necessary decision.) During the
period there were three bear markets, the first was some two
years before inflation rose, not unlike our recent pandemic
bear. Two more bears followed. Stock prices dropped 46% and
28%, but were exaggerated by another 21% loss and 8% loss
respectively due to inflation. This is the “worst case”
period that LFM&P uses for stress testing financial plans.
Over the last
decade, the purposely generated wealth effect made it look like
investors in financial assets and real estate were becoming
rich. Income and the country’s wealth disparity grew as a
result. In reality, however, much of that was an illusion.
Permanent wealth does not increase from financial manipulation.
It comes from producing useful goods and services. A house is
the same house, regardless of what Zillow says. In addition to
the income disparity, another result of the policy was the
implicit encouragement to take additional risk, promoted by low
interest returns and evidenced by chasing “investments” like
Bitcoin (now down 71% from its peak) for “Fear of Missing Out”.
periods are hardest on low- and fixed-income people.
Recessionary periods are hardest on the unemployed. Both are
hard on those who must derive income from investments. There are
few winning investments right now. Eventually, when interest
rates peak and the economy slows, bonds will come back into
favor. History suggests that stocks will also provide higher
returns once again to the extent that valuations retreat. In
this period, becoming more conservative in both investing and
spending is likely to be prudent for those who do not have an
TAs we look
backwards in history there are certain inflection points when
trends change. It has been important to adjust to new
scenarios as they develop. As we look forward to the future, it
is known that those points will be ahead of us somewhere and
it will be important to recognize them when they occur. With all
due regard to the great colloquial philosopher, Yogi Berra,
who advised, “It's tough to make predictions, especially about
the future”, it looks like this may be the inflection point
for which LFM&P has been trying to prepare clients and
readers. If there is no additional
policy change, that future may be now. If policy does change,
the future may be postponed and become even more difficult.
In either case, planning and adjusting remain important.
David C. Linnard, MBA, CFP®
LINNARD FINANCIAL MANAGEMENT & PLANNING, INC.
46 CHESTER ROAD
BOXBOROUGH, MA 01719
Barbara V. Linnard
A Registered Investment Advisor and NAPFA-Registered Financial Advisor
The contents of Outlook & Trends reflects the general opinions of LFM&P, which may change at any time, and is not intended to provide investment or planning advice. Such advice is only provided by means of individual agreement with LFM&P.