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Linnard Financial Management & Planning, Inc.

Fee-Only Financial Planning and Investment Advisor

 

July 1, 2022

Outlook & Trends

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.

The Economy

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 GDPNow 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.)

The Markets

Both the 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 Future Is Now

Ever since 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.

During this 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.

Apparently, 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”.

Inflationary 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 increasing paycheck,

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 O&T 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.

DCL Sig

David C. Linnard, MBA, CFP®
President

LINNARD FINANCIAL MANAGEMENT & PLANNING, INC.
46 CHESTER ROAD
BOXBOROUGH, MA 01719

BVL Sig

Barbara V. Linnard
Vice President

LFMP@LINNARDFINANCIAL.COM
WWW. LINNARDFINANCIAL.COM
978-266-2958









A Registered Investment Advisor and NAPFA-Registered Financial Advisor


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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.


 

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