June 7, 2022
“Your phone must be ringing off the hook” is a comment we hear a lot lately from friends and family. Actually, no. If you’ve been wondering how other investors are reacting to the recent market turmoil, the answer is that our clients, at least, have been calm and collected, so far.
Still, we understand that the market news has been unsettling since the new year, so let’s address a few points about what’s happening and what, if anything we should be doing about it. If you don’t have the patience for the brief review of events that follows, read the bold text and jump to the Q&A at the end.
Why did the U.S. stock market do so well while the economy underperformed? For the past decade, economic growth averaged just about 2%. That is anemic growth at best, well below the long-term average of greater than 3%. Over the same period, the U.S. stock market returned over 13%, well above the long-term annual average of about 10%. Remarkably, in 2020, the market returned over 20% while the U.S. economy shrank by 3.4%. (Sources: The World Bank, Morningstar)
How can the market do so well while the economy struggles? You can thank monetary policy largely for that. Monetary policy for this discussion refers to actions taken by the Federal Reserve to push interest rates down. Since the 2008 Financial Crisis, the Fed has been doing this by buying massive amounts of bonds from financial institutions and paying for it with newly created cash reserves. They call this Quantitative Easing. Buying bonds in such massive amounts pushes bond prices up and interest rates down. The strategy was calculated to frustrate the ability of savers to get any decent returns on cash or safer assets like investment grade bonds and to force investors collectively to bid up the price of stocks and other riskier assets like real estate. Bidding up the value of the stock market was intended to create a psychological “Wealth Effect.”
The Wealth Effect uses the following logic: consumer spending is about 70% of our economy; if investors’ portfolios are worth more, they will be more inclined to spend and boost economic growth; therefore, we (the Fed) will suppress interest rates and forces investors to bid up the price of stocks as the only place they can hope to achieve a decent return. We’ll let the financial historians decide if this policy was worth it, but without question it came with some serious side effects.
The side effects of loose monetary policy are coming home to roost. One is inflation. A boom in the money supply sows the seeds of inflation. It took a while to show up but it’s here now. From 2010 to 2020, the money supply grew at a rate of close to 6%, which is high but not outside of historical ranges and not so much that it promoted inflation. Inflation stayed low through 2020 because most of this new money was not in the hands of the spending public. Then the pandemic hit and over the next year the money supply grew by 27%. That figure represents historic, epic growth. It amounts to $4 trillion dollars added to the money supply in just one year. (Source: The Wall Street Journal, February 21, 2021)
And then there is fiscal policy. Fiscal policy refers to government spending. Since the pandemic, Congress has authorized several trillion dollars of stimulus spending, some of which was necessary, some of which was wasteful, and much of which added fuel to the fire. Trillions of dollars in Covid checks to individuals and local governments is so massive that it is hard to comprehend. The effect, though, is inflationary. As one economist noted, it is like flying a helicopter over communities across the country and dropping enough bills for everyone to have thousands of extra dollars to spend. They will
spend and they will drive up prices. Together, monetary and fiscal policy have added to the demand side of inflationary pressures.
There is also a supply side to inflationary pressures. Economic shutdowns across the globe in response to the pandemic caused a massive disruption to the global supply chain and it has proved difficult to get it back on track. Fewer goods to purchase especially when there are more dollars chasing those goods is the quintessential inflationary brew.
The other side effect of loose monetary policy is low interest rates which eventually will have to be reversed. That time is now. The Fed has committed to gradually raising interest rates in the hopes that higher borrowing costs will help snuff out the demand side of inflationary pressures. For investors, rising interest rates means that bond prices in the near term will fall. The poor performance of bonds this year is due to the toxic combination of rising inflation and rising interest rates.
We have no unique insight into whether inflation will be short-lived or with us for an extended period as it was in the 1970s. The Fed says it is now totally focused on tackling inflation and one of their major tools is raising interest rates. They are trying to produce what they call a “soft landing.” The Fed is in the difficult position of a gymnast trying to execute a tricky tumble and stick the landing. They are trying to push rates up enough to subdue inflation without throwing the economy into a recession.
- Are rising rates a good thing or a bad thing for investors? They are a mixed blessing, but ultimately for the good. In the near term, rising rates means bond prices will fall. Over the longer term (it could take several years), investors should be happy with rising rates. Good riddance to the rates of the past. As bond proceeds are eventually reinvested into bonds with higher yields, those better yields will eventually overcome the drop in prices.
- What role will bonds play in my portfolio in the meantime? Although bonds have struggled this year along with stocks, we are confident that should the market correction go deeper, high quality bonds will eventually be sought out as a “safe haven” as they have been in the past. Bonds, specifically investment grade bonds, serve two main roles in a portfolio: income and stability. The income role has been stymied by low interest rates for years, but this will improve as rates increase. In the meantime, high quality bonds are still the best asset class to own to offset the shock of stocks in a deep correction.
- What about stocks? Are we just going to “ride this down?” Yes, that’s essentially what we’re going to do. Unless you are taking cash distributions (see below) or your objectives have changed (we should talk), we should not be changing our allocation because the market has turned negative. The positive returns we experience in most years are the reward we get for taking risk. Risk has become a reality. We have always said that the allocation we hold is what is needed to meet your objectives and is an allocation we will hold in good markets and bad. The problem with “getting out of the market” now is two-fold: 1) we will likely make our losses permanent because, 2) we will never know when the market has hit bottom. To make back your unrealized losses, you need to stay invested. As quickly as the market falls, recovery days also can come fast and furious. Just like when the market is falling, a market in recovery does so in fits and starts - days of rally mixed with days of decline. Lastly, this is not entirely a “do nothing” approach. At some point, market corrections become an opportunity to rebalance into stocks at what are essentially “sale” prices. That’s an opportunity to take advantage of.
What if I am taking cash distributions from my portfolio? The most immediate challenge is for those clients taking distributions. As much as possible, you want to avoid selling from positions that are down in value and allow time for those values to recover. There are several ways to address this and we encourage you to discuss this with your advisor if this applies to you.
As an investor, remember that things are never quite as good as they seem in the best years and never quite as bad as they seem in the worst years. Patience is an investment skill.
Please contact your advisor if you have questions and especially if your circumstances have changed.
David Peartree, J.D. CFP®
Portfolio Manager - Financial Advisor