The two-year Pandemic Relief Party (in the form of $5 trillion in fiscal stimulus1and a Fed easy money policy) drove a stock, bond, and digital assets mania that is coming to an end. The word ‘transitory’ – initially used by central bank policy makers to describe inflation – now applies to the sky-high prices investors paid to get in on the investment game. That game is about to get much harder to win.
First Quarter in Review
For the first three months of 2022 (if MCS clients’ investments were treated as one large portfolio including their cash), on average clients lost 1.5%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 4.6%, and the Bloomberg Barclays Aggregate Bond Index lost 5.9%. The range of MCS individual client returns was from a gain of 0.3% to a loss of 5.8%.2
The clients with the lowest return had higher equity exposure. Clients with the highest returns owned legacy positions in oil stocks that outperformed after Russia’s invasion of Ukraine. Overall, MCS client returns were shielded from the bond and stock market underperformance by the focus on safer short-term bonds, which did not materially decline in price.
Investing in the Age of Financial Repression
Our mission statement ‘Transform Money form a Source of Worry to a Resource for Fulfillment’ is the philosophy underlying my portfolio strategy. Bond investing has been a pillar of that strategy for decades. Pension plans and insurance companies have historically relied on bonds to fund their liabilities (i.e. the claims they must pay in the future regardless of future economic conditions). Owning bonds from 1991 until about 2011 was a terrific strategy. Clients had strong steady returns and avoided the disastrous losses stock investors suffered from 2000 to 2010. Since 2011, interest rates have been manipulated by central banks, like the Fed, to historically low levels to aid the recovery from the Great Recession. This interest rate manipulation is called ‘Financial Repression’3because it deprives bond buyers of earning a fair risk-adjusted return.
The stock market loved rock bottom interest rates (no competition from bonds), and stock prices soared.
As the last decade progressed, it looked like Financial Repression was here to stay. Rates got so low that I felt longer term bonds were a terrible deal, offering too little yield and too much risk. (I did employ some other strategies targeted at very specific situations, but even those went away as bond market bargains were picked clean.)
In the past decade, commentaries by most economists and analysts indicated interest rates would probably stay low for years, and the market priced in this belief (i.e. the prices of higher-risk assets, like stocks, soared). Faced with central bank financial repression, I gave up on higher rates from investment grade bonds. I began to convert the portfolio to much shorter-term bonds to wait for a better opportunity.
Where would I be able to get a reliable stream of income with less risk than stocks?
I shifted my thinking toward buying high yield (junk) bonds in the next downturn. Junk bonds and stocks are highly correlated; both provide very good returns when the economy is recovering and doing well. While riskier than investment grade bonds, high yield bonds are safer than stocks. The interest provides dependable annual income rather than relying on unpredictable stock price appreciation for returns. Bond interest must be paid before dividends and earnings are available to shareholders. (As for safety, in a bankruptcy, stockholders get wiped out and the junk bond holders become the new stockholders.)
An opportunity to buy high yield bonds came when the pandemic caused a vicious economic decline. In response, US Treasury bond yields fell to record lows while high-yield bonds plunged in price, driving their yields past 10%. I expected this to be a painful (and longer) recession, but the Fed (by driving the Fed Funds rate to near 0%) and Congress (approving $5 trillion in stimulus) came to the ‘rescue’ in record time. The window of opportunity opened and quickly closed. I missed it.
I distrusted the rescue and the market’s response to it. Surely, there had to be significant economic consequences related to the pandemic and the unprecedented actions to mitigate its impact. The world could not go back to ‘normal’ i.e. the conditions that existed prior to the pandemic. Of course, the market does not care what Michael Stalker thinks. Markets celebrated the rescue, vaulting to new highs and spawning all manner of speculation.
I couldn’t buy into the euphoria. I felt that some sort of ‘temporal distortion’ had taken place; that the pandemic rescue had changed the timing and nature of a terrible financial event but not necessarily the certainty of it. Now the change is clear:
The pandemic created a global solvency crisis, and the pandemic rescue changed that global solvency crisis into a global inflation crisis.
40 Years of Inflation and Interest Rates: “Houston, we have a problem.”
My more mature clients may remember how high inflation and interest rates in the 1970s and early 1980s was a difficult time for stock and bond investors. Interest rates stayed above the inflation rate during most of that period.
As you can see from the chart on page 3, inflation has exploded while interest rates lag far behind. If you look at the period prior to 2009, notice that interest rates have been above the inflation rate. This ensured that inflation stayed manageable. After 2009 (The Great Recession), economic growth was weak and interest rates dropped to near zero to encourage risk taking and economic growth.
There was some rebound in inflation and interest rates in 2017-2018, but it went sideways. The Pandemic and Pandemic recovery changed everything.
Between a Rock and a Hard Place
No one knows what the future inflation rate is going to be. The consensus (if that can be trusted) is inflation is peaking now (the annual CPI inflation rate in March was 8.5%) will trend lower, yet how much lower and for how long is unclear. The Fed is trying to balance its need to raise interest rates to tame inflation with its desire to avoid a recession by not raising rates too high.
Yet, we’ve seen this movie before:
June 30, 2005: Quincy Krosby, chief investment strategist with the Hartford, said she thinks the Fed won’t stop raising rates until the real estate market starts to cool off. “The dilemma for the Fed right now is to keep raising rates to try and slow down the housing market without killing the economy and the consumer. That’s when monetary policy is more of an art form than a science. But I think they will keep going,” she said.4
The Fed now faces a similar dilemma, just substitute ‘inflation’ for ‘real estate market’ or ‘housing market’ in the article quoted above. The ‘housing market’ dilemma in 2006-2007 started the Great Recession. Today, inflation is killing the consumer.
So, What’s the Strategy?
The strategy is to continue in a conservative posture over the next few months and watch how this plays out. It seems like this down cycle is just getting started. (I’m mindful that the stock market dropped over 30% in a matter of weeks in the early days of the pandemic.) Today, the pandemic isn’t over. China is locking down entire cities, and the geopolitical situation (Ukraine) is worse. Both of these situations make inflation worse, the economic outlook is highly uncertain, and the Fed no longer has a clear option to rescue the economy.
MCS client portfolios have been vaccinated against rising interest rates by holding large positions in money market funds and bonds that mature over the next 16 months. Any small bond losses will be recovered at maturity and can be reinvested at higher rates or into riskier investments that are getting bashed now. Money market funds will also soon reflect the rise in interest rates.
I have held off buying bonds across client accounts so far this year. Given the near vertical rise in interest rates thus far, 2022 says, “Cash is King.“
DotCom Version 2.0?
Investors in some of the most popular Pandemic stocks have been hammered. Turns out, inflation isn’t transitory, but stock prices are. I haven’t seen anything this bad since the Dotcom Bust.
It’s worth noting that MCS clients were invested in stocks during the DotCom bust and did fine. We made money every year during the bust. That’s because we owned companies that were profitable and selling for reasonable prices. This environment is different. Nothing is cheap. Asset prices depend on very low interest rates and the absence of competing investments like higher yielding bonds. This is all changing: as higher interest rates make low risk investments more attractive, higher risk investments like stocks and long-term bonds must come down in price.
The stock market and the Fed are giving each other the same pep talk about how inflation can be brought under control with relatively little economic pain; betting on a soft landing whereby the Fed walks a tightrope, raising rates just enough to slow the economy and bring inflation down at the same time. This is extremely difficult to pull off. Considering that neither The Fed nor the stock market saw this level of inflation coming, it is prudent to remain skeptical and defensively positioned. There is more downside than upside at current prices.
Bottom Line
While this newsletter has focused on inflation, there are other risks that I am carefully evaluating as well. Covid variants aren’t going away, and China’s lockdowns are a reminder that C-19’s economic impact is not over. There are growing political risks both at home and abroad while the war in Ukraine is raising prices of oil and food, stoking inflation.
The potential for an escalation of the war in Ukraine is not to be taken lightly. I have put time into researching the risks of Russia using nuclear weapons. (The financial markets do not consider this to be a risk).
Rest assured that while MCS client portfolios are not risk free, we are well positioned to minimize losses and take advantage of bargains as the next phase of the market unfolds.
If you have any questions or simply want to talk about your portfolio, please contact me at michael@mcsfwa.com or call me at 541-345-7023.
MCS Family Wealth Advisors (MCS) consolidated client returns are dollar-weighted, net of investment management fees unless stated otherwise, include reinvestment of dividends and capital gains and represent all clients with fully discretionary Income/Growth accounts under management for at least one full month in 2021. These accounts represent 93% of MCS’s discretionary assets under management as of 03/31/2022 and were invested primarily in US stocks and bonds (8.4% of client assets on 03/31/2022 were invested in tax-exempt municipal bonds). The Stock Index values are based on the S&P 500 Total Return Index, which measures the large-capitalization US equity market. The Bond Index values are based on the Bloomberg Barclays US Aggregate Bond Index, which measures the US investment-grade bond market. Index values are for comparison purposes only. The report is for information purposes only and does not consider the specific investment objective, financial situation, or particular needs of any recipient, nor is it to be construed as an offer to sell or solicit investment management or any other services. Past performance is not indicative of future results.
Categories
2022 First Quarter Newsletter & Outlook
The two-year Pandemic Relief Party (in the form of $5 trillion in fiscal stimulus1 and a Fed easy money policy) drove a stock, bond, and digital assets mania that is coming to an end. The word ‘transitory’ – initially used by central bank policy makers to describe inflation – now applies to the sky-high prices investors paid to get in on the investment game. That game is about to get much harder to win.
First Quarter in Review
For the first three months of 2022 (if MCS clients’ investments were treated as one large portfolio including their cash), on average clients lost 1.5%, after fees. For comparison purposes, the S&P 500 Total Return Stock Index (S&P 500) lost 4.6%, and the Bloomberg Barclays Aggregate Bond Index lost 5.9%. The range of MCS individual client returns was from a gain of 0.3% to a loss of 5.8%.2
The clients with the lowest return had higher equity exposure. Clients with the highest returns owned legacy positions in oil stocks that outperformed after Russia’s invasion of Ukraine. Overall, MCS client returns were shielded from the bond and stock market underperformance by the focus on safer short-term bonds, which did not materially decline in price.
Investing in the Age of Financial Repression
Our mission statement ‘Transform Money form a Source of Worry to a Resource for Fulfillment’ is the philosophy underlying my portfolio strategy. Bond investing has been a pillar of that strategy for decades. Pension plans and insurance companies have historically relied on bonds to fund their liabilities (i.e. the claims they must pay in the future regardless of future economic conditions). Owning bonds from 1991 until about 2011 was a terrific strategy. Clients had strong steady returns and avoided the disastrous losses stock investors suffered from 2000 to 2010. Since 2011, interest rates have been manipulated by central banks, like the Fed, to historically low levels to aid the recovery from the Great Recession. This interest rate manipulation is called ‘Financial Repression’3 because it deprives bond buyers of earning a fair risk-adjusted return.
The stock market loved rock bottom interest rates (no competition from bonds), and stock prices soared.
As the last decade progressed, it looked like Financial Repression was here to stay. Rates got so low that I felt longer term bonds were a terrible deal, offering too little yield and too much risk. (I did employ some other strategies targeted at very specific situations, but even those went away as bond market bargains were picked clean.)
In the past decade, commentaries by most economists and analysts indicated interest rates would probably stay low for years, and the market priced in this belief (i.e. the prices of higher-risk assets, like stocks, soared). Faced with central bank financial repression, I gave up on higher rates from investment grade bonds. I began to convert the portfolio to much shorter-term bonds to wait for a better opportunity.
Where would I be able to get a reliable stream of income with less risk than stocks?
I shifted my thinking toward buying high yield (junk) bonds in the next downturn. Junk bonds and stocks are highly correlated; both provide very good returns when the economy is recovering and doing well. While riskier than investment grade bonds, high yield bonds are safer than stocks. The interest provides dependable annual income rather than relying on unpredictable stock price appreciation for returns. Bond interest must be paid before dividends and earnings are available to shareholders. (As for safety, in a bankruptcy, stockholders get wiped out and the junk bond holders become the new stockholders.)
An opportunity to buy high yield bonds came when the pandemic caused a vicious economic decline. In response, US Treasury bond yields fell to record lows while high-yield bonds plunged in price, driving their yields past 10%. I expected this to be a painful (and longer) recession, but the Fed (by driving the Fed Funds rate to near 0%) and Congress (approving $5 trillion in stimulus) came to the ‘rescue’ in record time. The window of opportunity opened and quickly closed. I missed it.
I distrusted the rescue and the market’s response to it. Surely, there had to be significant economic consequences related to the pandemic and the unprecedented actions to mitigate its impact. The world could not go back to ‘normal’ i.e. the conditions that existed prior to the pandemic. Of course, the market does not care what Michael Stalker thinks. Markets celebrated the rescue, vaulting to new highs and spawning all manner of speculation.
I couldn’t buy into the euphoria. I felt that some sort of ‘temporal distortion’ had taken place; that the pandemic rescue had changed the timing and nature of a terrible financial event but not necessarily the certainty of it. Now the change is clear:
The pandemic created a global solvency crisis, and the pandemic rescue changed that global solvency crisis into a global inflation crisis.
40 Years of Inflation and Interest Rates: “Houston, we have a problem.”
My more mature clients may remember how high inflation and interest rates in the 1970s and early 1980s was a difficult time for stock and bond investors. Interest rates stayed above the inflation rate during most of that period.
As you can see from the chart on page 3, inflation has exploded while interest rates lag far behind. If you look at the period prior to 2009, notice that interest rates have been above the inflation rate. This ensured that inflation stayed manageable. After 2009 (The Great Recession), economic growth was weak and interest rates dropped to near zero to encourage risk taking and economic growth.
There was some rebound in inflation and interest rates in 2017-2018, but it went sideways. The Pandemic and Pandemic recovery changed everything.
Between a Rock and a Hard Place
No one knows what the future inflation rate is going to be. The consensus (if that can be trusted) is inflation is peaking now (the annual CPI inflation rate in March was 8.5%) will trend lower, yet how much lower and for how long is unclear. The Fed is trying to balance its need to raise interest rates to tame inflation with its desire to avoid a recession by not raising rates too high.
Yet, we’ve seen this movie before:
The Fed now faces a similar dilemma, just substitute ‘inflation’ for ‘real estate market’ or ‘housing market’ in the article quoted above. The ‘housing market’ dilemma in 2006-2007 started the Great Recession. Today, inflation is killing the consumer.
So, What’s the Strategy?
The strategy is to continue in a conservative posture over the next few months and watch how this plays out. It seems like this down cycle is just getting started. (I’m mindful that the stock market dropped over 30% in a matter of weeks in the early days of the pandemic.) Today, the pandemic isn’t over. China is locking down entire cities, and the geopolitical situation (Ukraine) is worse. Both of these situations make inflation worse, the economic outlook is highly uncertain, and the Fed no longer has a clear option to rescue the economy.
MCS client portfolios have been vaccinated against rising interest rates by holding large positions in money market funds and bonds that mature over the next 16 months. Any small bond losses will be recovered at maturity and can be reinvested at higher rates or into riskier investments that are getting bashed now. Money market funds will also soon reflect the rise in interest rates.
I have held off buying bonds across client accounts so far this year. Given the near vertical rise in interest rates thus far, 2022 says, “Cash is King.“
DotCom Version 2.0?
Investors in some of the most popular Pandemic stocks have been hammered. Turns out, inflation isn’t transitory, but stock prices are. I haven’t seen anything this bad since the Dotcom Bust.
It’s worth noting that MCS clients were invested in stocks during the DotCom bust and did fine. We made money every year during the bust. That’s because we owned companies that were profitable and selling for reasonable prices. This environment is different. Nothing is cheap. Asset prices depend on very low interest rates and the absence of competing investments like higher yielding bonds. This is all changing: as higher interest rates make low risk investments more attractive, higher risk investments like stocks and long-term bonds must come down in price.
The stock market and the Fed are giving each other the same pep talk about how inflation can be brought under control with relatively little economic pain; betting on a soft landing whereby the Fed walks a tightrope, raising rates just enough to slow the economy and bring inflation down at the same time. This is extremely difficult to pull off. Considering that neither The Fed nor the stock market saw this level of inflation coming, it is prudent to remain skeptical and defensively positioned. There is more downside than upside at current prices.
Bottom Line
While this newsletter has focused on inflation, there are other risks that I am carefully evaluating as well. Covid variants aren’t going away, and China’s lockdowns are a reminder that C-19’s economic impact is not over. There are growing political risks both at home and abroad while the war in Ukraine is raising prices of oil and food, stoking inflation.
The potential for an escalation of the war in Ukraine is not to be taken lightly. I have put time into researching the risks of Russia using nuclear weapons. (The financial markets do not consider this to be a risk).
Rest assured that while MCS client portfolios are not risk free, we are well positioned to minimize losses and take advantage of bargains as the next phase of the market unfolds.
If you have any questions or simply want to talk about your portfolio, please contact me at michael@mcsfwa.com or call me at 541-345-7023.
Endnotes
3. https://www.imf.org/external/pubs/ft/fandd/2011/06/pdf/reinhart.pdf
4. Emphasis added. Source: https://money.cnn.com/2005/06/30/news/economy/fed_rates/index.htm