Markets Update | Central Banks vs. Inflation

The Federal Reserve raised interest rates a whopping 50 basis points (one-half of 1%) yesterday in its most significant move yet to combat the continued pattern of increasing inflation. Recent inflation data signals that prices in the U.S. are rising at an escalated rate of 8.5%. As one can imagine this has severely negative consequences for citizens of all income levels and acutely so for those with lower income. This isn’t just a domestic problem, as Europe and other regions of the world are also suffering from spiraling prices. After decades of almost non-existent inflation, how did we arrive here? How can we temper the rate of rising prices to protect our citizens and the economy? Will the Federal Reserve’s change in interest rate policy have a negative effect on the economy and financial markets? Let’s dive in!

The Root Cause of Today’s Inflation
The Covid-19 recession prompted the Federal Reserve and other global central banks to lower interest rates to near zero in an attempt to revive their economies. In conjunction the U.S. Treasury injected large sums of money into the system with the same goal. In a dual effort, both institutions continued to support the economy generously – even in the face of vaccines and treatments that surely would turn the economy back to the "on" position. This combination of unprecedented monetary stimulus and vaccine success turned the recession into not just a recovery, but a "booming" economic expansion! Consider that for the prior 15 years, the U.S. economy grew at a 2-3% annual rate, as measured by GDP, and post-Covid we have been growing at a 6% annual rate. The massive demand for goods and services has far outstripped supply during the past two years, which has sent prices skyrocketing! This is not a Covid related temporary problem as the Fed once thought, but a structural economic issue. A targeted 2% economy wasn’t ready for 6% growth – plain and simple.

How Do We Put the Inflation Horse Back in the Barn
For the reasons stated above, inflation can be very damaging to society and the economy. In many respects, to rid ourselves of inflation, we must reverse course on how we arrived at this point. The current rate of economic growth needs to be moderated so that demand slows and supply can catch up. In other words, the Federal Reserve and other global central banks must raise interest rates, which in turn will slow the economy effectively, and eventually, reverse the trend of rising prices of goods and services. This process began in earnest yesterday with the commitment to further rate increases in the near future. Basically, policymakers are tapping the brakes until the economy slows enough for inflation to steady and attempting a soft landing for the economy – easier said than done!

History Of Federal Reserve Taming Inflation
The Fed’s track record for effectively softening the economy enough to mitigate inflation while still allowing the economy to sustain a lower growth rate isn’t great. They have been successful in just three of the last eight hike cycles – while in the other periods, the economy didn’t just slow but rather came to a halt and brought on a full-blown recession. It is a challenging task at hand since they don’t know the real effect of raising interest rates on the economy for 3-6 months. Hence, the difficulty in knowing, "how much is enough?" and their history of going too far with rate hikes. Our team’s concern with the Fed’s challenge is that it is further complicated given the influences of the war in Ukraine, which adds layers of additional inflationary pressures on commodities, such as wheat and oil. With that said our hearts continue to go out to the people in Ukraine.

Interest Rates and Financial Markets
One should not wonder why global stock markets are wobbly and trending downward. As global central banks attempt to engineer slower future growth, corporate profits for many – but not all – sectors will be negatively affected. If economies can slow to 3% growth and inflation is "headed back into the barn," stocks may trade a bit lower or sideways from current levels. Upon confirmation that the Fed’s work has been successful, stocks should rally forward for the next few years and the bull market continues – an excellent outcome! We would see this as the best-case scenario. Unfortunately, there is a risk that this outcome may not come to fruition, as historically it has been a tough needle for the Fed to thread. In the event that the Fed and other central banks slow the economy too much, stock prices would suffer. As a reminder, and was often referred to in our Founder James Demmert’s first book The Journey to Wealth, stock markets typically decline anywhere between 38-55% during recessions. That is a long way down from today’s levels and the primary reason why we have shifted your portfolio to be more defensive in nature.

Your Portfolio’s More Defensive Posture
Given the risks outlined above, we have reduced your portfolio’s overall allocation to the stock market – this is the easiest way to reduce risk. Additionally, we have changed your stock exposure to sectors that historically do well in slower economies, such as healthcare and consumer staples, as well as sectors that are benefiting from some of the recent headwinds such as energy, agriculture, and commodities. Keep in mind that your current stock positions have stop-loss orders which would be executed if the market continues to decline – further reducing your stock exposure to limit losses. We have employed a strategy of less stock and more defensive companies until we can get more clarity on the outcome of the Fed vs. inflation fight. "Safer rather than sorry" may be the best way to express our strategy. We do this in the spirit of being your fiduciary and our commitment to protecting you from catastrophic market declines.

The Bright Side
Many of today’s market challenges could be alleviated by a number of factors. Resolution in Ukraine would help, while indicative data that the economy or the rate of inflation are slowing would also be welcome. In these cases, we would be quick to change our posture to be more growth-oriented and that would not take long – think hours/days, not weeks/months. In the meantime we will be watching data closely on all of these levels. Moreover, keep in mind that any potential recession and bear market will come and go within months from now and will create an amazing opportunity to "buy low," as they say.

Bond Time!
The silver lining in all of this trouble is that the rise in interest rates has created great value in the bond market for the first time in a dozen years. As we have said time and time again, avoid bond funds and stick with individual bonds. A ten-year treasury is currently yielding 3% and may eventually go higher from these levels. For most of history, money market yields have been above 2.5% and a majority of high-quality bonds have yielded 4-6%. We may be returning to this world, which would be great for all investor assets outside of the stock market.

We hope you find this update helpful and if you have any questions or would like to discuss your portfolio, please let us know.

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