On A Journey From Inflation to Recession?

"We live in strange times."- Douglas Adams

Global stock and bond markets have gone from bull to bear in the past six months. The Covid vaccine/Federal Reserve-induced economic boom and the ensuing bull market of 2020-21 have come to a screeching halt as inflation has taken center stage. The "Hulk-like" strength of global economies has caused significantly more consumer and business demand for everything from soup to nuts and bolts. Inflation is problematic since it effectively acts like a pay cut for society – particularly a society that lacks personal savings resources, and where many live paycheck-to-paycheck. As the famous economist Milton Friedman once said, "inflation is taxation without legislation." It effectively reduces income for all and, left unattended, can lead to civil unrest as we have witnessed in parts of the world in recent decades. Global stock and bond market investors – like yours truly – clearly see the remedy for inflation and we do not like it. To put the inflation horse "back in the barn," global economic growth needs to slow down, cooling consumer and business demand to allow supply chains to catch up. Inflation will then dissipate, and all will be well again. However, the remedy for inflation comes with pain as we have seen in recent months for both stocks and bonds – pain that may continue, but that also may not linger past this year.

Market Headwinds
The temporary problems with stocks and bonds include the policies that need to be implemented to tame inflation. The Federal Reserve and other global central banks were overly generous when they lowered rates during and after the pandemic, as well as when increasing the size of their balance sheets through buying securities on the open market. The after-effects of these actions caused both the booming recovery and the inflation we are experiencing today. Central banks need to put these policies in reverse to slow the economy and bring inflation down – effectively raising interest rates and reducing their balance sheet until inflation data softens. Stocks and bonds do not act well during these periods since slower growth reduces corporate profits...and stock prices. Moreover, higher interest rates reduce the price or value of bonds. It is no wonder to our team that stocks and bonds have been on a downward trajectory and that our Active Risk Management kicked into gear earlier in the year, effectively reducing our market exposure. We know that declining asset prices can feel like there is no end in sight – but we are here to remind you that such is not the case. In fact, as we will describe here, a fantastic opportunity lies ahead for all investors sometime in the near future.

The Fed and Central Bank Tightrope
All eyes will be on the Federal Reserve and other central banks to see if they can "pull off" moderating growth just enough to reduce inflation, colloquially known as the "soft landing." Their track record is not great. Historically, they’ve "nailed it" only about 30% of the time, while the other 70% they raised rates too far, pushing the economy into a recession. It is not that they are inexperienced, it is just an exceedingly challenging task and a balancing act with truly little visibility. The higher the inflation rate, the worse the central bank’s odds of success in this endeavor – and we are facing the highest inflation in over 40 years. The odds get stacked against their success with above-normal inflation because central banks and the Fed know that a temporary recession, though painful, is better in the long run than persistent inflation, which is harmful to society as a whole. Will the Fed risk recession to tame today’s inflation? Quite possibly.

From inflation to Recession – The Disposition of Markets
If the Fed can pull off a "soft landing," stocks and bonds would rally, and we would have a very constructive market to aggressively re-invest. We will be watching these data points very carefully. Given the odds, we will also be looking for the opposite, given we are already in a bear market. So, how long do these periods last and how far do stocks need to fall if a recession comes to pass? Our Managing Partner, James, penned a book full of some useful information about this subject, ‘The Journey to Wealth.’ In the book, James points out that recession-related bear markets typically last 9-13 months and global equity markets decline between 38-55%. The good news is that markets have already declined by half that much, over half that much time. The bad news is that we likely have another few months ahead, and further downside. So given the odds of recession and our likely journey from inflation to recession, we will continue to keep your portfolio defensively postured with much less stock exposure, along with stop loss orders, to protect your capital during this period. We are making progress on fighting inflation, but there is more work to be done over the next quarter, or possibly two, until we reach recovery mode!

Bear Markets, Buying the Dips and FOMO
Bear markets take time to evolve and resolve. One of the biggest mistakes investors can make is "buying the dips" in a bear market since these very often result in further losses. During these periods it is important to be data sensitive before investing aggressively. We will be watching several indicators to aid us in determining safe entry points such as inflation data, Fed policy moves, corporate earnings estimate revisions, and GDP status. Ideally, we want to re-enter the global stock market when it appears that the Federal Reserve is finished with its tighter monetary policy and inflation data is softening. Put simply, we are just not there yet. In the meantime, it is important for investors to avoid FOMO (Fear of Missing Out) during every bear market rally – these are just "head fakes" without concrete data to support a real recovery.

Recovery Mode & Recovery Portfolio
Once the Fed has made progress with inflation – recession or not – equity and bond markets will enter recovery mode. This is the very best time to be an investor. During the first 18 months of a recovery, stock indexes often catapult 25-30%! It is truly not to be missed and could possibly occur within the next two quarters. Since we believe we will be in recovery mode sometime later this year, or early next, we have been working on your behalf on our "Recovery Portfolio." This is a great exercise and prepares us to get right to work to ensure you participate in the next new bull market. The Recovery Portfolio has many exciting sectors such as technology, communications, consumer discretionary, and financials. It also will leverage global markets through foreign companies that have a dominant market share with extremely attractive valuations. Lastly, there are investments that will leverage a recovering economy such as infrastructure, cloud computing, Web 3, and semiconductors. We are looking forward to adding these exciting companies to your portfolios when market fundamentals are more constructive.

The Opportunities in Today’s Fixed income
Higher interest rates have created a great opportunity for those of us who buy individual bonds. For the first time in 15 years, we can capitalize on higher yields on high-quality fixed income. This may only get better as the Federal Reserve continues to fight inflation by raising rates. Once again, beware of bond funds and low credit quality/high yield bonds as these fare very poorly in recessionary times. You may have noticed that we have been very busy taking advantage of, and locking in, some of these attractive rates. In our view, the bond market has finally come back to life, and in the future will add tremendous value to your total portfolio return, as opposed to its dismal returns for nearly two decades. This will allow investors to potentially take less risk in future years. If you have significant cash sitting in savings accounts, checking accounts or bond funds, this is an opportune time to speak to us about helping you achieve higher returns.

As Douglas Adams once said, "we live in strange times." However, for our team, this is familiar territory, and we can see better days ahead in the not-so-distant future. In the meantime, we will continue to manage the risk of your portfolio by having less stock exposure, in less economically sensitive sectors, along with stop-loss orders. We will also continue to take advantage of this higher interest rate environment in the bond market.

We hope this update finds you well and if you have any questions or have experienced a change in your finances, please let us know. If you haven't received a copy of 'The Journey to Wealth' or would like another, please let us know and we'd be happy to send one to you.

As always, thank you for your continued confidence in our work.

Your team at Main Street Research

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