So, what do you do?
If you listen to some of the so-called gurus and market strategists, the outlook is indeed scary. But things that have never happened before happen all the time. COVID and the Great Recession are two such examples. Will the past repeat or will it be different this time? At AFC, we feel the times may be well changing. If you have been reading this newsletter or listening to our radio program, you know we have been predicting persistent inflation since early 2016 and employment issues since 2014.
On Friday October 16, 1987, Marty Zweig, looking at the actions of the Federal Reserve and the stock market, bought out of the market puts for his clients. Puts are options. When the market plunged on Black Monday, those puts soared in value. Zweig’s clients benefited from Black Monday, unlike most investors. It was Zweig who coined the phrase “Don’t fight the Fed”. This has become something of a mantra for most of Wall Street. So much so that, for the last year, the gurus and market strategists have been predicting the stock market to sell off and even crash. Asking them to explain why the market has instead climbed seems most often to elicit the response: “Just you wait. It is going to happen”. Possible, but it does not seem to be.
Then there is the inverted yield curve. According to some pundits, the yield curve inverting always results in a recession. Usually, investors’ interest rates for the same quality of bond are lower for shorter maturities than for longer maturities. The logic is that inflation reduces the value of the purchasing power of the dollar, therefore the longer the maturity of the bond, the less purchasing power for the same amount of dollars.
When the yield curve inverts, it means investors expect interest rates to come down in the future. That happens most often when inflation comes down. But there are other reasons for longer-term interest rates to be lower than short-term rates.
The Federal Reserve essentially controls short term rates by raising and lowering the so-called “Fed Funds” rate (the rate the Fed charges banks to loan money back-and-forth). The Fed has little control over longer-term rates. Longer-term rates are determined by demand for longer maturity bonds. Demand increases when there is a “flight to quality”. That happens when large institutions, hedge funds, money managers, and the like, fear the market is going to tank and they sell stocks to buy bonds. That is called “flight to quality”. If those strategists believe they should not fight the Fed, then it stands to reason that we should expect a flight to quality. They reduce their stock holdings and buy bonds. There is also a flight to quality when there are geopolitical concerns such as a land war in Europe that has the potential to expand beyond the borders of Ukraine.
In addition, foreign central banks tend to load up on longer-term bonds during times of world instability.
In the past when the Fed raised interest rates consumers slowed spending which in turn slowed the economy and led to increases in unemployment which further reduced overall spending and eventually resulted in a recession. That is why the gurus and strategists and business leaders have been predicting a recession last year or in 2023. But things that have never happened before happen all the time.
The Taylor Principle states that to reduce inflation, central banks need to raise short-term rates to a level that is above the rate of inflation. Inflation as measured by Personal Consumption Expenditures (PCE) in the United States has been running at around five percent (5%) for over a year. Unlike the Consumer Price Index, half of the PCE Index is based on factors that are wage related. Beginning with the Obama Administration, a major focus has been on job creation. That focus was carried on through the Trump Administration, and it has been a priority of the Biden Administration. All three administrations have been successful. They have been so successful that there are now 4 ½ million more jobs than there are workers to fill them. This situation will continue to get worse before it gets better. There are about 200,000+ jobs created each month, but fewer than 100,000 new workers joining the work force.
The lowest-income workers increased their wages by about five percent (5%) in 2022, and that trend will probably continue for some years to come. 47 million Americans quit their job. I have heard from several employers that they are experiencing something unprecedented: Half of their interview candidates do not show up for the interview and never even bother to notify the employer. Even those who do participate in the interview will have worked several jobs over the last year and are still searching for a new job after having been at their current position for just a few months. That is a trend likely to continue for some years to come as inflation is accompanied by low unemployment.
Unemployment is not increasing and consumers are continuing to spend. There is no recession in sight. But until the gurus and strategists and business leaders realize this time really is different, they will continue to buy those long maturity bonds and drive the yield curve to be inverted.
And the issue is not just American. With the exception of Italy, all of the G-7 countries have the lowest unemployment they have seen in decades. Many companies are going to be shorthanded and service challenged.
In our opinion, the next decade or so will see a selective market of stocks, giving the edge to stock pickers over indexers. Bonds will probably stabilize at decent rates with the risk of prices falling if inflation gets worse. Asset allocation portfolios are going to trail inflation, meaning most traditional portfolios managed by FAs are going to see purchasing power reduced. Traditional asset allocation portfolios have managed just a five percent (5%) return over the longer-term.1
When I was with the big brokerage firms, they had a mantra of “Sell the relationship and not the performance.” If inflation and unemployment continue as we expect for the rest of the decade, the fallacy of that mantra will become more and more apparent. The difference between $500,000 invested at a 5% percent return and 15% return over a period of 25 years is $1,583,177 and $16,459,476. Yes, there will be more volatility over the next decade. Where will you, the reader of this newsletter, put your money?
We must say past performance is no guarantee of future performance.
1. Anderson, J. (n.d.). Coach through biases – yours and your clients’. SEI. Retrieved December 22, 2021, from https://seic.com/knowledge-center/coach-through-biases-yours-and-your-clients.
