Excess Stimulus, Excess Inflation
During the COVID-19 pandemic, the government passed a series of economic stimulus packages that rapidly increased money supply within the United States. These packages, specifically the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the Consolidated Appropriations Act (CAA), and the American Rescue Plan Act, added approximately $5 trillion dollars to “M2” money, a measure of the cash people hold in checking accounts plus “near money” like savings deposits and money market securities. These stimulus packages essentially put cash directly into consumers’ pockets at a time when the U.S. service sector was hobbled by forced lockdowns and reopening limitations. Consumers chose to redirect spending of their stimulus cash into purchasing goods over services and put massive strain on global supply chains. This ultimately led to inventory shortages and delivery bottlenecks, putting inflationary pressure on prices (more dollars chasing fewer goods). Initially, the Fed (and many others, myself included) thought this price inflation was transitory and would quickly work its way out of the system as the service sector came back online and supply chains recovered. Today, the service sector still hasn’t recovered to pre-pandemic levels, and global supply chains are proving more fragile than initially expected.
Growth in M2 Money Supply
Now that it’s clear inflation isn’t transitory, the Fed has reacted by raising short-term interest rates. Raising rates increases borrowing costs for both consumers and businesses with the intention of slowing demand for debt and reducing asset price growth. Rising rates tend to hurt financial assets like bonds, due to their fixed payment structure, and stocks, since a component of a stock’s price is the estimated present value of future profits discounted at a business’s “cost of capital,” which generally increases when rates increase. As a consumer, higher financing costs coupled with potentially lower retirement account values can weigh on sentiment and ultimately lead to reduced spending.If the Fed manages to raise rates enough to lower inflation while only marginally chilling aggregate demand, it will have achieved its goal of a “soft-landing” for the economy. If it overshoots, it’s possible the country may fall into a recession. If it undershoots, inflation remains elevated and continues to erode consumer wealth. It’s a difficult task.
Russian Commodity Shock
The Russian invasion of Ukraine is a “black swan” event for investors. The Western world has now mostly turned its back on Russia, imposing strict economic sanctions, freezing the country’s foreign currency reserves, and striving to dramatically reduce imports of its commodities. These measures will undoubtedly negatively impact the Russian economy, with the World Bank predicting a staggering -11.2% contraction in Russian GDP in 2022.
While Russia is less connected to global value streams than other large nations (e.g., China), it’s a large exporter of commodities, such as oil, natural gas, fertilizer, grains, and precious metals. Russia is the single largest exporter of wheat in the world and the second largest exporter of cobalt. Additionally, Ukraine is a large exporter of agricultural cereal commodities such as sunflower seeds (and oil), soybeans, and rapeseed. The potential loss of Russian and Ukraine commodity supplies due to sanctions and war has put upward pressure on commodity prices across the world, inflating food costs and increasing fuel prices. There’s never a good time for war to break out, but this commodity shock adds inflationary pressure to already increasing prices from excess stimulus and goods/services consumption imbalances.
History of Bull & Bear Markets
How Do We Recover?
In short – reduce inflation, reduce commodity prices. In my opinion, the Fed’s strategy for reducing inflation should err on the side of short-term pain for long-term gain, being more aggressive with rate increases now. Aggressive rate increases may trigger a recession, but without taking the risk, it’s possible that markets may continue to trend downward for an extended period. The longer inflation persists, the more the Fed will raise rates, so more pain now may mean a quicker end to the rate-hiking cycle and provide the market a chance to recover. The global economic outlook is also important to consider when predicting the timing of a recovery, as many U.S. companies are highly globalized, and the countries they do business with are dealing with their own elevated levels of inflation as well.
It’s taken roughly a year for the market to reach the bottom during the last 13 bear markets, with an average drawdown of -32.1% and an average length of 11.3 months.
Investors today must now make the difficult decision to reposition their portfolios for the years ahead. Traditional portfolio allocation norms – like owning 60% stocks, 40% bonds – are proving to be ineffective in hedging downside risk. Bonds are performing poorly in the rising rate environment and have become highly correlated with stocks, reducing their volatility-minimizing qualities.
When considering a portfolio reallocation, first consider your investing time horizon. If your time horizon is greater than 20 years, you should still likely be invested in all stocks with a tilt toward growth stocks. If you’re closer to retirement and own bonds in your portfolio, consider selling intermediate and long maturity bonds (perhaps 10-15% of your current allocation) and instead buy a mixture of shorter maturity bonds, commodity funds, and real estate funds. With stocks, consider selling high-growth stocks (perhaps 5-10%) and buy more value-oriented dividend paying stocks. Businesses with good cash flow and profitability become more valuable in rising rate environments.
Remember that volatility is the price an investor must pay to gain wealth, and downturns are part of the investing journey. Stay informed and be patient, making smart tactical changes to your portfolio, and you will achieve your financial goals!