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The Hangover: Too Much Money

The Big Cash Party

As the worst of pandemic fears fade into memory it’s easy to forget the panic of 2020.

A “shutdown” had never been attempted, and amid the fear, uncertainty, and market panic, the Federal Reserve did the only thing it could do to help: print money.

It printed $4 trillion.  While this didn’t involve literally running the printing press, it created that much cash out of thin air.  What they really did was buy bonds on a massive scale.  When the Fed buys a bond from a bank it gives the bank cash for the bond, and that cash is freshly minted on the spot.

The flood of cash was helpful during the worse of the pandemic, it kept the markets lubricated and functioning relatively normally.  The fresh, new cash was the spiked punch in the punchbowl.  Cash in hand, investors bought everything they could.

Bond prices ran up, pushing interest rates down.  Stocks moved to record highs on valuations that made little sense.  We saw crypto currencies move into the spotlight and surge.  We saw home prices take off on cheap mortgages.  We saw new inventions like NFTs spike.  Why were people paying steep prices for things like the exclusive right to an NBA slam dunk video?  The list keeps going.

People were flush with cash, stuck at home, and drinking the Fed’s spiked punch.  To prevent a panic the Fed kept the punch flowing for too long, which they’ve now admitted.

The punch bowl was allowed to run dry in March when the Fed stopped buying bonds, and began increasing interest rates.  The hangover begins.

The Hangover

When lots of new cash is printed, under normal circumstances, the result is a spike in inflation.  Because of the complexities of the pandemic world it took a long time for the inflationary fire to get started.

The Fed was caught off guard, and did the only other thing the Fed can do, destroy money.  It began raising interest rates, told the markets it will keep raising interest rates, and announced a plan to start destroying some of the newly printed cash.

The bottom line: with cash leaving the economy en masse, the tide is going out.  This hangover has two painful symptoms: the inflationary fire caused by the high proof punch, and the Fed’s action of taking away the punchbowl by pulling out that cheap, new money, which puts downward pressure on almost all financial assets and growth.

The economy survived the pandemic, but now we’re in a painful place.  We see costs rising in real time, and our investment portfolios have taken a bruising.

Let’s look at stocks and bonds.

Bonds

Inflation is kryptonite to bonds.  As prices rise the purchasing power of bonds is eroded.  Prices and yields have a seesaw relationship.  When yields go up, prices go down.  Since bonds are expected to compensate for inflation, as inflation has increased, bond yields have increased to keep up, pushing prices down.

This is being exacerbated by a Fed that: stopped buying bonds (printing cash), began increasing the Fed Funds rate, which pushes all rates up, and burning money by letting bonds it owns mature without reinvesting the cash.

We haven’t seen this since the 1980’s, but it’s the same playbook.  The only way to put out an inflationary fire is to make money more expensive.  In the world of bonds what’s happened so far this year is as rare as it is painful.

The good news, the worst may be over for bonds.  The bond market is looking over the horizon, and sees a slowdown coming.  The bond market sees a Fed that could be forced to begin cutting rates in less than a year to combat a recession it helped create.  You read that right.

Stocks

If the bond market was the somewhat reserved partier through all of this, the stock market was like the cast of Animal House.  Stocks spent most of last year exceeding any reasonable valuations, and chanting drinking songs as if the speed of the pandemic recovery would be the speed of growth forever.  It was bizarre.

In January an inebriated stock market looked around and saw the bond crowd piling into Ubers, and realized the party was over.

Stock prices now only look fair in terms of bloated estimates that still haven’t come down.  The hangover could worsen here as prices begin to reflect an economy that is slowing down.

Despite the pain, with a long term perspective, stocks have a better shot at fighting inflation.  As inflation rises, companies charge more for goods and services, which allows earnings to keep up with inflation.  While earnings may drop with an economic slowdown, price increases offset the bite of inflation in the long run.

Wrapping It Up

The hangover has been painful, and the pain is likely to continue, possibly to the point of a recession within the next twelve months.

The Fed did what it had to during the depths of the pandemic to keep the economy from unraveling.  Printing, or destroying money, is always a blunt force that lacks precision.  The system doesn’t turn on a dime, and The Fed waited too long to take the foot off the gas.

Bonds may have turned the corner in that they are now rising as stocks drop, which is the typical relationship as investors seek the shelter of bonds amid uncertainty.  Inflation is close to a peak, and should begin a long road back to “normal.”  Stocks are getting close to reasonable values, but remain rocky.

The good news: we still have a functioning economy, something that shouldn’t be taken for granted.  The bad news: it’s been a wicked hangover that’s probably far from over.

Hopefully, this is the beginning of the final chapter of the pandemic’s impact on the economy.  It was quite a “party.”

 

 

Buoyant Financial, LLC is a registered investment adviser located in Charlotte, NC. Buoyant Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. A copy of Buoyant Financial’s current written disclosure statement discussing Buoyant Financial’s business operations, services, and fees is available at the SEC’s investment adviser public information website – www.adviserinfo.sec.gov or from Buoyant Financial upon written request. This note is for informational purposes only, and should not be construed as investment advice, or a recommendation to buy or sell securities. 

Removing Life Support: Post Pandemic Challenges

 

When the pandemic began, the world’s largest economy was put into what can be thought of as a medically induced coma. The Federal Reserve and Congress took steps to ensure the patient would survive a trip to intensive care like no other. The world’s largest economy had never been put to sleep intentionally, and then revived.

Congress passed legislation to support employers, and employees, with things like paycheck protection, PPP loans, direct payments, and supplements to state unemployment benefits.

The Federal Reserve or “Fed” did what it knows how to do. It lowered interest rates, and printed a ton of money. The Fed essentially printed over four trillion dollars, that’s $4,000,000,000,000, for those who like to look at numbers. This flooded the US and global economies with cash.

These actions worked better than many expected. During 2021, the economy rebounded, and is now on a trajectory to pre-pandemic levels. Strong medicines can have strong side effects, and the most fearsome side effect of printing money is inflation.

The Fed had expected the inflation surge to pass quickly; however, supply chain issues caused inflation to become intrenched.

Wage increases became common, and are usually seen as a good thing. Who doesn’t like to make more money? However, as prices rise, wage increases are struggling to keep up. This begins what’s often called a “wage price spiral,” and it’s not a healthy pattern.

Most economists agree that it’s time to wake up the patient, and move out of intensive care. This analogy is important because if you’ve ever known someone who was in intensive care, the journey back to health is long and challenging. The economy became hooked on cheap money, and because of the inflation flare up, the Fed will have to move much faster than expected.

Next month, the Fed will stop buying bonds, which was a way of printing money, and is expected to begin increasing the fed funds rate. The fed funds rate is the overnight rate banks charge each other. It’s like the mother of all rates because it informs and influences everything from corporate bonds to car loans.

The market lives for expectations about what’s going to happen next. Last fall, the expectation was that the fed funds rate would increase 2 or 3 times this year. Each move is generally 0.25%. Inflation has become so wild that the expectation is now five to seven hikes this year.

For reasons I won’t bore you with, higher interest rates are generally the only way to tame inflation. For those of you old enough to remember, this was painfully, and successfully, demonstrated by Fed chair Paul Volcker in the 1980’s.

Now markets face a variety of challenges, which feed on one another. Just to give you a sense, here are a few of them:

• When interest rates go up, the price of bonds fall, hurting the “safer” side of portfolios
• When interest rates go up, stock prices tend to drop because it costs companies more to borrow, and new bonds at higher yields become tempting to investors when compared to stocks
• When interest rates go up, mortgage rates go up, making housing seem more expensive

The list goes on, but those examples really get to the point. It quickly becomes a sticky wicket for the Fed.

Rates will have to go up, and as you may have seen, this is already playing out in bond yields and mortgage rates. The Fed hasn’t actually done anything yet, but it’s ability to influence the markets is so strong that they move in anticipation. This also means the market agrees with the notion that the Fed has no choice other than to increase rates quickly, and begin vacuuming up the money it printed over the last two years.

The risk now: the Fed increases rates quickly to tame inflation, and ends up triggering a recession, or economic contraction. This has happened in the past, so it’s not a theoretical risk, it is very real.

Markets are constantly trying to look around corners, and into the future. While there is no expectation for a recession in 2022, there is now a real risk of one beginning next year.

What does all of this mean for our portfolios? While none of this is what investors want to hear, it’s not all bad news, and it’s a challenge all long term investors face from time to time.

Bond prices have dropped, but if you are: dollar cost averaging, reinvesting dividends, or both, you will be purchasing shares of bond funds at lower prices, and the new bonds in these funds will be issued at higher yields, which is good news for you long term. The other good news is that when a recession does come, and the Fed cuts rates, bond prices will rise, causing bonds to act as good ballast in what will be a storm.

Stocks have been overpriced for some time. While we don’t like to see stocks fall, we do like to see healthy valuations that make sense. Getting back to that point is better in the long run. And again, with dollar cost averaging, and dividend reinvestment you’ll end up purchasing stocks at lower prices, something long term investors love to do.

Those of us who plan to hold stocks for the rest of our lives, and will continue to buy along the way, don’t mind these ebbs and flows of the market. They present opportunities to buy what we love on the cheap, which is really ownership of the world’s largest economy.

If you have been speculating in stocks, day trading, buying what’s popular, and getting into the “meme stock” trend, it’s probably time to reconsider those positions and activities. The best way to invest in stocks for the long run is to purchase diverse, high quality portfolios, such as the S&P 500, with a plan to hold them for a long time.

These storms will come and go during our investing lives, they shouldn’t surprise us. While the pandemic economy was unusual, we’re seeing an economy and market returning to long-term norms in terms of growth, and it’s time for the Fed’s strong medicine to be withdrawn.

Even if there is a recession in the coming year or so, we should be prepared to weather that storm, and continue to grow our portfolios over the long run.

 

 

 

Buoyant Financial, LLC is a registered investment adviser located in Charlotte, NC. Buoyant Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. A copy of Buoyant Financial’s current written disclosure statement discussing Buoyant Financial’s business operations, services, and fees is available at the SEC’s investment adviser public information website – www.adviserinfo.sec.gov or from Buoyant Financial upon written request. This note is for informational purposes only, and should not be construed as investment advice, or a recommendation to buy or sell securities.