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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.

 

 

 

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