Welcome to the Paragon Podcast. A Podcast focusing on the needs of high net-worth individuals and their families. We discuss the markets, tax strategies, and how to better manage wealth with the goal of living better for today while planning for tomorrow.
Hi everyone, welcome to the podcast and thank you for tuning in. I’m Elean Mendoza and I’m here with Evan Shorten, the firm’s founder and principal.
Hi everyone, I hope you’re all doing well and had a prosperous 2021. All things considered, I hope 2022 is starting off on the right foot for you, and speaking of 2022, today we’re going to discuss a few notable topics that may influence markets this year. But before we get started please subscribe to the Podcast on whichever medium you enjoy listening to most. You can find us on the Apple podcasts app, Stitcher Radio, and YouTube.
So this year has been much different for markets than previous years. With the exception of two months during the early outbreak of the coronavirus back in 2020, US equity markets have been in a prolonged bull market dating back to 2009 – starting right after the Global Financial Crisis.
It’s been over a decade that the Federal Reserve has maintained an easy money policy, keeping nominal interest rates near zero in order to support asset prices across most sectors in the economy. To clarify, an easy money policy is another term for increasing the money supply, often referred to as money printing. I’m sure you’ve seen some of the memes about “money printer go brrrr” with Jerome Powell printing greenbacks from his speaking podium.
It’s this easy money policy that led to a decade-long growth cycle in our economy. That is until the Covid-19 pandemic hit in 2020.
Yes, the Covid-19 pandemic was the black swan event that no one expected. All of a sudden, businesses around the world were required to cease operations ultimately breaking down supply chains and creating supply shocks. Both Congress and the Federal Reserve responded with their own policy versions of liquidity injections. In total some estimates claim as much as $9 trillion dollars were injected into the US economy in 2020 for various bailouts and stimulus programs.
We’re now approaching the second year anniversary of the Covid-19 pandemic and we’re seeing the effects of both prolonged supply shocks and trillion dollar liquidity injections present themselves in the economic cycle and that’s what we want to discuss in this episode. The economic cycle and its effects on markets for 2022.
So you didn’t actually say this but I think it’s important to make the connection between supply chain disruptions and record levels of money printing. In other words, for the last two years, the global economy produced less goods and provided less services. However, there is more money than ever before chasing those fewer goods and services. In other words, the cost of everything has gone up, and rather quickly.
Correct. Additionally, record levels of money printing also inflated asset prices across the board, influencing even the riskiest of assets. I don’t think meme stocks like AMC and Game Stop would have been as popular without all the excess money floating in the economy.
Moving forward in 2022, inflation in some way shape or form is going to dictate a lot of what happens in markets. I think we can say with a high level of probability that the decade-long growth cycle that started in 2009 has most likely peaked. The Bureau of Labor Statistics recorded a 7% increase in the Consumer Price Index for the year 2021. That’s the highest level of inflation we’ve had since 1982.
Inflation negatively affects consumer sentiment ultimately reducing consumer demand. Simply put, as things get more expensive, consumers have to buy less of those things. I was recently doing some research which indicated consumer sentiment ended 2021 with the lowest numbers for sentiment since the 1970’s.
I also want to point out, despite high inflation and low consumer sentiment, there is light at the end of the tunnel. As supply chains come back online, the cost of goods should begin to normalize and while consumer sentiment may be low right now, we’re still experiencing a tight labor market which should support wage growth for the consumer. Not to mention people have higher savings and disposable income.
It’s also important to keep in mind that one of the reasons 2021 experienced such a large inflation print is because inflation is reported on a year-to-year basis and as we mentioned 2020 was a year of unprecedented supply shocks combined with unprecedented amounts of money printing. Price increases across the board were inevitable in that type of scenario. Moving forward, I’m hopeful that 7% was the inflation peak. Without record breaking bailouts and stimulus, it’s unlikely that we could recreate the inflation pressures from 2020 to 2021 in the upcoming year-to-year calculations for 2021 to 2022. And please keep in mind, this does not mean we will not see inflation, but likely a lower increase of inflation.
Now that reported 7% increase in inflation may have created another notable headwind facing the economic cycle. Regardless of whether inflation does decrease on a year-to-year basis moving forward, it’s put the Federal Reserve in a bit of a bind with their current monetary policy of easy money.
Yes. The Federal Reserve is sort of caught between a rock and a hard place with respect to monetary policy. With inflation reported at 7%, keeping interest rates low and increasing the money supply runs the risk of creating even more inflation and puts Powell and Federal Reserve on the hot seat with respects to their credibility in navigating the current economic landscape.
On the other hand, asset prices are currently supported by low interest rates and an ever increasing money supply. If the Federal Reserve were to reverse course and normalize, meaning raise rates, asset prices would most likely being impacted. Higher risk stocks lose some of their appeal if investors can get returns in lower risk assets or savings instruments guaranteed by the Federal Government; higher rates decrease the value of existing bonds; and higher rates lead to higher mortgage payments which ultimately affect the real-estate sector.
An actual shift in monetary policy towards normalization would begin to reverse the decade-long tailwinds in asset growth. In fact the Federal Reserve has begun to normalize by eliminating its bond purchases which should be completed by the close of Q1 this year.
And we’ve seen some of this take place in the last month or two. While interest rates have remained relatively unchanged, simply mentioning the intent to raise rates later in March has been enough to send equity markets into negative territory with the riskiest markets like the NASDAQ and Russell 2000 taking the most punishment – actually coming down about 18.5% since their November 2021 highs.
Now slowing growth doesn’t necessarily mean the end of the world for investors. It simply means investors may need to take a more tactical approach to how they invest.
And even though the Federal Reserve hasn’t moved short-term rates yet, the 10 year treasury is fast approaching 2% which may trigger more downward pressure on stocks. We mentioned a couple times how the last decade experienced a prolonged expansion with respects to the economic cycle. During the early and mid-expansion period of the cycle it’s fair to say a rising tide lifts all boats. Easy access to capital, availability of credit, and an accommodative monetary policy all contribute to corporate growth and increasing profits. This is also the period when even companies who operate at a loss can increase in value due to an abundance of easy money.
With the lingering effects of the pandemic and shift in monetary policy, we’re most likely transitioning from the middle phase of the economic cycle to the late phase. Are we at the peak in the middle phase of the cycle? Probably not. Are we officially in the late phase of the cycle where credit becomes tight and corporate earnings decrease? Probably not. We’re likely somewhere in between.
Yes, we’re facing headwinds at the moment with inflation and a possible shift in monetary policy. We can see this sentiment as the largest draw drowns are occurring in the riskiest assets, but we’re also seeing record profits from some of the strongest blue chip companies. Apple and Microsoft reported record profits for 2021. The healthcare industry reported large profit increases for the year 2021 with companies like United Health Group and Pfizer.
Despite these headwinds, we are starting to see global supply chains recover and we’re seeing several countries around the world remove and significantly reduce their Covid-19 restrictions. A return to normal life around the world in 2022 could prolong growth, albeit at a lower rate than the last decade.
The last thing I want to discuss is portfolio rebalancing. As we move away from a prolonged expansion to the second half of the mid cycle phase of the business cycle, it’s time to review your portfolio holdings. Historically, stocks have done well in this part of the economic cycle, but the various stock sectors and style of investing begin to differentiate from one another. Sector and security selection become extremely important. As interest rates rise, companies that promise “future earnings” that generate no earnings today tend to run into problems. Strong blue chip companies tend to become more attractive as well as sectors that can continue to find growth.
For example, healthcare is an evergreen sector that tends to do well overtime regardless of economic conditions. Hand in hand with healthcare are subsectors like biotech, medical devices, and pharmaceuticals, albeit these two industries require more scrutiny. The technology sector can also yield promising results with companies that can continue to innovate regardless of economic conditions. As we continue to experience higher levels of inflation it’s worth considering a tactical allocation to commodities which tend to rise with inflation; and finally, as America engages in new conflicts around the world, the aerospace and defense sector can also provide a source of returns.
Ok, we hope you enjoyed this episode of the Paragon Podcast and found it informative. We discussed a lot in this episode and if you have questions or want to speak with us about your portfolio or your specific financial situation, please don’t hesitate to reach out to us. Lastly, please don’t forget to subscribe to the podcast. Thank you for tuning in.