Celebrating 15 Years of Service

February Newsletter

Feb 15, 2022

The Markets, Interest Rates and Inflation

Markets have been volatile to start the year as investors reacted to the anticipated decrease in liquidity and rising interest rates. The Federal Reserve has long-planned to end their quantitative easing (QE) program and taper asset purchases. The markets traded lower in January due to the Fed
accelerating their timeline to raise the Federal Funds Rate, which is currently at 0.00%. The Fed is badly behind in its fight against inflation, currently running at 7%, and rate hikes are now expected as soon as March. The markets had previously expected the rise in rates to occur in December of 2022 but that timeline was moved up to June then revised again. This pivot by Fed Chairman Powell is indicative of how badly the Fed underestimated the breadth and durability of inflation and the need to normalize monetary policy sooner rather later.

This acceleration of the Fed’s timeline has pushed short-term interest rates higher with U.S. 2-yr Treasury note rising from 0.40% to 1.20%! The U.S. 10-yr Treasury has risen to about 1.90% from 1.60% since year-end. The short-end of the yield curve has moved up much more sharply than the 10-yr Treasury which has resulted in a flattening of the yield curve. Historically, when the yield curve has flattened, this has signaled an economic slowdown. While we do not think that is the case today, it does bear monitoring.

This acceleration of the Fed’s timeline has pushed short-term interest rates higher with U.S. 2-yr Treasury note rising from 0.40% to 1.20%! The U.S. 10-yr Treasury has risen to about 1.90% from 1.60% since year-end. The short-end of the yield curve has moved up much more sharply than the 10-yr Treasury which has resulted in a flattening of the yield curve. Historically, when the yield curve has flattened, this has signaled an economic slowdown. While we do not think that is the case today, it does bear monitoring.

The Fed must raise interest rates because they have let inflation move ahead at a very concerning pace. As the supply chain issues continue to get resolved some inflation metrics will recede, but the Fed’s desire to let inflation run higher than 2% without raising rates seems laughable now in hindsight. Real inflation adjusted yields are negative by about -5% as shown in the chart to the right for the 10-yr. Treasury and even more for shorter term notes.

The Fed and the government are pulling back monetary and fiscal support that was needed at the beginning of the pandemic, but now the economy is on much stronger footing, U.S. credit quality is stronger than ever, and corporate bankruptcies are at record lows. The easy money policies and bailouts are no longer needed, at least not right now.

The chart on the following page illustrates the impact inflation has had on the price of every-day items. Inflation acts as a tax on your savings and the burden is felt most in lower income communities and those that lack financial assets like stocks and real estate which can serve as a
hedge against some of the inflationary pressures.

Total Debt and its Impact on Economic Growth

Economics papers published in 2012 by economists Carmen Reinhart and Kenneth Rogoff showed that when the ratio of debt-to-GDP reaches a level of 90% for a period of at least five years, the resulting growth rate in the economy is reduced by about a 1/3 or 33%. Since the year 2000
America’s growth rate has fallen below its trend rate from 1870 to 2000 by 50%! And currently the
U.S. debt-to-GDP ratio is at 122% (see chart below).

As the level of debt increases so to does the cost to service that debt. Interest payments rise, governments then move to increase taxes, and the result is less reinvestment available to fund growth. When governments accelerate debt levels to over a 90% ratio to improve faltering economic conditions, it actually slows down economic activity. While government action may be required for political reasons, governments often only compound existing problems. However, for the people who want to quick answers to economic stress, inaction by the government is impossible.

Valuations Come Back Down to Earth

Much of the volatility seen in the markets in January occurred in richly valued growth stocks which was one of frothiest areas of the market entering the year. Many companies that reside in the Nasdaq index were completely unprofitable or carried excessive price-to-earnings (P/E) multiples. These companies were the beneficiaries of quantitative earnings, excess liquidity and low interest rates. As the Fed pivots monetary policy, stock valuations become more important. An astonishing 42% of companies in the Nasdaq Index are now down by more than 50% from their 52-week highs and P/E multiples have backed off their recent highs.

In our experience, these valuations were unstainable and this is one of the reasons why we have always emphasized owning quality companies, with strong balance sheets and management teams that have strong track records. This principled approach to investing has served us well through different market environments and various economic cycles and we are confident that will continue into the future.

Move Away From Mutual Funds

Now is a good time to move away from mutual funds and into ETF’s (Exchange Traded Funds). Mutual funds can be very expensive to buy as some have sales charges up to 5.5% just to purchase the fund. They are also expensive to own, as you are charged ongoing management fees and trailing fees (called “12b-1” fees) that are paid out to the brokers that sold them to you. These fees incentivize the “adviser” to keep you in the mutual funds.

Mutual funds can also be very burdensome from a tax perspective and can have costly capital gains distributions! We prefer and utilize ETF’s because they are low-cost, tax efficient and offer the benefits of diversification similar to mutual funds. If you hold mutual funds, let us review them and detail the expenses, you will likely be surprised.

It is often the case that your company 401(k) plan only offers you a limited investment plan menu with a small selection of mutual funds and Target Date Funds. If you or someone you know has a 401(k) from a previous employer we want to help! There are almost always better strategies that align with your long-term goals and as fiduciaries, what is in your best interest always comes first.

Call to Action Section

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