Stembrook Brief - Thoughts on Inflation and Market Stress
The Federal Reserve raised the Federal Funds target rate for the fifth time last week to 3% - 3.25%. Interest rates across the maturity spectrum have increased dramatically over the past six months. In historical terms, they are unremarkable, but relative to recent history, the change is substantial. Given this shift, corporations and households will need to adjust to a new reality.
What does this mean?
After years of attempting to boost inflation, the Fed finds itself in the unfamiliar position of trying to reduce it. Their primary tool in this endeavor is to increase borrowing costs for consumers and businesses, which tends to reduce demand growth, slow economic activity and tamp down inflationary impulses. Last Wednesday, Fed Chair Jerome Powell clearly articulated his resolve to fight inflation. He also indicated that it is highly likely that additional rate hikes will be warranted.
This may take time
The Fed’s actions may take time to have an impact. One input of inflation that Powell focused on is wages, which have been driven higher by a very tight labor market. Employment tends to lag other economic factors, so the Fed’s efforts will likely take a while to have the desired effect on inflation.
Complicating matters is Russia’s escalation of the war in Ukraine. Aside from the human suffering, the war in Ukraine has disrupted critical energy and grain supplies. Allies have joined together to boycott the purchase of these items from Russia. This has exacerbated supply shortages and driven prices even higher. Another side effect is that Europe is facing an energy crisis that could not only mean a cold winter for its citizens, but also a shortage of natural gas for manufacturing and commerce. This war is a destabilizing force in an already tense political environment and markets dislike instability.
What to do?
These events have several implications for investors and their personal finances.
As an investor, there are a few things you can do, right now:
- If you have cash on the sidelines, consider putting it to work. How you go about that will depend on your plans for the subject funds and your overall situation. For short-term holdings, cash equivalents are now yielding well over 2% and are likely to move higher. This is not high by historical standards, but represents $20,000 to $30,000 of income on a $1mm investment. Not a lot, but not nothing. Also consider that investments compound over time, so whatever interest you make this year will be available for investment next year. Bonds are also getting more attractive, with municipal bonds offering tax-equivalent yields of nearly 6.4% (see our note from November 2018 Interest Has Become Interesting for more detail on the implications of higher rates). In the fixed income (bond) space, we have begun to lengthen the maturity of our portfolio, as returns on longer-term bonds better compensate risks. We are not moving into high yield bonds at this time, as credit spreads (or the amount of yield investors demand to lend to riskier borrowers) are still not wide enough to warrant the risk. For longer-term investors, there are attractive parts of the stock and bond markets to look for opportunities. Keep in mind that investments in more volatile assets need to be matched with a willingness and ability to wait out a market cycle which could last years.
- Make sure you’ve reviewed your liquidity needs and that your portfolio has the funds necessary to get you through a rough patch in markets.
- Be careful not to panic on the downside, or the upside. On the downside, don’t rush to sell risky assets. On the upside, be careful not to chase recent performance. As an example, commodities are down -17% since the middle of June after rising 130.6% from March 2020 through June of 2022.
On a personal finance level, start thinking about the following:
- If you’ve started taking Social Security, watch for higher payments. Social Security is indexed to inflation, so higher inflation brings higher benefits, a bright spot.
- Your mortgage might be worth more now. If you borrowed or refinanced at lower rates, don’t rush to pay it down. If you have the cash, you might be able to earn more on a safe investment rather than pay down your mortgage.
- Delay purchases of goods or services that have dramatically increased in price. As the Fed increases interest rates, there is a good chance that economic activity will slow, demand will fall, and the supply/demand balance will begin to normalize. For instance, lumber prices are down -73.4% from their high in May of 2021.
We feel like a broken record when we say this, but review your Strategic Investment Plan. Make sure your liquidity is in line with your potential needs. In some cases, you’ll want to weather a downturn with cash or stable assets on hand.
Don’t get too caught up in the day-to-day news. There is a lot to take in and much of it is bad, right now. Take a breath and remember to focus on the big picture.
The Fed has pledged to get inflation in check. The economy will be slowed in order to accomplish this. Make sure your cash is working for you – short-term or long-term, you have options. Be patient; the Fed’s actions will take time to work their way through the system.
If you want to talk through this or think we should re-evaluate your plan, given new information, please let us know. As always, we thank you for your continued confidence and support.
Peter & Tom