Friday Thoughts
Spring has sprung in Sumter. But, it’s still early March, so I won’t be switching out all of my winter clothes for shorts and t-shirts just yet. It has been nice to see the beautiful afternoons, though.
After a rough year last year, the broader stock markets rallied to start 2023. However, they’ve given some of those gains back up in the last few weeks. I suspect that we will be in for more of these volatile swings this year and wanted to share my thoughts on why and what I’m looking for as an indication that we’re through the tough parts. And, yes, I do see great opportunities in our future, albeit probably a bit further into the future than we all would like.
I think that the financial, and corporate, world is in the midst of a sea change. This is a change in the way or environment that things operate so large that it does’t happen very often. I think it will be as big of a shift as we saw after the tech bubble burst and Ben Bernanke slashed interest rates, which is the last great sea change, in my opinion. And the reality is, we’re just now starting to deal with the repercussions of years of low interest rates.
When the Federal Reserve lowered interest rates in order to get the economy back going in 2002, they created a blue print that would be used again when the economy tanked in 2007-08. The low interest rates hadn’t led to high inflation, so why not keep doing it? Except there were some other factors at play in keeping inflation down that were ignored. We had a large working age population, China was ramping up its industrial might to allow us to make more stuff cheap, and global trade agreements were in place to allow free flow of goods around the world.
That was all starting to change in 2019. The Baby Boomers were beginning to retire, the Chinese population was reaching a peak and a global trade war was happening as Europe was dealing with Brexit and the US and China were arguing over fair trade. But, before we could even begin to digest these matters, COVID was here. The answer from the Central Banks and political class was the same as before - Zero interest rates and print money to hand out for any and all things.
For a number of years, there had been talk of something called Modern Monetary Theory (MMT). The term was coined in 2008 in a book called Full Employment Abandoned by Bill Mitchell and Joan Muysken. By 2013, it was making rounds in academia and it was a popular talking point for US Representative Alexandria Ocasio-Cortez in 2019. In short, the theory is that the US government should run large deficits and provide financial support for its citizens. The theory is that by keeping interest rates low and having the global reserve currency (every around the world wants to do business in US Dollars), it will have minimal impact on inflation.
Many have disputed the claims of MMT, and I’ve always thought it was foolish. As my grandfather once told my dad, “a man who plans on living his entire life in debt is a fool.” Yet, we basically tried MMT when the government shut down the economy in response to COVID.
The initial reaction from the Fed to increases in inflation in late 2021 was that it was “transitory”, meaning it wouldn’t last long. Again, I was skeptical. All of this money being printed and passed around would have to have an impact, somehow. Chairman Jerome Power was in a tough spot, though. He wanted to keep his job and he was up for renomination. So, he stuck with the “transitory” line until his job was extended another term. In May of 2022, his nomination was approved by Congress. Then, his tone changed. The next meeting after his nomination was the first of several 0.75% interest rate increases.
Through the summer and fall of last year, Wall Street kept talking about the “Fed pivot” that they were expecting. They were expecting Chairman Powell and the Fed to say that they were done raising interest rates and would lower rates again, as they had done before. Here is where the sea change comes into play. I don’t think we’re going back to a low interest rate environment again anytime soon. And, I think that’s a good thing in many ways.
My main reasoning for this expectations is that I don’t see inflation coming down to the Feds goal of 2% soon. That’s because I don’t think that it was the low interest rates that caused the jump in inflation. I think it’s the government spending, and that isn’t really slowing down. In 2021, The “Infrastructure Investment and Jobs Act’ was passed, which authorizes $1.2 trillion in spending. Congress wasn’t done. In August of 2022 they passed the “Inflation Reduction Act”, which was said to spend $738 Billion. But, a report by Credit Suisse said that just the climate spending in the legislation could surpass $800 billion. That is a lot of money that will be spent for years.
More money going into the economy while we have a smaller labor force, less globalization, and increasing taxes will be inflationary, I suspect. So - the Fed has to keep using the only tool they have to try to cool the economy, raising interest rates. Chairman Powell said as much this week in his testimony to Congress. If you were to go back to his previous Congressional testimony, he’s been saying the same thing since last summer. Someone actually cut together his opening speeches at these hearings with date stamps of the testimony and its kind of eerie how consistent his messaging has been.
But, Wall Street analysts are still waiting for that pivot. If they're so smart, how can they keep being so wrong? I think it's a recency bias. Most Wall Street analysts have only known low interest rates. The folks who were trading bonds and stocks in the 80’s and 90’s are retired and moved on. I think that these current analysts are starting to get it, though. You can see that in their recent views on longer term interest rates.
Last year we reached a situation where short term interest rates were paying more than longer term rates. That’s historically been an indication of a coming recession. The situation comes about because the Fed raises the overnight interest rate that banks pay them. Banks have to raise their short term rates to be able to keep people willing to loan them money versus someone else paying a higher amount. But, because this usually brings about a recession, there’s an expectation of rates coming back down soon, so no need to pay higher rates for longer term loans. We’re finally starting to see those longer term rates coming up.
That’s what I’m really paying attention to. Normally, we would see short term rates come down to longer term rates. I suspect that we’ll see the longer term rates come up to the shorter term rates as it sinks in that we’re in this shift to higher inflation for longer and higher interest rates for longer. This will be a sign of the acceptance of the sea change.
We will finally be rewarding the savers. It will also generate fiscal discipline. When interest rates are low, there’s less incentive to make your money work smart. We’ve seen a tremendous increase in corporate mergers in the last 20 years, while rates were low. Rather than work hard to compete, companies just buy their competitors. The cost of doing so is cheap, so why not? Now, if it costs more, companies and executives that run them will need to be more careful. They need to justify the expenses.
There will be some losers in this sea change. Those with high debt and those with floating interest rate loans will be the first casualties. There are many companies that have been living on cheap debt for years. I can’t mention any specific companies in this blog, but you see the carnage already starting with certain retailers closing stores around the country. There will also be companies that fail because their executives are still thinking that rates are coming down and they aren’t able to adapt. Perhaps they have some large debts coming due in the next few years and their plan is simply to refinance them at that time. If rates are higher, their expenses will be higher. If they're not prepared, it will cost them.
But, there will be winners too. Those who provide goods and services that are necessary will still do well. As a mentor told me in 2008, we still need to put food on our table, clothes on our back, and educate our children. Those who are expecting this will also do well. Those with low debt and strong balance sheets will be in a great position to pick up the scraps of the failed companies at deep discounts. Recession also bring about innovations. People tend to look around for ways to solve problems. As Ralph Waldo Emerson famously said, “Build a better mousetrap, and the world will beat a path to your door.”
As far as individuals and their investment portfolios, I think that the incentive to put money into CDs and bonds will be competition for stocks, especially the higher risk stocks. I suspect that a truly well diversified and balanced investment portfolio should once again become attractive, as compared to the mindset of “fear of missing out” that had been driving many investment decisions over the last few years.
I suggest that everyone be careful with their debts and watch their own spending carefully. With inflation staying somewhat elevated, this will be more crucial than it used to be. Grocery spending can get away from you if you aren’t paying attention. Also, those automatic draft expenses can add up. It’s amazing how close our “entertainment” expense have come back to the amount we used to spend on cable with all of the subscriptions that we now have. Time to really take a look at what we actually use!
If you want to review your budget or discuss your investment portfolio, please feel free to call or send me an e-mail. I’m more than happy to help where I can.
My best advise, though, is not to panic or stress over the things that are changing. The world has always changed, and always will. We just need to be prepared for that change and go along with it.
It looks like true spring weather is coming back this weekend, with cooler temps and the possibility of some rain. I hope the rain comes and washes some of this pollen away. Next week, the Sumter Rotary Club is bringing Farm to Table back after a three year hiatus. It will be on Thursday night, March 16th from 6-9 at the Sumter Civic Center. If you would like to come, I have tickets available for $40. All proceeds go to the Sumter Rotary Scholarship Fund, Coins For Alzheimer’s Research Trust (CART), the Sumter 4-H, and United Ministries. I think we have around 16 vendors from around Sumter and drinks are included. I’ll be arriving late, as Wilson Hall is having a Daddy / Daughter dance that night. I’ve never had a chance to take Clara to one and won’t miss this chance to do so.
Have a great weekend, and don’t forget to set your clocks forward as we “spring ahead”!
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