Living and Investing with Inflation & Rising Rates
It is no secret that everyday expenses are rising. Inflation is very real and very much “baked into the cake.” As I suggested in a blog post in August 2021:
“At first inflationary conditions act as a tailwind to equity markets; However, this honeymoon period is typically less than 12 months, at which point selling pressures mount on fears of future cost increases. This can paralyze production and therefore future earnings begin to suffer. Generally, this type of environment is negative for markets over the forthcoming 12 months.”
I have also outlined why the combined policy efforts of the US Federal Government and that of the Federal Reserve Bank created the inflation we currently are experiencing. Rather than spend any more time talking about policy errors made over the last few years or how we ended up in this mess, it would be far more productive to focus, instead, on what this type of economic landscape really means for you, what you should be focused on, and how to best navigate through to the other side.
First, let’s look at things from an investing point of view. As suggested in the quote above, inflation is hardly a conduit for prolonged stock market success. Specifically, high inflation has the greatest negative impact on equities (stocks). The reason is simple - businesses have a far more difficult time planning for future costs when those costs are rising at a high rate, just as our own budgeting becomes more difficult when the cost of gas, groceries, etc. is uncertain and rising rapidly. The stock market is a “future pricing machine” in that the market is always trying to sniff out a “fair value” for the price of publicly owned companies. This becomes far more difficult with increased inflation, therefore stocks are less constructive. This doesn’t mean there aren’t many stocks that perform well, but on the whole, stocks are likely to be sluggish.
Fortunately, we have not dealt with many periods of sustained high inflation. The late 1970s to early 1980s provide the best example in recent history. The chart below shows the monthly S&P 500 (blue line) and the Consumer Price Index (CPI) for all items (green line), as well as the 55-month rate of change for the CPI (blue histogram lines) during this time. This rate of change is significant. Note that when the 55-month rate of change of the CPI exceeded 12-14%, the S&P 500 was effectively flat until that rate of change capitulated, a period of 4,990 days between 1968 and 1982. However, once that upward rate of change did turn down, we can see how positively the stock market responded.
In 2005, we saw this 55-month rate of change on the CPI exceed the 12% threshold. It meandered around 12% until ultimately exceeding 14% in late 2007. The following 18 months were significantly worse for stock performance, but the global financial crisis put the lid on the inflation pot rather quickly, so this doesn’t necessarily serve as a great reference for how prolonged inflation impacts stock performance.
So where are we today? As of June 2021, the 55-month rate of change in the CPI exceeded 12% and was quick to jump above 14% in December ‘21. It has moved higher since, showing no sign of capitulation so far. There is no need for despair. Though the market, as a whole, may be muted by high inflation there are pockets of opportunity. These types of markets simply require a discerning eye and a focus on downside protection. This comes as a stark contrast to recent history in which many investors have been lured into believing that successful investing is easy and without consequence. As they say, “Don’t confuse brains with a bull market”.
From what few historical references we have, we may loosely conclude that high inflation is like a wet blanket on investment markets and equity performance, however, a more discerning eye would recognize the real threat is the pace at which the rate of inflation is increasing. A high rate of increase is most impactful. We also know that markets do not create inflation on their own. Inflation is a man-made problem. In most cases, a man-made problem that we idly accept as we are told it is necessary to promote investment, progress, etc. While this is accepted as the gospel truth, the reality is far more complex, but this is no place to present a thesis on the efficacy of monetary policy and “controlled inflation”. Instead, I bring to mind the man-made nature of inflation to highlight the fact that the same hand that can create it, theoretically has the power to destroy it by way of tighter monetary policy - but not without a cost. Many pundits, “gurus”, and “experts” today are bemoaning the immense threat that rate hikes have on the well-being and prosperity of equity markets.
As with almost any headline-grabbing statement from “experts” … you guessed it… we need to look a little closer at these claims. There is some validity in their concerns, however, it is not as cut and dry as often presented. In a rather unexpected twist, markets actually have a history of performing quite favorably during rate hike periods (it just may be a bumpy road along the way). Let’s revisit our monthly chart of the S&P 500 index (SPX). Below you will see the SPX along with the Effective Federal Funds Rate (EFFR). The periods highlighted in gray on the EFFR correspond to the gray, green, and red periods highlighted on the SPX. Of the ten periods in which the EFFR was raised for more than two consecutive months, 60% of the time the SPX ended higher from the time rates began increasing to when the Fed halted monetary tightening, 30% of the time it was flat, and only 10% of the time the SPX ended down:
I bet you weren’t expecting that! Based on the way rate hikes are discussed right now and how the market seems to react to the talk of rate hikes, you would assume it is time to run for the hills immediately now that the Fed has lethargically begun raising rates. History suggests this may not be the case, and that rate increases may not be all that bad for stocks, after all.
But, and this is a HUGE BUT, this is not all rainbows and sunshine. To someone who has never seen the Effective Federal Funds rate charted over time, you may be surprised to see just how volatile it is. What’s more, you may also notice that rarely is a period of aggressive rate increases not followed by an equally precipitous rate-cutting period. This is where there is some truth in the claims that rate increases “are bad for stocks”. The reality is that the Fed, as inept as it is, is exceptionally good at acting way too late, and when they do, they over-correct almost every time. Let’s look at the same chart as above, except this time we will remove the shaded boxes in favor of recessionary periods highlighted in gray:
Notice how many of the recessionary periods were immediately preceded by a fairly aggressive rate increase. The Fed’s unscientific tightening of monetary policy causes the rate of economic expansion to slow and then, in a Pavlovian response, the Fed rushes in to cut rates and ease monetary policy in an attempt to stimulate economic activity. And so the cycle begins again. While not every economic recession is mirrored by a decline in the equity investment markets, there is at least one sharp decline (-15% or greater) during those periods of economic retraction, as evidenced above in the SPX.
Perhaps the Federal Reserve has learned from its long history of policy errors, to be more measured in the pace by which it raises rates. Perhaps this is why they have chosen to only raise rates a quarter to a half of a percent per hike. While arguably still late in taking action, maybe they recognize how impactful aggressive rate hiking can be? Maybe this is why they are choosing to move the needle in such insignificant increments? Maybe so, but the problem is year-over-year inflation has currently pressed up through 8% on its way to 9%, levels it has not seen since the early 1980s (see below). In other words, inflation continues to plod along down Main Street, U.S.A. like Godzilla through the streets of Tokyo. In the case of inflation, there are even fewer weapons capable of subduing the monster, the most effective being aggressive tightening of monetary policy - a.k.a. Rate Hikes.
So what can we do with this information as far as equity investments go? The answer to this query rests on a number of factors unique to you as an investor. Are you a long-term investor who won’t be bothered by three, four, five, maybe even six years of almost flat or mildly negative investment results? If so, you may be inclined to stay the course, per se. While a more tactical approach is often necessary for most investors as their life and financial needs cannot afford to wait 6 years for investment recovery, if you are someone who has that ability, you may choose to pay no mind to any of this. In the case of the S&P 500, even an investor with the worst possible timing - meaning they purchased at a peak just before a major selloff (more than -15% decline) - the longest period of time before they were back to even is approximately 2745 days, or 7.5 years, between 1973 and 1980. The second-longest period was following the tech bubble bursting in 2000, which lasted until 2007. But of course, these would be a rough few years requiring you to remain steadfast and unwavering, which is not likely the case for a vast majority of individual investors.
For those who don’t adhere to such an extreme version of passive investing or those of us who recognize the value of a more tactical, risk-adjusted investment approach, we are now in a time that warrants extreme caution, but there are not yet signals suggesting it is time to become excessively defensive. It is probable this time will come, however, there remains solid evidence that certain areas of the equity markets have room to improve. While the past three years have enjoyed wildly accommodative, dare I say “easy” investing markets, the reality is that this is not natural, normal, or anything close to it. An understanding of risks in a portfolio is paramount in any market environment, however, we believe now is a time to suppress the risk appetite you may have become accustomed to over the past two to three years. We also believe now is a good time to reassess and rationally frame expectations going forward. Investment expectations are so often framed by one’s most recent investment history, which can currently prove to be destructive as you chase the returns of the past two to three years. Having appropriate expectations better prepares you to combat the emotional reactions you may have in volatile or tumultuous market conditions.
We currently believe that growth equity is less favorable than its value counterpart. Looking to the NASDAQ 100 as a proxy for large-cap growth, we believe it will be met with significant resistance around its July ‘21 highs (approx. 15,140 NDX). It just so happens this level coincides with the current 144-day moving average (we favor moving averages based on the Fibonacci sequence, rather than the traditional 50-day, 150-day, and 200-day moving averages). We see support around its May ‘21 lows (approx. 12,970 NDX).
We closely watch one specific indicator to understand whether our focus should be on growth or value. Without getting too deep in the weeds, the following chart takes into consideration the large-cap market as well as the small-cap market. When this chart is trending up from left to right, growth is favored and a downward trend from left to right suggests value is favored. While there are several levels of interest, the most significant is 1.84. This might be likened to the Mendoza Line for baseball fans or P10 in Formula 1. This has proven a critical line of resistance and support. So long as this remains below 1.84, we believe growth is out of favor and value is in favor. For this reason, we believe equity investments should be weighted toward value.
Generally speaking, fixed income (bond) investments and cash are most negatively impacted when inflation is increasing. For this reason, bond investments must be carefully considered as their risk profiles change with inflation, as well as with subsequent rising interest rates. These investments no longer offer the same risk diversification as they had before. It is no secret the bond market has been troubled for some time now. Treasury yields have spiked aggressively, likewise, the more equity market correlated fixed-income investments (like convertible bonds) have faired poorly leaving bond investors scratching their heads. The good news is that we believe a lot of this bond underperformance is likely the market trying to “price in” the future rate hikes expected from the Federal Reserve. This may mean some opportunities could soon present themselves, but we are not in the business of predicting the future. Instead, we rely on the evidence currently available, which suggests minimizing exposure across all fixed-income.
Additionally, while it contrasts conventional wisdom, holding excess cash (beyond your emergency reserve needs) is disadvantageous. By investing that cash, it becomes participatory in the inflationary market, rather than idly sitting on the sideline losing purchasing value. For this reason, holding excess cash does not act as a risk control in the fashion most believe it does.
Commodities remain the strongest macro asset class. Because most investors are unfamiliar with commodities as investments, it is not uncommon to underestimate the breadth and diversity of the commodity universe. This often leads to investors fearing this asset class. We believe this area offers significant opportunity and indicators suggest this strength could last for the foreseeable future. Energy remains the most dominant right now, due in part to the Russia/Ukraine conflict. Agriculture has begun surging upward for a combination of reasons. I will discuss how this impacts the experience of living with inflation in a moment, however from an investment perspective, there are many reasons agriculture is showing signs of investment strength.
Please note: There may be more tax considerations or complexities associated with commodity investing. As always you should consult with your CPA or a professional tax expert to understand how your personal tax situation may be impacted.
Okay, enough about investment management. Now, it would be worthwhile to explore a few considerations that impact your daily life, spending, budgeting, et cetera so as to better frame expectations and plan for the road we most likely have ahead. As the Federal Reserve claims they are attempting to suppress these inflationary pressures, its board should continue to vote to increase the federal funds rate (FFR) which, in turn, will lead to increased costs to borrow money. Credit card rates, mortgage rates, auto loans, you name it will be increasing (for now).
Where we have to be careful as savvy consumers, is to recognize how hungry lenders are to capture a higher return on their lending. They will look to front-run the Fed’s monthly meetings if there is an expectation of a large rate increase. Essentially, if sentiment suggests the Fed is expecting to raise rates half a percentage point, lenders will look to increase their lending rates disproportionately higher in advance of that meeting. They will lock in a number of loans, then if the Fed only raises the FFR by a quarter of a percent, these lenders will then have to reduce their rates to align with the market rates, but they at least locked in some new loans at that marginally higher interest rate.
Just have a look at this screenshot I grabbed from zillow.com's weekly mortgage rate chart.
See that spike and immediate decline? That was the lead-up to the March Federal Reserve meeting when they were expected to conduct their first rate hike. While, yes, the Fed raised rates from 0% to 0.25%, the expectation was that they would do what is actually necessary and go much higher. The big lenders, which drive the national averages, were looking to bank on this opportunity. But once speculation was replaced by reality, these lenders had to adjust to more realistic rates based on the market. This same thing happened in 2018, when the Fed last pretended they were serious about normalizing rates. While we may be quick to blame the big bad banks (and there are plenty of reasons they do deserve blame), it is likely not as simple as the big banks are a cliché movie villain.
Something interesting happened back in 2021. The Fed changed the language used when discussing inflation, namely, they began stating their focus was on fighting “inflation expectations” rather than inflation, itself. I have since proposed that the Fed would much prefer to leverage its immense power and role in the world economy by manipulating market sentiment through rhetoric rather than take any real action. Or worse yet, they may be intentional in not taking action while simultaneously enacting policies that promote higher than normal inflation. There is a long list of reasons why this is likely, but two are worth noting:
First, the role the Fed plays in the open markets has become bloated to a frightening degree over time, and much more so following the Great Recession (’08-’09). As such, this otherwise “independent institution” has been, and will continue to be, leveraged as a political tool. The Fed Chair, being a non-elected appointee of the President, is much less incentivized to make decisions that are beneficial for the long-term economic success and stability of the American People, instead the short-term financial and economic state of affairs is where the focus lies. Economic prosperity is highly correlated to incumbent election success, which is a fairly short timeframe in the grand scheme.
Secondly, as many are aware, the United States has a slight issue spending more than we earn, which is why we have such a significant national debt and why we operate on what is known as deficit spending. For this reason, there is a significant concern when it comes to servicing that debt or paying interest on the money we borrow. The necessary tool for combating very high inflation is to tighten monetary policy, a.k.a make borrowing money more expensive. If the Fed raises rates as sharply as would be needed to effectively combat this inflation, it would also cause the cost to service the national debt to go up, thereby exponentially increasing the rate of deficit spending. This could spell disaster.
Now, I am going to propose what may seem like some preposterous ideas. What if the Fed actually wants inflation to run higher, despite how it impacts the average American? What if the monetary policy, asset purchases, and the aggressive stimulus enacted in the wake of the 2020 government forced shutdowns, as well as the lack of reaction to curb the negative impact of this stimulation, were intentional? What if the exponentially increasing wealth gap is a known result of the aforementioned policy initiative?
I believe it is important to shed light on a very serious policy initiative that is very likely driving much of what we are experiencing today so you are better equipped to navigate as best as you can for your own personal success, prosperity, and financial freedom. Let me introduce you to a term you likely haven’t heard: “Financial Repression”. Simply put, this economic term describes a rather sinister set of measures undertaken by a federal government to “channel funds from the private sector to themselves as a form of debt reduction.” (Source: Investopedia.com). To avoid brushing over relevant details, below are links to a number of articles I believe are well worth reading on this subject. To be fair, I want to offer various perspectives, some in favor of and some more aligned with my view of this detrimental and dangerous initiative:
Investopedia Definition of Financial Repression
“The Meaning of Financial Repression” (06/01/2015)
Rather than do what is necessary, and almost certainly painful, for long-term financial and economic health, the Federal Government and Federal Reserve seem to be trying to have their cake and eat it, too. There is a pattern emerging of the Fed using a number of PR tools ahead of each Federal Reserve Board meeting to plant ideas in the market that they are set to become hawkish, or very aggressive in tightening monetary policy, very soon. While I cannot say with complete certainty, I don’t believe there are any known instances of a dove transforming into a hawk overnight. Even if doing so would be advantageous or the “right thing to do”, the fact is that a dove is a dove and likely always will be. The current Federal Reserve has been a dove for a very long time. Even if it would be better for the American People if the Federal Reserve morphed into a hawk, the incentives for remaining a dove likely outweigh the costs in the eyes of the Federal Reserve members, as well as the Federal Government.
So what can you do? In the most immediate future, this means extra scrutiny is required when borrowing. The market for borrowing money will likely be erratic, and unpredictable in the near term. Avoid taking on big loans right now, whenever possible. If you do need to, be considerate of the lending rates being offered by the bank or institution you may borrow from. Ask for a history of recent rates and rate increases. If you see a big spike up, you may want to hold off for a few weeks or reach out to a competitor to see if they also have increased lending rates to the same degree.
Grocery prices are not likely to come down any time soon. While much of the recent spikes in prices are the market trying to price in the next crop cycle, there is also a shortage of fertilizer mainly as a result of the Russia/Ukraine conflict. The nature of the agricultural marketplace (commodities) is driven by futures contracts. This adds layers of pricing complexity which is further exacerbated by the uncertainty of future fertilizer availability/price/etc. This is compounded by the continued shipping and logistics challenges, not to mention the fuel costs. All said, the food-stuff market may have aggressively priced up and may slow in terms of increases, but there is no current signal for prices to recede. This needs to be factored into your personal budgeting.
The last major suggestion I have for the short term is for readers who are not yet “work optional”. I strongly encourage you to reconsider your personal value in this market. Employers are in a tough spot right now. Hiring is beyond challenging, the workforce remains sluggish, and in many cases, employers are simply being stubborn about increasing wages which feeds their hiring problems. I can’t blame them completely as the cost to hire is high, uncertainty about the future is abundant, and they may still be making up for the past two years, but these are the challenges of being the boss. When I say reconsider your personal value, I recommend you consider whether your compensation aligns with the value you bring to your employer. When I say compensation, I am not strictly speaking of financial compensation. I also mean experience offered, work/life balance afforded, as well as many other ways by which your employer compensates you. Now is the time to ask for a raise or make a change. Your employer is not responsible for your well-being. You are. Take the necessary steps so you don’t find yourself with irreparable damages stemming from the current state of markets and the economy.
Over the long haul, I caution you to understand the value of ownership. A direct result of financial repression is that savers are punished, which in turn fosters a world focused less on saving, more on borrowing and spending. We have steadily moved towards something I call “loanership”. We operate our lives on a subscription basis or we borrow rather than buy. This can be convenient or it may make something affordable today, however, this can, and does, lead to significant wealth attrition over time. Saving is forgone in favor of renting your life and lifestyle while sacrificing long-term financial security.
For the sake of your sanity, I’ll cut myself off here. If you have any questions or would like to discuss any of this or other concerns you have, please let me know. And for those who are looking for help in reaching your goals, I would welcome the opportunity to meet you and see if Carriage House Planning would be a good match for your needs. I encourage you to email us at CHP@carriagehouseplanning.com or click the “Schedule an Introduction” button at the top of the page.
Sincerely,
Casey V. Fulp, CFP®️
Owner & Principal
