Enduring the Turmoil
“It is tough to make predictions, especially about the future” Yogi Berra, Yankee Hall of Famer.
Near Term Turbulence
Several actions and effects are driving national and global economic rebalancing:
The War in Ukraine has globally displaced over 10% of petroleum and 20% of food supplies creating shortages and imbalances worldwide
These global shortages are reducing GDP and driving annual price inflation in some cases 10%;
Central banks are generally reversing monetary posture from stimulative, post-pandemic, to restrictive. Interest rates (cost of money) are rising and assets at sale are being discounted;
Global supply chains are breaking down in many industries due to political and idiosyncratic uncertainty, causing shortages, price spikes and sudden localized surpluses;
Consumers initially absorb price increases, but in time reduce consumption;
The growth in the economy (GDP) is mediated by the supply and demand of all products and services. Reduced consumption means most companies sell less of their output, reducing profits and margins. This profit decline can also be projected into a reduced growth outlook, which investors see as a reduced asset price to earnings ratio. A reduced GDP will affect equity prices by a factor typically greater than one, and in some cases on the order of ten or more.
These economic inferences are bounded by caveats. In particular, the economic impact of these forces depends on the duration of the imbalance, and the ability of consumers to adapt and substitute inputs. Aggregate economic response is extraordinarily complex, making predictions following massive condition changes quite variable. A so-called soft landing, a mild recession or even a hard recession are called after the fact. These caveats based on human decisions and response, induce inherent uncertainty. When anyone assigns numbers regarding how long a recession will last, how deep it will be, how high interest rates will rise, or how far will the stock market drop, at best they are making an educated guess based on historical data that may or may not be relevant, and at worst they may be engaging in wishful thinking or trying to influence the behavior or perceptions of others expediently. However, humans are not dissuaded in their quest for answers. To quote a well-known aphorism, “Enquiring minds want to know.” You can hear any number of prognostications on financial news television, the Wall Street Journal, or even on the Fidelity.com website. Our view is that we are already experiencing a global economic contraction of unknown magnitude, with duration a mix of short-, medium- and long-term cyclical components.
Responding to Economic Cycles
Economics is inherently cyclical, mathematically the sum of cycles of various duration and magnitude. John Maynard Keynes famously said, “In the long run, we’re all dead” alluding to the fact that there are long term cycles which are an ultimate destiny outside human control but at our point in history, we must live in the here and now, and control our decisions and behavior. It is convenient to group cycles in short, medium, and long duration even though it is always very difficult to discern the precise duration at the time we are living through it. We refer to these cycles as waves and sometimes group them as seasonality waves (1-12 quarters), the business cycle (3-10 years), and secular waves (multi-decade, generational or even industrial periods). This distinction is helpful as many decisions in life fall into these duration groupings. Almost all decisions have some level of expenditure associated with them, so we plan our finances in a way that supports the short-, medium- and long-term goals and habits of our lives.
When inflation rises above modest levels, our financial plans are often disrupted, as our ability to plan for expenditures years away becomes uncertain. Inflation is cumulative in time, so costs in the future can far exceed what we have saved, and our ability to find savings vehicles that in some way keep up with inflation is limited. In this way, inflation is a particularly onerous double whammy, as it discounts our investment saving immediately in market terms, and then challenges us to somehow accommodate rising prices for an unknown period. Inflation thus discounts our future standard of living and erodes our confidence in the civil society supported by that standard of living. That is why central banks and national treasuries work hard to assure the stability of currencies and control inflation.
Economists have no magic or silver bullets to solve inflation in the short-term except for raising interest rates which slows economic activity. In other words, policy makers opt to pay now to reduce inflation by slowing the economy rather than pay later in the future by accepting the corrosive effects of inflation on a society over time. Slowing the economy is inherently painful and inequitable. People with fewest options for working, saving, consuming and investing endure hard choices regarding undesirable jobs, cash accounts with low inflation hedges, rising food and energy prices, and limited investment options. Yet unchecked inflation affects everyone in an economy, rich and poor, young and old.
In the long-term, economists predict that growth in GDP and increasing productivity (output per person) enables an economy to outgrow bouts of inflation and contraction, but this takes time. These factors with different duration and magnitude are among the cause of economic cycles.
As advisors, we have limited capacity to shield people from inflation. What we advocate is to bin money into accounts that are targeted for short-, medium- and long-term plans. The short-term money needed in the next 1-3 years should be mostly in cash or near cash investments. We cannot tell conclusively how far the market will fall and when the contraction might end. Though inflation might reduce the purchasing power of those funds, the nominal value of the funds will remain mostly constant.
Medium term funds to support 3–10-year expenditures should be in a 50%-50% mix of dividend paying, high quality stocks and U.S. Short-Term Treasury Inflation Protected Securities (TIPS).
Long term funds needed to sustain goals beyond ten years need to be more fully exposed to equities or stocks (a 70%-30% stock to TIPS mix), despite the inherent volatility of the stock markets. Value stocks (lower PE multiples, stable or growing customer markets and share, higher cash flow and low debt/equity ratios) as a category can theoretically keep up with variable inflation over time. While studies are not conclusive, the implication is that these companies survive over longer periods because they adjust their balance sheets and business plans to maintain positive real rates of return (inflation adjusted) However, returns on medium- to long-term investments have been historically high over the past thirteen years due to monetary stimulus, and with the tightening policy, slowing economy, inflation, and reduce global growth trends, we anticipate a longer-term period of sub-par investment returns. Interest rates, being a measure of the time value of money and potential returns, are rising but still are categorically a fraction of their historic averages.
Our advice for people with medium- and long-term investment goals is to “look through” the short-term ups and downs of the market by maintaining a relatively stable portfolio mix, based on the historical ability of stocks to continue to be the workhorse of your financial investment needs. Finally, everyone with limited financial resources should also find it appropriate to review their consumption considering tighter economic conditions looking out into the short-, medium- and long-term. Proper planning can often reduce or eliminate instances of future financial pain.