Inflation and the Fed have Fundamentally Changed the Investment Climate
And it’s not going back to business as usual anytime soon.
Ever since the financial crisis, in other words, for the entire working career of today’s 35 year olds, investment markets and the US economy have been dominated by one overarching reality. That was constantly falling, ultra-low interest rates, and massive money creation by the Federal Reserve in the form of “Quantitative Easing”.
14 years of these easy money policies led to “easy money” for investors as well. Pour your money into speculative growth stocks, or just the big tech “FAANG” stocks, and sit back while stock valuations soared. Market setbacks in 2015, 2018, and even the pandemic shock of 2020 were bound to be short lived, since money was cheap and readily available. Stocks were appreciating at double digit rates almost every year.
It is going to take a while for many investors to get used to the idea, but those days are gone. And I don’t believe they are coming back anytime soon. It was inevitable that sooner or later our government's profligacy would result in inflation. The big surprise to many of us economic geeks is that it didn’t happen earlier. In retrospect, it seems inflation needed not only the “easy money” the Fed had been providing for years, but the added boost provided by an open government checkbook, a rapidly shrinking workforce, and supply bottlenecks created by COVID. But here we are, and now that the genie is out of the bottle, it is likely to prove much harder to put him back in than many people expect.
This means that the Federal Reserve is going to need to keep interest rates higher for longer than many people expect. Higher rates will eventually slow the economy, or even lead to a recession (but maybe not for another year at least!). Higher rates will also cause even more short term losses to bond investors – even if, once rates finally level off, investors will be reaping some much nicer dividends! Higher rates will also be a long term headwind for stocks. Companies that have been experiencing record high profit margins for much of the last decade will likely see those margins eroded as inflation, higher interest rates, and worker shortages drive up costs and impair profits. At the same time, higher rates force down stock valuations, as a nice safe 10 year Treasury bond paying over 4% will attract many investors away from stock investing.
OK, this is all nothing new. But here’s the main point I want to get across in this post. As should be readily apparent by now, this downturn is not another flash in the pan like the fall 2018 or even the Covid market crash. This is a major and fundamental shift in the economic landscape. Here’s what it means to me:
- Set modest expectations. We will have to wait a while before double digit annual stock returns come back.
- Value stocks and dividend paying stocks will outperform the still overpriced tech and growth names (as they did in 2022).
- Companies with strong profits today will outperform growth companies which base their valuations on the expectation of profits in the distant future
- International stocks (which have under-performed for years and are thus cheap relative to US firms) may finally outperform US stocks.
- Bonds investors may have to endure more losses in the short term – but will ultimately prove to be much more attractive than they were a year ago.
- Stocks and bonds for the near future are more likely than usual to move in the same direction, which means traditional allocation strategies such as are common in target date funds will continue to be subject to much more volatility than investors are accustomed to.
- Strategies such as buffered or indexed annuities and defined outcome ETFs may provide a much needed third leg of diversification in this new world order where both stocks and bonds are much more likely to move in tandem.
So is it still worth investing at all? Should you just put all your money in a 2 year CD at 4% and give up? Yes (to the first) No (to the second).
Yes, in this new high interest rate world, cash can now be an important part of your overall asset allocation. In my client portfolios, I’ve been steadily adding to cash positions over the last six months (mostly using 0 to 2 year CDs) In a rising rate environment, it makes sense, perhaps, to replace a chunk of the bond portion of your portfolio with high yielding CDs or money market funds. But while tweaking your investment strategy to reflect a new economic reality makes sense, wholesale changes (i.e. abandoning stocks and bonds) will often backfire. Eventually rates will peak, inflation will come down, and stocks may rally again. You won’t know when that will happen until after it does. If you aren’t invested, you won’t take part – and once the train leaves the station it is really hard to get back on. Not only that, but keep in mind that a substantial part of stock returns is the dividends that are paid out to investors. Even as stocks go up and down, dividends provide consistent income to investors. (true, dividends may be cut when corporate profits are badly hit – but for the most part they are quite consistent). You don’t own the stocks, you don’t earn the dividends.
Even though staying invested is important, it is also true that investing in the next few years will be more complicated than just buying Apple or Amazon and watching it go straight up. Discipline and a much more nuanced approach to diversification will be crucial in this new environment. We’ve seen this playbook before. Through the abysmal 2000 – 2010 “lost decade” for investors, investors who stuck with the “buy growth and watch it go to the moon” strategy that was popular in the 1990s got clobbered. The transition we are going through now is in many ways reminiscent of the 2000 growth stock crash (although the stock bubble this time was not nearly so overinflated!) I witnessed people who had retired with a multi-million dollar portfolio at the peak of the growth bubble in 2000 who had run through most of their retirement savings 10 years later as stock values got crushed. On the other hand, those who maintained a well diversified portfolio consistent with their life stage and goals did ok. They still experienced downturns in the 2000-03 recession, and of course in the financial crisis – but even in a decade where the S&P 500 didn’t grow at all – these disciplined investors generated mid single digit returns.
We are well prepared, I think, to usher clients through this changing investment climate. 2022 was difficult for most investors – but our portfolios did remarkable well when compared to major benchmarks such as the S&P 500 or the bond market indices. I continue to watch economic and market developments closely and will maintain robust and carefully vetted diversification strategies. The easy money era may be over for a while – but that’s ok with me. These are the times in which a good investment manager can prove his worth.