Update on the Economy and Investment Markets

Welcome to the Stearns Financial Poolside Chat. (Aren’t we all ready for Spring?)

March Madness is well underway with the best Men’s and Women’s college basketball teams competing across the country.  Those of us not actually playing in the tournament still believe we are a part of the action as we compete with our family, friends and co-workers in tournament challenges, all with great hopes of predicting who will win. 

Sports fans are not the only ones confronting challenges, however, as the Federal Reserve has embarked on its own challenge in recent weeks – with much higher stakes.  The Fed is tasked with the tall order of taming inflation while maintaining economic growth.  On March 16^th, therefore, the Fed announced its plan to raise the federal funds rate by 0.25% – the first rate hike since 2018.  While this move had long been anticipated, there was still a chance the Fed could increase rates by as much as 0.50%, which would have stirred the markets with a mild surprise.  The Fed also ended its bond purchasing program earlier this month, making monetary policy less accommodative.  The hope, of course, is that these moves will rein in inflation while maintaining full employment and a strong economy.  The task will not be easy, as Chairman Powell has alluded in multiple comments over the past several weeks.  For a deeper dive into Fed’s current situation and its ability to tame inflation, see the FAQ below.

The Fed isn’t the only one, sadly, that is taking action.  We continue to be bombarded with events both here and around the world: the war in Ukraine continues, with no end in sight; oil prices remain elevated; Japan’s Fukushima prefecture experienced a 7.3 magnitude earthquake, triggering a tsunami warning; COVID is surging in parts of Asia, while also trending up in Europe and parts of the U.S.; Iran launched missiles at the U.S. consulate in Iraq (claimed to be retaliation for an Israeli airstrike in Syria earlier that week that killed members of Iran’s Revolutionary Guard); Russia and Japan ended talks over disputed territory stemming from WW2; and much of the yield curve in the U.S. has inverted (meaning shorter term rates are higher than longer term rates). 

These events, however, even combined with the hawkish tone from the Federal Reserve, did not pour cold water on stocks, at least in the short term.  In fact, the week of March 14^th was the best week U.S. stocks have seen since 2020, with the NASDAQ index rallying over 10%.  Amazingly, European stocks are now trading about where they were the day Russia invaded Ukraine.  At the same time, the Chinese stock market experienced a historic rally when policy makers came to the rescue of investors.  From Bloomberg: “In a brief statement carried by state media, China’s top financial policy body vowed to ensure stability in capital markets, support overseas stock listings, resolve risks around property developers and complete the crackdown on Big Tech ‘as soon as possible.’ Yi Gang, governor of the People’s Bank of China, followed with a statement saying the central bank would help implement the policies, as did the banking watchdog.” 

In response, Chinese markets rallied the most in a single day since October 2008, with the Dragon Index (China’s NASDAQ equivalent) rallying over 30%.  Note the Dragon Index had experienced a decline of more than 70% over the last 13 months.  Time will tell whether these rallies are sustainable as we endure an ongoing war, less accommodative monetary policy, and elevated levels of inflation, both here and abroad. 

Tragically, the war in Ukraine rages on, propelling a humanitarian crisis to unfathomable heights.  It appears a stalemate is ensuing in parts of Ukraine with Russia’s military “digging in” around Kyiv to establish defensive positions.  Meanwhile, conditions are deteriorating in the besieged city of Mariupol (port city in SE Ukraine where the main language is Russian) with a defiant government refusing to surrender, even in the face of unrelenting bombardment from the Russian military.   Sadly, the bombing now appears either indiscriminate or aimed at civilian targets in an attempt to terrorize the citizenry.  While the Ukrainian military continues to exhibit resilience and strength, President Zelenskyy also continues to direct pleas to leaders around the world, from D.C. to Beijing, for further assistance in defending his homeland.  Zelenskyy did acknowledge last week that Ukraine will not be joining NATO – a top item on Russia’s list of demands. 

The U.S. announced an additional $800M in military support for Ukraine, and other countries have pledged additional assistance.  However, what Zelenskyy really needs, the West is unwilling to supply – that is, a no-fly zone over Ukraine.  Such an action, it is feared, would lead to a direct military conflict between NATO and Russia, essentially igniting the start of a third world war.  Instead, the West is looking to China for relief, if not abstention.  While the U.S. and its allies want to drive a wedge between China and Russia, it is feared China will instead provide economic relief to its neighbor, while also potentially supplying Russia with military equipment. China has claimed it has no intention of providing such aid; however, the talks held between President Biden and China’s President Xi Jinping yielded no concrete agreement.  At the same time, China voted to keep Russia in the G20 economic forum to be held later this year, and abstained from condemning Russia for its initial invasion of Ukraine, citing Russia’s “legitimate security concerns.”

Biden is traveling to Europe this week to discuss the Ukraine crisis.  One topic will be how to respond if China does provide material support to Russia.  As we have mentioned before, China is keenly studying the response of NATO to the Ukraine situation, given its own ambitions in Taiwan.

While the pandemic has taken a media backseat in the midst of other news, rising rates of a new variant continue to raise concern.  Cases in China have risen in recent weeks, leading to lockdowns reminiscent of those observed in the early months of Covid.  Hong Kong has experienced a surge in cases that has been accompanied by a surge in deaths.  The theory as to why Hong Kong is experiencing increased deaths this wave that were not observed in other countries is that Hong Kong’s elderly population has a low vaccination rate, so, while their initial zero-COVID policies appeared to have worked, they have not been able to have the same success with this more infectious variant.  Europe has also experienced an uptick in cases of the Omicron variant BA.2 which, in vintage form, is making its way to the U.S. This will be something to monitor in the coming weeks, but current thinking suggests we will not experience a similar surge to earlier this year, given our vaccination rates and growing herd immunity here in the U.S.   Investors will naturally continue to monitor the impact of additional strains on already teetering supply chains. 

In addition, while attention has been focused primarily on the Ukraine/Russian conflict, the U.S. treasury market has experienced a significant rise in rates.  From the beginning of March through to intraday on Thursday (March 24), the rate on the 10-year treasury has increased from 1.7% to 2.45%.  At the same time, rates for shorter term treasuries have also risen sharply, with the rates of the three-year, five-year and seven-year now exceeding the rate on the 10-year.  While rising rates are an obvious headwind to bond prices, we also have a potential problem when short-term rates are higher than long-term rates, a condition referred to as an inverted yield curve. Typically, the treasury yield curve slopes upward when investors are optimistic about the prospects for economic growth and inflation. Buyers of government bonds will then demand higher yields to lend money over longer time periods.

Historically, an inverted yield curve has preceded a recession in many instances, though not always.  While history is no predictor, we do know that in such situations, a recession is many months or even more than a year out from when the yield curve inverts.  The below chart shows the length of time between an inversion between the two-year and 10-year until the recession.

At this time, the two-year rate is still approximately 0.20% lower than the 10-year, so this part of the yield curve has not inverted yet.  It must also be noted that the confluence of events: high inflation, the war in Ukraine, and a tightening Fed also affect rates.  It is, therefore, unclear whether our current inverted yield curve is predictive.  We will continue to monitor this situation closely in coming weeks and months and adjust our portfolio strategies as required.

SFG’s Take: We believe the U.S. and global economy will weather the spike in oil costs, but the prospect of dampened growth in 2022 is likely. Inflation is now even more of a problem, but is likely to begin calming down later this year, albeit still at elevated levels. This is a good time to hold diversified portfolios, as the Russia/Ukraine war and many other risks to individual asset classes remain elevated.

There are also many headwinds and tailwinds to corporate earnings and stock prices, with continued volatility at a higher level very likely in U.S. stocks. For those of you accessing your portfolios to fund living expenses, you may consider increasing your outside cash reserves. Please contact your advisor to discuss whether this makes sense for you.  

 KEY POINTS TO CONSIDER

• Currency Wars? – Earlier this month, the U.S., its Western Allies and Japan imposed sanctions on Russia’s Central Bank by freezing its foreign-denominated reserves held with Central Banks outside of Russia. This cut Russia off from a significant portion of its “savings” and sent the value of the Ruble falling. Russia attempted to provide support by increasing interest rates to 20% in an attempt to prevent capital flight. In retaliation, Putin announced this past Wednesday that Russia would only accept Rubles for natural gas that it continues to provide to Europe.  There are ongoing discussions around the world about the continued use of the U.S. dollar in transactions surrounding oil (the petrodollar), but to date, the U.S. dollar remains the world’s main reserve currency.  Actions by Central Banks earlier this month to cut Russia off will have potentially unintended consequences, as countries are forced to rethink how they will conduct business around the globe.   

• Mortgage Rates – The 30-year fixed mortgage rate is quickly headed towards 5%. As a result, mortgage and refinance applications are dropping, and the pace of new home sales is decreasing. The higher rates are making it harder for first-time home buyers to buy into a market that over the past two years has experienced soaring prices throughout most of the country.  However, all things are relative, as even at 5%, rates remain low by historical standards.

• Initial Jobless Claims (i.e., new claims for unemployment benefits) for the week ending March 19^th were 187,000, the lowest level since September 1969, as the demand for workers continues to outpace the supply. Also, the number of people collecting unemployment benefits hit a more than 50-year low.

FREQUENTLY ASKED QUESTIONS

Q: How did Paul Volcker tame inflation?

A: In August 1979, Paul Volcker was confirmed as the Chairman of the Federal Reserve following his appointment by President Jimmy Carter.  Volcker inherited a U.S. economy that had experienced a rough decade (the following is not a comprehensive recounting of all the events that took place or policies that were enacted during this period). 

U.S. government spending had increased during the 1960s under President Lyndon Johnson to support the Vietnam War, launch Medicare and expand the Food Stamps program.    While these increases in government expenditures did contribute to some short-term prosperity, the costs were not offset with higher taxes, which eventually contributed to higher inflation.  The decade of the 1970s began with the “Nixon Shock” in 1971 which implemented a number of economic policies.  The goal of these policies was to control both rising inflation and rising unemployment.  The policies included removing the U.S. dollar from the gold standard, establishing an import surcharge of 10% to protect American manufacturers (and encourage other countries to revalue their currencies) and imposing price and wage controls.  President Nixon was headed into a reelection year in 1972, and these policies for the most part turned out to be great for his reelection campaign – but an economic failure for the U.S. in the long-term.

Initially, the price controls were successful; however, each time Nixon attempted to relax the controls, inflation shot up.  Adding insult to injury, members of the Organization of Arab Petroleum Exporting Countries (OPEC), led by Saudi Arabia, targeted countries that had supported Israel during the Yom Kippur War, resulting in further inflationary pressure in 1973-74.  After a brief respite, prices in the U.S. again began to rise in the second half of the 1970s, with a second oil crisis during the Iranian Revolution of 1979 – again contributing to inflation.  In short, higher inflation begat higher interest rates which begat higher unemployment levels in the late 70s.  The U.S. economy experienced stagflation in the late 70s and early 80s, a term used to characterize slow economic growth combined with rapidly rising prices.  This period also shed doubt on a macroeconomic theory known as the Phillips Curve, which states that inflation and unemployment have an inverse relationship – clearly not the case in the late 70s and early 80s. 

When Volcker stepped into his role as Chairman of the Federal Reserve, inflation was at or near double digits with no end in sight.  In October of 1979, Volcker and the Fed made a fundamental decision to target the money supply in the U.S. instead of the federal funds rate.  Prior to Volcker and under subsequent Fed Chairs, the Fed targeted an interest rate (essentially what Powell and the Fed did earlier this month by increasing the federal funds rate to 0.25-0.50%).  Under Volcker, at an unscheduled meeting in October 1979, the Fed decided to utilize its ability to control the money supply as a mechanism to combat inflation.  Without getting down into the weeds, the Fed had the ability to control the money supply available to banks through its management of reserves, which in turn, dictated the federal funds rate.  This led to greater volatility in the rate from 1979 to 1982.  A federal funds rate that was already sitting at 11% when Volcker became Chairman rose to as high as 20% during this period. 

Despite higher rates, inflation remained in the double digits for most of 1979 through 1981.  Higher rates and persisting inflation led to a short recession during the first half of 1980, pushing unemployment to almost 8%.  The federal funds rate decreased during this six-month period before beginning to rise again.  However, inflation relief was nowhere to be found and remained above 10% through 1981.  The U.S. experienced a second and much longer recession during this period, from July 1981 through 1982, during which the unemployment rate reached 10.8%. 

Needless to say, Volcker and his Fed were not popular and were widely criticized given the short-term economic pain that the U.S. experienced as a result of these policies.  Ultimately, however, Voker was able to “break the back” of inflation, reducing it to under 4% in 1983.  At this point, the Fed became accommodative, kicking off a period of strong growth and low inflation in the U.S. In fact, inflation levels in the U.S. remained relatively low from 1983 to 2021.

Despite critics questioning the necessity of his actions, Volker was reappointed to a second term in 1983, serving as Chairman until 1987. Today, he is widely respected for the actions he took to tame inflation, despite the near-team pain his policies caused.

Q: Will the current Federal Reserve be able to succeed in taming inflation without sending the U.S. into a recession?

A: This is an increasingly debated topic, given the current state of inflation and the federal funds rate here in the United States.  Inflation has clearly not been “transitory” if one defined transitory as a period of a year or less, while the jury is still out if one defined “transitory” as a two-to-three-year period following the abrupt halt to the economy as a result of COVID.  Given the conflicting interpretations, and the fact it appears elevated inflation will persist at least through 2022, the Federal Reserve removed “transitory” from its most recent statements. 

From the Federal Reserve’s website: “The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy ‘so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.’  Even though the act lists three distinct goals of monetary policy, the Fed’s mandate for monetary policy is commonly known as the dual mandate. The reason is that an economy in which people who want to work either have a job or are likely to find one fairly quickly and in which the price level (meaning a broad measure of the price of goods and services purchased by consumers) is stable creates the conditions needed for interest rates to settle at moderate levels.” The Fed’s dual mandate goal refers to focusing more on achieving stable prices and maximum employment.

The needle the current Fed is attempting to thread is to get prices under control without disrupting economic growth – which would lead to increased unemployment.  Monetary and fiscal policy have both been extremely accommodative over the past two years, as the economy has recovered from the initial disruption caused by COVID.  During this time, many factors have contributed to inflation levels that have not been experienced for four decades.  These factors include pent-up demand coming out of COVID, the ongoing supply chain disruption caused by COVID and the war in Ukraine, and the increasing prices of commodities including oil, natural gas and certain food inputs such as wheat (Ukraine and Russia account for greater than 25% of global wheat production). 

The Fed’s hope that inflation would be short-lived has not played out, and the Federal Reserve has done little to aggressively attack inflation up to this point.  The Federal Reserve ended its new bond purchases earlier this month, which have steadily been expanding its balance sheet throughout the pandemic.  The below chart shows the size of the Federal Reserve’s Balance Sheet since 2008.  What is always surprising/interesting is comparing the relative sizes of the balance sheet increases that took place during the Global Financial Crisis vs. COVID.  The Federal Reserve’s Balance Sheet has increased by over $4 trillion over the past two years. 

Federal Chairman Powell stated earlier this week during prepared remarks after announcing the first rate-hike since 2018 last week that “The labor market is very strong, and inflation is much too high. My colleagues and I are acutely aware that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation. There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability. We are committed to restoring price stability while preserving a strong labor market… how likely is it that monetary policy can lower inflation without causing a recession? Our goal is to restore price stability while fostering another long expansion and sustaining a strong labor market.In the FOMC participant projections I just described, the economy achieves a soft landing, with inflation coming down and unemployment holding steady. Growth slows as the very fast growth from the early stages of reopening fades, the effects of fiscal support wane, and monetary policy accommodation is removed.”  Powell went on to state that he understands that some believe the odds are stacked against the Fed achieving a soft landing and acknowledges that this soft landing will be challenging and not straightforward. 

Powell also stated that raising rates more quickly (i.e., more than 0.25% each meeting) has been discussed.  Even if the Fed pursues this strategy, it is unlikely that they will take aggressive action on par with Volcker’s actions in the late 70s and early 80s.   With that said, Volcker’s moves came at a time when the U.S. economic situation was worse than it is today, with higher unemployment, higher inflation, and higher interest rates.  In addition, the U.S. at that time was coming off of a very rough decade, unlike today, which follows a very strong decade in spite of a pandemic.

Time will tell if Powell is able to tame inflation this time around while driving the U.S. economy to a soft landing.

SFG’s Take: As mentioned in the last Chat, some of the current factors affecting inflation are out of the control of the Federal Reserve, as they are due mainly to supply chain issues and, more recently, to higher commodity prices as a result of the war in Ukraine.  Even so, the Fed can take steps to lower inflation by increasing rates which should eventually cool demand for goods.  The question is if the Federal Reserve will continue to slowly raise rates, as has been their recent habit, or if it will be more aggressive and hike faster?  In Powell’s recent comments, he indicated fighting inflation will take priority if the Fed cannot achieve its dual mandate (discussed in FAQ above). The Federal Reserve policy decisions over the next two or three months will provide insight as to how serious the Federal Reserve is about getting inflation under control.  We believe the Fed is serious about taming inflation, but the ability of the Fed to achieve this outcome without taking aggressive steps that may shock the equity markets and/or disrupt economic growth is uncertain.    

INTERESTING PEOPLE, INTERESTING TIMES

In our recent Live Chat, Dennis talked to Brooks Raiford, CEO of the North Carolina Technology Association. Brooks also sits on several national technology association boards and has a powerful network of friends inside and adjacent to the industry. We’ve included a link below to view the whole interview, but here are key highlights:

• The positive state of the NC technology industry and the highly positive views of C-suite leaders about the future.
• Brooks’ #1 advice to a young person entering college to hedge the uncertainty of the techno-industrial revolution. Some client’s particularly liked how he stressed the demand for the balance of STEM versus liberal arts skill sets needed by most technology companies, public and private.
• Some reasons for the Great Resignation, and its effect on the technology industry. Not as bad as some sectors of the company, still many challenges for company leaders.
• Impact of the Ukraine/Russia war on supply chains and supply chain disruptions in general.
• Comments about the “back to work” versus hybrid in-person/virtual work environments post pandemic. Both models are being embraced.

This interview went in many different directions – you can watch the replay here: https://stearnsfinancial.com/chats-about-life.html

MEET YOUR TEAM

This month we introduce Heidi Bannerman, from our Chapel Hill office.

What is your role at SFG, and what services do you provide to our clients?    My title is Client Service Advocate (or CSA), and I provide client and account services. Requests to transfer funds or open accounts or provide documentation are for me. And I love looking for the answers to unique situations and challenges.

What brought you to this area of the country? What’s your favorite thing about where you live now, or where you’re from? I’ve been here almost 20 years, from California as a youngster, by way of Arizona in college and as a young adult. This is home now – I have no desire to move back and now my family (Mom) is here as well. I like having four seasons or weather and being right in between the beach and the mountains. I’ve always loved all the GREEN – love the trees and foliage in comparison to Arizona.

What was your first job? Any special lessons from it? I was fifteen when I started scooping ice cream and frozen yogurt at a place called Heidi’s (not mine ?). I learned that I needed to be responsible for my shift assignments and had to learn how to switch shifts if I needed to be off, etc.

Early bird or night owl? I was always a night owl when in the restaurant industry. Now as a mom with a day job, I think I can be both, or neither. To have a good morning, I need coffee and quiet. “Wine-down” at night is key to a good evening.

If you could snap your fingers and become an expert in something, what would it be? I don’t want to be an expert at one thing – I like being a Jill of all trades. My husband and I have talked about how we’d like to be SUCCESSFUL Bed & Breakfast owners in our next act, so maybe multitasking is where I need expertise!

What’s one thing you’re currently trying to make a habit, or one skill you’re trying to learn/hone? I was hired during the pandemic, so learning about our team (the one in Chapel Hill and the larger team of the firm) and clients has been the focus since I came on board. But the skill I hope to hone is event planning, as we move towards more in-person events.

Tell me about your family. I’m married to Scott, and have a son, Kellen and a daughter, Shelby. My mom, Cheryl, lives near me in the Raleigh area. Favorite relative, aside from Mom or Dad? We spent a lot of summers when I was a kid with my mom’s dad Richard, who was a lobsterman in Maine. He taught me to fish and tie knots. Dogs or cats, or both? Both – we have Piper the puppy and kitty littermates Pinkie and Roxie.  Beach or mountains? Beach 100%. All my vacations are tropical!

What was the first concert you ever attended? I went with several fellow Girl Scouts to see Bon Jovi when they were touring for the New Jersey album, and not long after that I saw Ray Charles with my folks!

What’s your favorite local restaurant? There’s an old-school steakhouse called Vinnie’s that we love, and they also have delicious seasonal items. Your favorite thing to do outside of work? We’re homebodies – we do love concerts, but also listening to music at home, having friends over and hanging out with family.

What’s the most fun thing you’ve ever done: at work, at home, or on vacation? We always try to do something special, active and unique on vacation, so those are my favorite times.

What’s your favorite part of your job? 100% the clients. I love my work family but I really enjoy getting to know our clients and learning about their lives.

SUMMARY

SFG’s three pillars of recovery remain in positive trend territory in 2022, although many economic crosswinds, especially the prospects for higher interest rates to combat inflation, are spooking investment markets.   

Wildcard risks (low probability, high possible impact) discussed in this and previous Chats remain, suggesting some caution. For those of you accessing your portfolios to fund living expenses, you may consider increasing your outside cash reserves (emergency funds). Please contact your advisor to discuss whether this makes sense for you.

SFG is balancing numerous opportunities and threats in our portfolios, customized to our clients’ unique circumstances.

In growth portfolios, we are leaning into a variety of short- and intermediate-term asset classes and trends that we believe have favorable, forward-looking risk/reward relationships.

In more conservative growth and income portfolios, we are maintaining good diversification, while striving for positive real returns over inflation.

Our COVID-19 investing approach can be summed up by six themes:

• Diversification with a balance of offensive and defensive measures, depending on the desired risk tolerance of our clients,
• Underweighting, or avoiding areas of higher future concern,
• A focus on higher-quality investment themes,
• Identifying and implementing buying opportunities that may be appropriate for more growth-oriented portfolios,
• A more defensive stance using different portfolio tools for more conservative growth and income portfolios, and,
• Utilizing select alternatives to traditional bonds and stocks.

~ Dax, Dennis, Glenn, Jason, John and PJ
(the SFG Investment Committee)