Update on the Economy and Investment Markets 8-27-22

Welcome to the Stearns Financial Poolside Chat.

Thank you for the many notes, e-mails and calls about our recent letter to clients outlining our strategy and action plan for this period of heightened uncertainty. Common sense obviously indicates that near-term inflation, Federal Reserve tightening, a slowing economy, and geopolitical tensions here and abroad require an allocation in keeping with your risk tolerance and Financial Independence Roadmap™ objectives. We continue to monitor these issues closely and adjust our strategies accordingly.

One of the many trends we’re following relates to the housing market, which is softening even as multi-family rentals remain at all-time highs. A recent RBC study projects that single family homes in Canada may decline a whopping 30%, while prices in the United States are predicted to decline 10% or more. Higher mortgage rates resulting in fewer people who can afford a home are chief among the reasons, although the slowing economy is also causing some potential buyers to become inherently more cautious, avoiding a home purchase even if theoretically affordable.

Inflation, on the other hand, is riddled with both good and bad news. First, the good news – energy and commodity prices are declining. The cost of goods remains stable and, in many cases, is also declining. JD Powers just reported used car prices (which make up 20% of the CPI) will decline later in 2022. And, most importantly, gnarly supply chains are slowly getting straightened out.  

The bad news – oil prices may trend back up a bit, food inflation remains high and strong payrolls are putting upward pressure on wage inflation. While this is good for American workers, (remember the Gross Domestic Income discussed in our recent “Inflation Watch” Live Chat), it is not so good for corporate profit margins that drive earnings growth.

In addition, “shelter” inflation – which refers to prices paid to live in a home or an apartment – is likely to be with us for a while longer even though home prices themselves are trending down in many markets. Shelter inflation is an important statistic to follow as it makes up 40% of the CPI.

How does all this shake out?

We expect inflation to moderate by year end, but this slowdown may involve two steps forward and one step back. As the chart below shows, the money supply is highly correlated with core inflation. From Startegas this week: “We think money growth moving down is the key to getting inflation down.”

Remember that the actual impact of inflation on you depends a lot on how you personally spend money. For example, if you own a home with a fixed mortgage rate, shelter inflation has no impact on you.

Keys to Consider

• Recession watch: The Fannie Mae Home Purchase Sentiment Index survey data shows that one in four employed respondents is concerned about losing their job. Strategas believes this is emblematic of just how fragile the economy and consumer currently are. Retail companies reporting over the last week highlighted consumers shifting away from name to generic brand labels, lower transaction volumes, and price sensitivity with higher income earners.

• The SLIM (Strategas’ Leading Indicator of Manufacturing) survey indicates that supplier deliveries will quicken in August, a sign that supply chains are becoming healthier. Strategas also believes improving supply chains will help bring core goods inflation down further. SLIM is designed to provide an early indication of change in U.S. manufacturing activity during the current month by focusing on New Orders and Supplier Deliveries as indicators of present and future growth or contraction in the sector.

• Recession watch: Gross Domestic Income in the second quarter has again diverged from GDP, going up while GDP has gone down. As discussed in our recent Live Chat on recession risks, GDI (gross domestic income) is an indicator of consumer health – a positive reading is a good thing. Recall that GDI has been a better predictor of economic conditions during several pivotal times in economic history, one of which was the Great Recession of 2008-9. We’re not celebrating just yet, as other indicators are still suggesting a slowing economy.

GDP for the second quarter was revised upwards, signaling almost flat “real over inflation” economic activity.

Frequently Asked Questions

Q: I’m feeling more uneasy in this recent downturn even though our portfolio has held up well and our plan says we are still right on track with a good safety margin. I slept pretty well through the 2008/09 financial meltdown even though elements of it were unsettling. Is something different in this downturn? 

A: Five factors are affecting some of our clients more in this current downturn compared to past downturns.

First, many are closer to retirement or are already retired, making the impact feel more significant than 12 years ago. It’s often more difficult to endure market volatility when relying on your portfolio to fund your living expenses.

Second, the COVID-19 pandemic has psychologically affected many of us. Some fear their genetics, their age or their health issues will make it more difficult to recover well from a bout of COVID-19. Others find all the conflicting health and safety information available, particularly around mask-wearing, troublesome. And, finally, some find it unsettling that China’s COVID-19 policy is creating such havoc and inflation pressure on our supply chains here at home. Going to the grocery store and paying a lot more for meat and butter, even if you can well afford it, creates anxiety in most everyone.

Third, the 24/7 media is now everywhere and it’s hard to get away from the doom and gloom discussions required to maintain clicks, views and advertising dollars.

Fourth, the super trend impacts on our economy (and the globe) have arrived in full force and created other changes with labor, politics and world events. Globalization post-pandemic is a mess, with supply chain problems and hyper-demand creating above average inflation in many industrialized nations. The U.S. is somewhat stabilizing while countries like England are experiencing persistent hyperinflation. The big impact of demographics is retiring boomers without enough workers to replace them. In the technology accelerator category, it’s a double-edged sword – our clients with various diseases are being treated with drugs and techniques not available just five years ago, while social media continues to create havoc with politics and cyber-addiction in young adults and teenagers.

Fifth, while geo-political events should usually be ignored, it’s tough to ignore the Russian-Ukraine war and its impact on world food supplies and energy cost volatility, plus the potential impact on NATO (and the United States) if it escalates. The rise of the “other” world super power – China – is a bigger challenge today on many fronts including the ongoing conflict over Taiwan.

SFG’s Take: Stress management has always been important. Today it’s more important than ever. SFG client Elaine Dermody is a gerontologist by training and co-wrote the Successful Aging Program used by many hospitals three decades ago. Our new Fourth Quarter Champions workbook (the companion guide to our Fourth Quarter Fumbles book) is dedicated to Elaine and her husband, Win, both thriving in their 80s and recognized recently in a Colorado aging study as champions.

The advice from Elaine’s Successful Aging program:

• If you can’t fight and you can’t flee, flow.
• Recognizing, understanding and dealing with stress can strengthen your inner resources in advance of stress-induced illness.
• You’re responsible for how many life changes you put upon yourself. Assume responsibility that some of your stress may be self-induced. 
• New experiences and challenges are positive factors in keeping healthy mentally and physically and moving forward.
• Let go of past resentments, mistakes and conflicts.
• Most situations that cause stress are not life threatening – consider deep breathing exercises. [Editor’s note: today’s Navy SEALs do the “four breaths in, hold for four, four out, hold for four” box breathing before they engage in a stressful mission.]
• Maintain optimism – approach stressful events, situations and problems with a one-step-at-a-time attitude. Don’t add insult to injury by assuming the stress of what could happen. It’s hard enough dealing with what is happening. [Editor’s note: this is key today given the 24/7 media telling us all the bad things that may occur, even though most never do.]
• Take a walk and clear your mind!

Summary

Many factors are still indicating a slower growth scenario for the U.S. and global economy, with recessions (depending on definition) in the U.S. and other countries increasingly likely. Income, as measured by the U.S. Gross Domestic Income indicator remains in positive territory, a saving grace.

Many issues that are causing fear, including elevated inflation, are expected to show improvement in the next 6-12 months, but stress fractures will persist, indicating ongoing volatility within the financial markets.

Wildcard risks (low probability, high possible impact) discussed in this and previous Chats remain, including Putin’s future actions, and China’s potential actions toward Taiwan, suggest caution. 

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 “Sailing in Uncharted Waters” 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)