February 2022 Commentary: What Should Investors Do?
Inflation is now at the front-and-center of today’s economic story. The Federal Reserve’s (the Fed’s) ability to control inflation is generally thought to be a function of lowering and raising overnight lending rates (the Fed Funds rate) and through open market operations (buying and selling securities). Currently, inflation stands at levels higher than we’ve seen in 40 years (1982). In 1982, the Fed’s effort to control inflation was reflected by a Fed Fund rate above 10% which was significantly higher than inflation at the time. This stands in sharp contrast to today’s Fed strategy which is to target the Fed Funds rate at 0% and continue to buy back billions of bonds each month. Together, these policies actually act in a pro-inflationary manner.
While the current policy reflects emergency measures taken in 2020 to offset the risks of a pandemic-related slowdown, it is also as pro-inflationary as ever, in our opinion. We are seemingly stimulating our way into more inflation.
The Fed’s Fight on Inflation
In acknowledgment of inflation pressures, the Fed has announced it will begin to fight inflation by increasing the Fed Funds target rate and by slowing down the bond purchasing program. The members of the Fed expect the Fed Funds rate will be 0.9% by the end of 2022 (Source: FOMC; St. Louis Fed as of 01/21/2022). This expectation is still quite low and implies the Fed is still quite concerned about an economic slowdown. It also demonstrates the Fed is more concerned about the consequences of raising rates than it is about the absolute rate level.
The amount by which inflation is higher than the Fed Funds rate is historic (see chart below).
Pro-inflationary policies are believed to stimulate:
- The supply of money
- Borrowing and lending
- Interest rates and long-term bond yields
Indeed, we are beginning to see impacts on each of these variables.
The M2, a measure of the money supply that includes cash, checking deposits, and easily-convertible near money such as money market funds, has risen above its long-term levels following the 2008 financial crisis and has climbed well-above record levels since 2020. As this chart compares money supply to overall economic activity (Gross Domestic Product or GDP), it should be observed that the increase in money supply has not been offset by an increase in GDP.
On the other hand, the potential for increased spending has risen – which favors higher overall economic activity and further price increases (i.e., inflation) as the demand for goods and services exceeds the overall level of supply.
Borrowing and Lending
Consumer liabilities are growing at higher rates today than in the past 12+ years (refer to the red line in the above chart). From 2008 to 2021, consumers were conservative in managing their balance sheets overall. Before 2008, however, this rate was higher (in the 5-10% range) which is more consistent with current consumer liability levels.
Businesses, on the other hand, remained a bit more aggressive following the 2008 financial crisis by taking advantage of low-interest rates and thereby borrowing more funds.
While a pick-up in lending activities might seem irresponsible, household balance sheets are in better shape today than over the past several years in our opinion. More borrowing is associated with economic growth (and inflation). From this perspective, the Fed’s battle with inflation may be getting a bit more intense.
Rates Are Starting to Increase
Eventually, investor consensus about long-term inflation expectations leads to a rise in long-term interest rates. This contrasts with the Fed’s target of short-term, or overnight lending rates. Coming off a historic low of approximately 0.5% in August of 2020, long-term rates have effectively tripled, and they are now at 1.8%. However, current levels are still historically low when looked at from a multi-decade standpoint.
When compared to inflation, long-term rates are especially low. Based on the chart below, substantial moves in either long-term rates or inflation (or both) will have to occur for this relationship to normalize.
As a result of a rapid pick-up in money supply, increased consumer borrowing, and rising long-term rates, we believe the Fed will have to act more forcefully than the rate hikes expected from Federal Reserve members (see above at 0.9% by end of 2022).
The Fed’s current priority of battling inflation seems to be managing the pace of rate hikes which places a lower priority on the absolute level of rates needed to dampen inflation. The implication is that the Fed is more concerned about the fallout of spooking the market than stabilizing prices (inflation).
What Should Investors Do?
Consistent with most scenarios, investors who adhere to long-term asset allocation strategies should use moments of weakness to consider rebalancing. Investors who have a considerable allocation to stocks would benefit by holding businesses with good long-term economics, financial flexibility, and that are not overvalued. We endorse this approach on a long-term basis consistently in a variety of markets.
The current market implies inflation and rising rates may have an outsized impact on returns. Our view is that excessively overvalued stocks, such as ones with high price-to-earnings ratios, are subject to continued pricing pressures. Further, businesses that cannot maintain profit margins in the face of inflation (and higher borrowing costs associated with higher rates) may struggle more than average.
The good news for 2022 is the economy is growing. Long-term investors whose asset allocations are aligned with their financial plans and objectives should be comforted with the insight that businesses are also growing which tends to be favorable to stock prices over time.