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SWMG Economic and Strategy Update

| June 16, 2022
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SWMG Economic and Strategy Update

June 16, 2022

 This week I spent Monday – Wednesday at the University of Chicago’s Booth School of Business with several of the top economists and finance professors in the world.  For those who do not know, the University of Chicago is considered the birthplace of modern economics and is home to Nobel Prize winning economist Milton Friedman, Eugene Fama, and Austan Goolesbee. 

The discussions, as you would imagine, centered on inflation, the Fed, direction of asset prices (stocks and bonds), and the possibility of recession.  Below I will try to summarize the general thoughts of the group.

 

The Markets

As of Monday June 13, a bear market officially began thanks largely to stubbornly high inflation.  For many of you, it has probably felt like a bear market for a while but the S&P 500 index didn’t close 20% off the January 3rd high until Monday.  Tech stocks, as measured by the Nasdaq Composite, are down a bit more than 30%.

So now that the bear market is here, what should we expect?  At this point, stocks are near the average decline without a recession (24% is the actual average), so most of the damage appears to have been done already.  Unless earnings collapse, many sectors of the market are starting to look attractive at these prices.  More on that later….

Interestingly, the median 12-month gain after the S&P 500 has entered a bear market has been 24% with advances in 7 of the past 10 instances dating back to 1957 (only 1973 and 2008 saw declines).  Additionally, the average historical 12 month gain off a midterm election cycle is over 30%.  This suggests patience has been and most likely will be rewarded.

Interesting note…. Almost everyone measures their losses from the January high.  In behavioral finance, we call it mental accounting.  So, this is interesting:  The 3-year period beginning July 2019 through June 14, 2022 (a period that includes the covid sell off and the current 20% market decline), the S&P 500 is still positive 29%, which is about a 9% annualized per year gain. 

  

Dual Headwinds

What has made this decline so particularly painful has been that bonds have actually performed worse than equities during the same period.  In most stock bear markets; bond prices rise with the risk of recession and stock market uncertainty.  But as interest rates rise, bond prices decline.  With inflation the main issue, there really has been no place to hide.  Cash is losing 8% or more each year to inflation, stocks and bonds are both impacted negatively and even gold has been of little help. 

 

 The FED

As I mentioned in my April 24th Market and Strategy Update, I believe the Fed has made 3 significant policy mistakes:

  1. They mistakenly believed the inflation created by increasing the money supply by roughly $4 trillion dollars in 16 months (about a 40% increase) would be “temporary and transitory.”
  2. Once they realized their mistake, they waited at least a year too long to respond. 
  3. They underestimated the impact of excessive government spending dating back to even before Covid.

The excess cash in the money supply created a surge in consumer spending while supply chain disruptions due to Covid lock downs restricted supply.  This is the classic definition of too many dollars chasing too few goods.  I firmly believe that had the Fed started withdrawing the excess funds from the money supply in 2021 rather than waiting until June 2022, inflation would not have reached its current levels. 

 

The FED II

So where does the FED go from here?  On Wednesday June 15, 2022, the Fed raised the key borrowing rate by 75 basis point or three quarters of a percent.  They also indicated that another three quarters of a percent increase is possible in July.  What will this do?

It’s important to understand that the FED can only impact demand for interest sensitive sectors of the economy (houses, boats, cars, etc.).  They have very little impact on the demand for consumer services (travel, entertainment, etc.).  I believe the increases in interest rates we have already seen plus the ones to come WILL reduce demand for these sectors (mortgages rates are nearing 6.5% up from around 3% a year ago).  It’s unclear how much consumer spending will taper due to higher borrowing costs, but I suspect higher gas and food prices will have a similar impact over time. 

 

Strategy – DO SOMETHING TO STOP THE PAIN

I understand why many feel this way and we stand ready with strategies to protect where we are IF we see this getting much worst.  While it feels good to go to cash, short or hedge market exposure, or just stuff it under the mattress, there is almost always a very hefty price to be paid for doing so.  Selling assets during temporary declines creates permanent losses.  Asset prices tend to recover very quickly and well ahead of the all-clear signal which means you will almost certainly buy back at higher prices.  While this may make you more comfortable in the short run, it puts your long-term goals of managing longevity and inflation risk in jeopardy.

 

Outlook

There was quite a bit of discussion among the group as to where we go from here.  Are we headed for a recession?  Are we already in a recession?  We all agreed that the FED will slow the growth of the economy to slow inflation.  A recession is defined by two negative quarters of GDP growth and most of the group believed that if we don’t hit that measurement, we will be very close. 

The consensus of our group was that we should see signs of inflation trending downward by September and that markets could respond positively. That could give the FED some breathing room to pause further rate increases and reduce the risk of further damage to the economy.   Couple that with midterm elections in November and it is very possible you see a nice rally in stocks (and maybe bonds) into the end of the year. 

The group also believed that even if the US economy does enter a recession, it should be short and mild.  Households in the US are still in the best shape they have been in over 60 years coupled with almost record low unemployment.  Debt service is low and most have excess cash reserves.  Demand destruction will be less than during normal recessions and recovery should be quick. 

 

Portfolio Strategy

As I write this today, markets are punishing all investments that are interest rate sensitive.  This includes bonds with longer maturities (duration) and stocks whose promise of earnings is in the future (think Tech) as opposed to now.  Dividend paying stocks who have predicable CURRENT earnings have and should continue to hold up much better in this current environment.  We have added several of these strategies to the portfolio since December 2021 and are poised to add more until we see data points suggesting inflation is slowing.  We have an average duration of 3 years on the bond sleeve vs the bond index of more than 6 years. 

As I mentioned earlier, we are prepared to add short (inverse) equity positions to the portfolio if things start to break down.  We will be watching several key indicators for direction over the next several months including improvements to the supply chains, energy prices, home sales (a slowing would be good for inflation), unemployment, and more. 

No one knows how “sticky” inflation will prove to be.  The FED can not do much about the excess capital that is in the system but they absolutely can control the cost of borrowing and the rate at which new capital is added (money supply).  That is their clear and stated intention.  I think we will have a much clearer picture of where we are by September, at which time, we can look to be opportunistic on some much-discounted sectors. 

 

Final thoughts

We are here for you.  If you have questions or concerns or just need someone to talk you off the ledge, contact us.  We can walk though individual strategies for your situation.  We are fiduciary fee-based advisors* so we hurt when you hurt and we understand this can be scary.  We are in this together to solve long-term risks and goals and I have confidence we will be able to accomplish this. 

 

Christen Sanchez, CFP®, AIF®, CFS

Sanchez Wealth Management Group, LLC

A Registered Investment Advisor

Chris@Sanchezwealth.com


* Fiduciary capacity is with advisory clients only.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.

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