Happy Independence Day.
With everything that has happened so far this year, it is hard to believe we are only halfway through 2022. We’ve had the Federal Reserve change course and aggressively go after inflation, the Russian invasion of Ukraine, the worst quarter for U.S Bonds in over 40 years, along with the worst first half of the year for U.S. equities since 1970. I believe what has gotten us to this point are the extreme measures taken during the Covid pandemic. We went on a two-year binge of flooding the U.S economy with almost $10 trillion. The “Fed” effectively printed money through its Quantitative Easing policy and lowered interest rates to near zero. The federal government sent out direct payments to individuals, businesses, cities, and states. All this additional money flowing into U.S. households caused a massive spike in retail sales, so it wasn’t just supply chain issues that caused prices to increase, but a 26% increase in demand over the two years of Covid. The two years prior to the Covid Pandemic, retail sales increased a little over 6%, so with a four-fold increase in retail sales, we would expect a spike in inflation during normal times. This reminds me of the punchbowl metaphor, the Fed now must come and take away the punchbowl while we are all having fun. The head of the Federal Reserve, Jerome Powell, has even admitted that they left the punchbowl out too long.
With the Fed now raising interest rates, unwinding their Quantitative Easing program (removing liquidity), and the federal government reducing spending from the pandemic levels, will the U.S. economy go into recession? This along with stagflation has become the topic of discussion amongst the financial experts in the media. On the inflation front there are several positive trends occurring now that should bring some relief: consumer spending shifting to services and away from retail goods, a strong dollar, countries reopening around the world, supply chains beginning to catch up, higher energy prices (that leads to lower demand and lower prices), and higher mortgage rates (which has a slowing effect on housing sales and prices). Many of the longer-term trends that have led to lower inflation over the past 20 years are still in place, including globalization, lower population growth, and technological innovations. It may take some time to get inflation back to the Fed’s target rate of 2%, but it’s critical we stick to this plan. Inflation is the silent economic killer, slowly eating away at a person’s purchasing power over time.
Trying to answer the recession question is virtually impossible, though you would never know this by watching the news. If we enter a recession, there are reasons to believe it will be mild and short-lived. U.S households are sitting on record levels of cash/savings and have record low levels of debt service. U.S. businesses are in a similar situation with plenty of cash, rock-solid balance sheets, and near record-earnings. Banks have all just passed their annual stress tests, the States are all in good fiscal standing due to the U.S government spending stimulus money during Covid. Typically, when we are nearing a recession, consumers are maxed out with credit, banks are experiencing an increase in loan defaults, and corporate sales are leveling off.
We must remember the words of Peter Lynch, the famous Fidelity Stock fund manager, “The real key to making money in stocks is not to get scared out of them”. The reason we invest in equities, is that they are the one asset class that over time brings a positive return adjusted inflation.
We would also like to thank you for your support over these past 20 years. July marks the 20th anniversary of the founding of Heritage, which ironically was during the recession following the dot.com bubble bursting, and 9/11. It will take some patience, but we will work through this “re-normalization” process as well.
Brett Carleton, CFP®