I am an avid cyclist, but even after 30 years of cycling, I admit that it’s difficult to recognize when I have been riding with a tailwind. My favorite ride is a 30-mile loop between St. Michaels and Tilghman Island on the Eastern Shore of Maryland, and I frequently feel like Lance Armstrong on my way out to Tilghman, jarred back to reality when I turn around and realize I’ve been riding with a tailwind and now have 15 miles of headwinds in front of me.
It’s similar with investing. When the markets are climbing higher, it’s easy to overlook the fact that the U.S. economy and the financial markets have been riding a strong tailwind since the pandemic lows of March 2020. It started with an emergency move on Sunday, March 15, 2020, when the Federal Reserve – colloquially known as the Fed – cut rates to zero and launched a massive $700 billion quantitative easing program. The additional measures the Fed has taken in regard to monetary policy – which addresses interest rates and money supply – throughout the ensuing two years have been unprecedented. In terms of fiscal policy – which involves government spending to influence the economy – that too has been unparalleled with the government injecting trillions into the U.S. economy.
On January 19, 2021, incoming (now current) U.S. Treasury Secretary Janet Yellen said, “…right now, with interest rates at historic lows, the smartest thing we can do is act big.” I spent a few hours re-reading the countless monetary and fiscal policy responses to the pandemic and concluded that, overall, the response to the pandemic was undoubtedly BIG and dwarfs the response to the 2007-2009 Financial Crisis. Put simply, the answer from our government has been unlike anything we have seen and experienced before, and it has been a strong tailwind for investors.
Unfortunately, there can be too much of a good thing, and, in this case, too much monetary and fiscal policy translates into higher inflation. The Consumer Price Index (CPI) – a measure that is frequently used to gauge inflation – rose 7% in December from a year earlier, the fastest pace since June 1982. It’s Economics 101: too much money chasing too few goods equals inflation. Over the last year, economists have been debating whether this spike in inflation is transitory or a sign of a secular change after decades of low inflation.
On December 15, after a year of discounting the inflation threat and labeling it as transitory, the Fed removed the term “transitory” in its Federal Open Market Committee (FOMC) statement and accelerated its tapering program. This signaled the end of the Fed’s pandemic-induced accommodative monetary policy, clearing the path for a 0.25% interest rate hike in March, exactly two years after the Fed cut rates to zero, as a tool to slow the economy and tame inflation.
Additionally, we have likely seen the end of the excessive stimulus programs that injected more capital into our economy than what was needed to assist the individuals and businesses that were disrupted by the pandemic. The stimulus programs helped countless individuals, families, and businesses affected by the pandemic, and that was a good thing; however, going “big” by expanding the stimulus program to include individuals who never missed a paycheck and businesses that were only mildly impacted by the pandemic unduly augmented inflation pressures. Well over a trillion dollars went to individuals and business that didn’t need the money; a costly fiscal policy error that has contributed to our inflation problem.
Why all this talk about inflation? It’s been a while since we have had to deal with it, and, currently, there is no consensus on how much the Fed will raise rates in order to curtail the inflation threat – investors dislike this kind of uncertainty. Some economists think we will see three or four 0.25% rate hikes by year-end and four more 0.25% hikes in 2023. Others believe – and I concur – that our inflation problem will dissipate on its own, after the supply chain improves and the excessive stimulus payments filter their way through the economy. If that turns out to be accurate, then the Fed will have unnecessarily raised rates on an already slowing economy.
While we have been long overdue for a correction, the Fed’s about-face on inflation caught investors by surprise, and that has triggered a lot of aggressive selling in the major market indices. Through January 24, 2022, the S&P 500 Index is down 8.5%, the Dow Jones Industrial Average (DJIA) is down 7.0%, the tech-heavy Nasdaq is down 14.5%, and the Russell 2000 (small-cap index) is down 17.3%, all numbers relative to the indices’ respective 52-week highs. To put things into context, this is the 14th correction in the tech-heavy Nasdaq since the Financial Crisis ended in 2009. The average post-Global Financial Crisis Nasdaq correction has lasted 53 days with an average loss of 15.2%, making this current correction already 11 days longer than the average.
For now, investors need to accept that the winds are shifting, and they can no longer count on a monetary- and fiscal-policy-supplied tailwind to boost returns. As mentioned, I don’t believe the Fed needs to aggressively hike rates to control inflation. Instead, it needs to be patient while the supply chain heals itself and the 2021 stimulus payments work their way through the economy. Even if the Fed does hike rates more than expected, it should stay on the historically low side for one simple reason: a 1% hike in interest rates adds approximately $290 billion to our country’s debt service, and, one of these days, our debts will become an acute issue.
Similarly, we encourage investors to maintain patience and to contact us if your investment time horizon has changed or if you want to review your risk profile.