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Quarterly Review and Outlook: September 2022

"The Chickens... Have Come Home To Roost"

Loyd Johnson Photo

By Loyd Johnson, Chief Investment Officer
LJohnson@fcbanking.com
412-208-7687
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A Look Back

The quote above is an old saying that is normally used to mean that the bad things someone has done in the past have come back to haunt the individual…you have to face the consequences of your past. As we have met with clients throughout the last several months…and gone over some fairly depressing absolute return numbers for the year…the relevance of this old saying has become quite prominent. We talk often about, not only where we are at from an economic and market standpoint, but also how we got here. A fair and unbiased look into the past is helpful, and indeed needed to have the same kind of look into the future. The history of the “effective zero” Fed Funds rate dates back to December of 2008, when the rate was taken to zero as a result of the leveraged mortgage problems and The Great Recession timeframe.

The chart above shows the history of the Fed Funds rate from 1954-present. Even though the recession technically ended in June of 2009, the key rate was kept at zero all the way until 2015. We only got back to a high of 2.5% in December of 2018, and then, responding to the Coronavirus pandemic, the Fed again cut rates to zero in March of 2020…and there they stayed until March of this year. After several rate hikes in 2022, it now stands at 3%. If we went back even further in history, we would see that there is no precedent in having this key rate at zero for so long. In fact, in the late 1970’s into the early 1980’s the Fed Funds rate was routinely above 10% and actually reached a high of 20% in 1981!

So, what does it all mean? There can be no question that the Fed was responding to extremely turbulent times in 2008 and again in 2020. The idea of taking the rate to zero was to make access to money “easy”. Inflation was in the double digits in the late 1970’s and unemployment reached nearly 11% in 1982. Of course, the drivers were different in 2020, as the Fed was responding to a global pandemic and economic shutdown the likes of which we have never before seen. Significant response from the Fed and our government was needed. But, there are consequences. The flip side of zero rates is that that it is not so good for those who save and depend on money market or short-term CD returns for income. Left with that real dilemma, many turned to other, riskier financial instruments to get their return. Over the last several years we have seen the advent of many acronyms such as TINA(There Is No Alternative) or FOMO ( Fear Of Missing Out) to describe the investment landscape. There is little question that the search for alternative yield was a significant factor in the V-shaped recovery in the stock markets in 2020, and the additional 28% positive return we saw in stocks in 2021. 401Ks and investment accounts were at all-time highs as we entered 2022. In fact, we made that high in the S&P 500 in early January. This all was happening with the backdrop of ever-increasing inflation, that really started to take hold in 2021. The Fed and other leaders believed (hoped) that the rise in inflation would be transitory, and would revert back to pre-pandemic levels once economies were re-opened. Well, that has turned out to be wrong.

The above chart shows just how sticky inflation has been over the last 18 months. We’ve seen a slight decrease since the 9.1% CPI reading in June, but still way above the Fed target of 2-2.5%. The Fed reaction to this stickier-than-thought inflation has been to aggressively hike the Fed Funds rate this year…by 3% so far. In addition, they have made it clear through their written and verbal comments that they intend to stay diligent and continue to raise rates until inflation is under control. The bubble has effectively been popped. No more “easy” money. No more TINA. There are alternatives now. The one year U.S. Treasury Bill is currently yielding around 4.6%. It was at .39% at the beginning of 2022. That represents a real change and a real alternative to stocks…especially if you are of the belief that there will be more pain to endure as the Fed endeavors to get inflation under control.

So, the realist says, “we’ve had a really good run since the lows of 2009. The S&P 500 got to a low of 666 in March of that year. The broad-based index printed an all-time high of 4800 this January, representing a 620% return over that 12-year span, or nearly 18% per year. That is nearly double the long-term average and has padded investment account returns across the spectrum…all very positive stuff. However, the price of keeping rates artificially low for so long, along with the various stimulus packages that many in the U.S. enjoyed over the last couple of years has come home to roost more recently. Flush with cash and easy money from which to borrow, consumers help bid up prices on everything from cars to homes. Coupled with other supply-side issues, higher inflation has become the issue facing most consumers today.

We continue to show the asset class returns in the table below. Although the same general story can be shown with the more balanced asset allocation white box being near the middle of the pack in performance, the absolute numbers are more than a little depressing. So far this year, the balanced allocation is down more than 19%. With large-cap domestic stocks down by 24% and core bonds negative by nearly 15%, there were really few places to hide. As it was in 2018, owning cash was a pretty good place to be on a relative basis. Nonetheless, having a diversified approach still helped soften the blow a bit…just not nearly as much as we have historically experienced.

A Look Forward

We believe that the next 3 to 9 month timeframe is one of the more uncertain ones that we have seen in quite some time. There are so many variables that could affect markets either way in the short-term:

  • mid-term elections
  • too Hawkish/too Dovish Fed
  • escalation/de-escalation of Russia/Ukraine war
  • increase/decrease in inflation

That is just naming a few of the issues that could significantly affect financial markets in either direction in the near-term. We continue to take advantage of what markets give. After a 15% rally in June/July we trimmed our stock allocation. After a similar size retreat since, we took the opportunity to do the opposite and slightly increase our stock percentage. It is what our good friend, Warren Buffet has talked about often. He said that he wants to be running in the door when others are running out and vice versa. It is one of the more difficult things that we discuss with clients, but also one of the more important. It is the idea of having a well thought, appropriately diversified, asset-allocation game-plan…and then, managing to it. That approach has stood the test of time and worked. There is no question that it is difficult to do at times. We only have to go back to 2020 to remind ourselves of the benefit of this approach. The S&P 500 was down over a five-week period between late February and March. From that point to the end of 2020, the index rallied over 70%. That was followed by a 28% return in 2021! Buffet also said, opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.” We do not believe that it is currently raining gold, but the sentiment still holds true. Taking advantage of significant upturns and downturns can add value to longer-term overall performance…which means more money in client pockets at the end of the day.

The table below really hits that point home. It looks at other 25% drawdowns that we have experienced over the last 60 years. We have had such a drawdown this year from January through September. One year later, it has only been negative one time, and that was in the Great Recession period of 2008-09. Even then, it was negative by only 5%. More important are the numbers when you look out 3,5, and 10 years. In all cases, the returns are appreciably better.

We often use charts like these to help tell the story. In addition, we love looking at real numbers…what has actually happened over long periods of time. In any 10-year period, there are inevitably going to be periods of struggle…economically, and certainly in the financial markets. There are times when returns are better than the long-term averages, as investors take on more risk or are too optimistic. Conversely, there are periods where the chickens come home to roost…where prior excesses have to be paid for. We believe that we are and have been in one of those periods. We also strongly believe in the history of our economy and financial markets. Buffett also wrote, “for 240 years it’s been a terrible mistake to be against America, and now is no time to start.” We could not agree more.

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