Imagine Rip Van Winkle woke up from a two-year nap and cornered you on the street. “What’s been happening?” he asks. “What did I miss?”
After catching him up on the last two years – COVID, the presidential election, Russia invading Ukraine, Will Smith slapping Chris Rock at the Oscars, etc. – he asks you: “By the way, how are the markets doing?” (Rip Van Winkle’s an investor, too, after all.)
Taking a deep breath, you say, “Well, the Dow dropped over 1000 points on Thursday, May 5.” (Which, as you probably know, it did.1)
Rip stares at you in surprise. “How?” he asks. “Why?”
Do you know what you would tell him? Do you know what your answer would be?
Well, here’s how I would explain what’s going on in the markets right now. I would say there are four things that he – and all investors – need to know. Let’s go through them one by one.
1. Inflation is the highest it’s been in decades
Between March 2021 and March 2022, inflation in the United States rose 8.5%.2 That’s the fastest 12-month pace since 1981.
One of the root causes of this rampant surge in prices remains the pandemic. Thanks to COVID, it became more expensive both to produce and ship a variety of goods – everything from computer chips to furniture. Before these supply chain problems resolved, though, the lockdowns and social distancing measures used earlier in the pandemic began to loosen. That caused consumers – buoyed by increased wages and lower borrowing costs, which we’ll get to in a moment – to spend more and more on goods and services. The simultaneous occurrence of skyrocketing demand and short supply drove prices up almost across the board.
COVID has also affected inflation in other ways. For example, wages have gone up in multiple industries due to a shortage in workers. That shortage has given many workers more say as to where, when, and how they work. To compensate for the increased expense of paying their workers, many companies have raised prices on the goods and services they provide.
The pandemic has also indirectly driven up home and rental costs. When COVID broke out, the Federal Reserve made it practically free to borrow money by lowering interest rates to near zero. This was to encourage people and businesses to spend money rather than save it, thereby buoying the economy. This indisputably worked, but it brought several side effects. One such was that making it easier to buy a home led to a rise in demand for homes. This escalating demand, naturally, led to higher and higher property values. (The U.S. housing market grew by $6.9 trillion in 2021 alone.4) But we’ve come to a point where home prices rose so high that, for many people, buying a house just wasn’t feasible even with low interest rates. Instead, they looked to apartments. The result? Rental costs are now the highest they’ve been in two decades.
How Inflation Has Affected Prices (as of March 2022)3
Other developments haven’t helped inflation. The war in Ukraine, and the sanctions placed on Russia, have driven prices up further on commodities like oil, gas, precious metals, wheat, and corn. New lockdowns in China, thanks to another wave of COVID cases, has snarled supply chains even further.
“Okay,” Rip Van Winkle says, “inflation is bad. What are people doing about it?”
2. To tamp down on inflation, the Federal Reserve announced its biggest interest rate increase in 22 years
On May 4, the Federal Reserve announced it would lift interest rates – more specifically, the federal funds rate – by a half-percentage point.5 That may not sound like much, but it’s the biggest single rate increase since 2000.
*What Is the Federal Funds Rate? The federal funds rate is essentially the interest rate that banks pay each other for overnight loans. When the rate goes up, it costs more for banks to loan each other money, so in response, banks raise their own interest rates. That’s why, when the Federal Reserve raises the federal funds rate, it eventually affects consumers and small businesses whenever they apply for a loan.
Essentially, what the Fed is trying to do here is cool down inflation. As we mentioned, low interest rates prompted people to keep borrowing and spending even during the worst of the pandemic. With higher interest rates, the idea is to reward saving over spending. If Americans spend less and demand goes down, companies then have little choice but to lower their prices if they’re to attract new business.
Lower prices, of course, means lower inflation.
History shows that raising interest rates is an effective way to tamp down on inflation. For example, from roughly 1965 through 1982, inflation soared to almost unimaginable levels, peaking at 13.5% in 1980.6 (That’s almost double what we’re at today.) To combat this, then-Fed chairman Paul Volcker initiated a policy of dramatically higher interest rates. At one point, the federal funds rate rose over 19%!7 The policy did its job, with inflation falling back to more “normal” levels by 1983.
Unfortunately, while using higher interest rates to cool inflation works, there’s a downside. It’s sort of like performing surgery with a blunt instrument instead of a sharp one. Why?
Because it often leads to a recession.
Now, before I go on (I would say to Rip), understand that I am not predicting a recession. Predictions, as you know, are a fool’s errand. Nor is it guaranteed that higher interest rates will cause a recession. But there’s also no use pretending that history doesn’t exist. And history has several examples of the Fed’s “fight inflation with interest rates” strategy leading to an economic contraction.
Whether you’re a gymnast or an airline pilot, landings are hard. But what economists call a “soft landing” is exactly what the Fed is hoping for. What is a soft landing? It’s when consumer spending and economic activity slows down enough to lower inflation, but not so much that the economy stops growing and businesses start laying off workers.
The problem is that there’s little margin of error to work with. For example, take Paul Volcker’s war against inflation in the early 1980s. It worked, but at the cost of a “double dip” recession from January-July 1980 and July 1981-November 1982. (At one point during the latter downturn, unemployment rose as high as 10.8%.8) More recently, the Great Recession can be seen as a kind of “hard landing,” in part due to the Fed’s attempt to cool the US housing market. But there were many reasons for the Great Recession that had little to do with interest rates.
On the other hand, the Fed has “stuck” the landing at least once, in 1994-95. Back then, the Fed doubled interest rates to 6%.9 While there were side effects, the country managed to avoid an economic recession.
Historians and economists debate whether other periods of tightened monetary policy led to hard or soft landings, so we’ll leave that discussion to them. All our drowsy friend Rip needs to know – besides how to use Zoom – is that the Fed is currently walking a tightrope, with high inflation on one side and high unemployment on the other. Time will tell whether the central bank can keep its balance. Much will depend on just how much the Fed raises interest rates, as well as how long global supply chain issues last. (Most economists expect rates to rise to around 3% by the end of the year.)
“So,” Rip Van Winkle says, between sips of much-needed coffee, “is that why the markets are going haywire? Because of a recession?”
*A Third Way? There is a potential third option that lies between a soft landing and a hard. Some experts call it a “growth recession.” This is where economic growth slows but doesn’t stop altogether, while unemployment ticks up without ever taking off. The years immediately following the Great Recession have sometimes been described this way, as was an eight-month period in 2001.
3. Investors are trying to digest what this means for stocks – and for the economy.
As you know – but Rip needs to be reminded of, as he’s been asleep – the markets move less on what’s happening now and more on what they expect to happen in the future.
The volatility we’ve been seeing is proof of this.
The markets are trying to deal with a hard truth: The era of “free money” is over. Interest rates not only went to near zero due to the pandemic; they’ve been at historic lows for most of the last twelve years. Why is that important? Because super-low interest rates weaken government bond rates. That leaves investors searching for higher returns with little choice but to plow their money into stocks, which helped propel a historically long bull market that ended only when the pandemic hit. (But then resumed just a few months later.) So, higher rates are something the markets will simply have to adjust to.
It's important that Rip understands this point about expectation, though. Expectation is why we don’t overreact to daily market swings, even extreme ones. Because at any point, expectations could change. Positive news out of Ukraine or China could do it. A strong jobs report could do it. Lower oil prices could do it. So, as long-term investors, what we’re really looking at right now is not short-term volatility, but long-term developments that will impact our long-term strategy.
Which leads me to the last point Rip should know (other than “murder hornets” being a thing now).
4. We knew this was coming – and we’re prepared for it!
To someone like Rip Van Winkle, waking up to a new world, this all might seem shocking, bewildering. After all, none of these storylines were around when he fell asleep in early 2020! But for us, none of these stories are new. None of it is unexpected. Which means none of it has taken us by surprise.
The rest of 2022 is going to be an interesting one. Headlines – economic, financial, political – will continue to raise eyebrows, stir debate, and even cause angst. But our long-term strategy accounts for both high inflation and higher interest rates. After reviewing everything, which we do on a regular basis, my team and I remain convinced that we’re positioned exactly the way we want to be to move closer to your long-term goals.
So, the last thing you should know, is to go enjoy the upcoming summer. After all, you haven’t been asleep these last two years. Neither have we. Our eyes have been open the entire time.
And the last thing we should tell Rip Van Winkle? Get to work, friend.
You’ve got a lot of memes and videos to catch up on.As always, please let me know if you have any questions or concerns about your portfolio. I am always here for you.