By David R. Guttery, RFC, RFS, CAM
President, Keystone Financial Group-Trussville Al
I believe that one of the biggest factors that contributed to volatility last year was the tendency for global markets to become shortsighted. Over a year ago, Chairman Powell and Treasury Secretary Yellen suggested that inflation was transient. In my mind, this implies that inflation would be short-lived. Simultaneously, we heard the Federal Reserve beginning to offer thoughts pertaining to tapering, and ultimately tightening. I believe that markets largely discounted the impact of tightening, because after all if inflation is transient, you can easily make the assumption that tightening, in an effort to control that inflation, would also be relatively mild.
In March of last year, when the Federal Reserve laid out a schedule for predetermined increases in the discount rate, and also indicated the degree by which it would begin to unwind its balance sheet, I believe this shocked the markets. Very quickly, markets moved away from considering the next 30 months, to considering the next 30 days, before the next Fed meeting.
I’ve always believed that the Federal Reserve was aware of the impact that tightening was having on the economy, and that it was my belief that the Federal Reserve wished to avoid being a catalyst for stagflation. In this chart, out of the four possible economic outcomes, it would appear that the overwhelming majority of responses received from economists in this survey indicated the belief that we would indeed find ourselves in a stagflation environment.
When a schedule for tightening is offered early in the year, the assumption is that such a schedule will be followed in a scripted manner without deviation. Frankly, who can blame the markets for coming to that conclusion when over 90% of the world’s central banks are seemingly doing the same thing, in tandem, it leaves you with the impression that economic declines may accelerate, and result in a period of stagflation, rather than the soft landing about which we have heard so much.
Furthermore, as late as last week, chairman Powell once again reiterated that the target of the Federal Reserve was to achieve a personal consumption expenditures price index level of 2%.
Clearly, we remain far away from that target. When markets become shortsighted, and fixated on a period of days, rather than periods of months or years, it becomes increasingly easy to overly price risk into current assumptions. I believe that was the theme of 2022, and as I described in my previous video, I am encouraged that we are finally beginning to see evidence that suggests markets may be once again be considering what may happen over the long run instead of the next week.
I’ve recently celebrated my 31st year in practice, and in many ways, the year of 2022 was a year of “firsts”, or at least, things we haven’t seen in many decades.
The Federal Reserve has only begun to unwind its balance sheet. As a precedent-setting amount of money was printed, it was used to purchase treasury securities as the country went more deeply into debt, to fund such things as two CARES Acts, a SECURE Act, and infrastructure bill, and a myriad of other initiatives designed to bridge economic shutdown, and recovery.
Speaking of an unprecedented amount of money, clearly, we have never seen the M2 money supply at these levels, and this is creating a unique problem for the Federal Reserve, which requires a unique solution.
There is a glut of U.S. Treasury debt on the open global market right now, and as the Federal Reserve continues to unwind its balance sheet in the billions of dollars per month, throughout the year, prices of these treasury securities have plummeted, and yields have risen sharply. This has resulted in a period of time where fixed income and equities are positively correlated, meaning, prices are moving in the same direction, and seemingly in lockstep, for the first time since 1972. I was three years old the last time we observed a phenomenon like this.
This has resulted in a treasury yield curve that is more inverted than at any point since 1981. I was in the sixth grade the last time we observed such an inversion.
These are just a few examples that I can offer to indicate how unusually strange this year has been. It has required a very deliberate and tactical approach to the management of money in this environment. Throughout the year, I have suggested that within an environment such as this, it would be best to give deference to areas where demand was likely to be durable, and to avoid discretionary areas where demand was likely to be variable.
These are six sectors of the economy right there. The point being, you will take whatever is left of your income after taxes and inflation and continue to consume the things that you need. The only question, is how many cups of that nine-dollar designer coffee are you not going to consume this month. Indeed, through November, this approach seems to have worked well this year.
A key for 2023 will be to monitor the Federal Reserve, and hopefully we see their conviction to pursue targets of tightening in a less hawkish manner. Should that be the case, then I believe that markets will be encouraged to return to normalcy as it pertains to discounting risk over longer periods of time. I believe that the Federal Reserve had to act quickly, while the window was open, and in a unique way to address a precedent-setting inflationary threat. My hope is that the first phase of this effort is behind us, and continuing toward long-term inflationary targets can occur with less disruption to the economy and assumptions made by capital markets.
In conclusion, regardless of the period of time, or the state of the economy, remember that the achievement of long-term goals is predicate on the consistency with which you meet the implementation of the strategy. The composition of the investment accounts should change to reflect current periods of time, but the approach, dedication, and commitment to the strategy should be unwavering. I believe that we’ve seen a point of inflection, and now is the time to have conviction, and intestinal fortitude, to continue working through periods of time such as this, and avoid the risk that comes with riding the emotional roller coaster.
(*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 31 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.