Inflation, interest rates and the current state of things
Inflation has had more impact over the past than at any time in almost the past 40 years. After peaking at 9.1 percent in July, inflation came in a little lower in August at 8.5 percent. Producer and import prices remained high and the supply change problems persisted. The chip shortage affected just about everything (would you believe more than 300 chips go into a car?).
Going back in history, inflation in 1981 was above 10 percent and by 1982 the unemployment rate was over 10 percent and interest rates were well above that. The USA and the world experienced two recessions in the early ‘80s and those followed a very difficult period of the 1970s where the markets underperformed and the economy struggled. The Dow Jones Industrials Average was higher in 1972 than it was in 1982. And then, things began to change. It started with changes in tax legislation, private and public investment and believe it or not, the decline of the US dollar. The economy grew, interest rates came down, unemployment came down, and inflation made its way down to less than 2 percent over the past two decades. Prosperity was more that norm than the exception. Fast forward to today and the Dow is over 33,000 at this writing, which is up from 742 in August of 1982.
Today, a lasting labor shortage
Investors are right to wonder just how we ended up here. There is no one answer – it is a combination of things. First is the tremendous monetary and fiscal stimulus throughout the pandemic. That unleashed a lot of capital which many still have saved, invested or can borrow and at still historically low rates. Next, many left their jobs (38 million in 2021) and either went to other jobs or, at a significant pace, started their own businesses. Third, the combined impact of stock market and real estate markets over the past few years had many people feeling more confident of retiring early. What do these things add up to? Wage pressures, which keep inflation elevated. Investors should take note to consider those investments that have historically outpaced inflation.
Real Rates of Return or more important now
The real rate of return is what is left after inflation (and don’t forget taxes). As inflation has risen many investments (cash, CDs, many bonds) have had a low to negative real return. That is not always easy to realize so investors and savers are encouraged to take a step back and consider the real return. Most people want to keep pace with inflation at the very least and to outpace it at the very best. Stocks and real estate still command the lead for returns vs inflation and other asset classes. Of course those asset classes come with higher degrees of risk and volatility.
Vanguard says bonds are back
In its recent paper “Active Fixed Income Perspectives Q3 2022: Bonds are back,” Vanguard points out several key things for investors to consider. Most important of these is that bonds have had the worst performance in history over the first six months of 2022. They point out however that real returns, or positive returns, now exist. They argue “with bond yields higher than expected inflation over the next five years and beyond.” We agree with their sentiment that bonds once again offer diversification and less risk for investors’ portfolios after not having done so in the recent past. We also look at the returns on municipals (for those in higher tax brackets), and according to Raymond James, some of the best values may exist with maturities in the 8-20 maturity range. Raymond James also makes available to investors the important statistic of duration, which is a measure of risk for a given bond which considers its maturity and call dates.
Europe continues to adapt to the crisis and is bringing some coal-fired plants back and Norway recently vowed to outproduce Russia in natural gas supply as long as the crisis lasts. Natural gas prices at this writing are at their highest levels in the past 14 years. The implication for investors in our opinion is to continue to overweight holdings in the energy sector relative to its current weighting (in the S&P 500) which is 4.4 percent. That is significantly lower than it was just 10 years ago. Another way we see it is that despite the pandemic, and the crisis in Europe, the world continues to grow and more and more people in emerging and developing countries are increasing their standards of living. The demand for electricity might continue to grow significantly in the US. In a recent editorial, the Los Angeles Times pointed out that California alone could see energy consumption grow as much as 68 percent by 2045. They argue that in line with the electrification of cars, that would be a key driver. The world will need more energy from whatever form it may come. We also think investors should pay attention to the reemergence of nuclear power. States and countries are hard at work solving for waste storage and there is also the long-term promise of small modular reactors which create a fraction of the waste. While a lot of companies are working on that technology it is not near being scalable.
Interest rates and savings rates
Investors can finally enjoy more competitive returns on their most conservative investments. Many brokerage firms and financial institutions are now offering CDs over 3 percent for one year and many money market fund yields have increased as short-term rates have increased. Many are left wondering how long rates will continue to climb. We are not convinced that it will become a long-term trend. We agree with a lot of the sentiment we hear and read that short term rates are likely to peak at 3.5 percent. We will have to see what the future brings.
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