Q1 2022: PFM Quarterly Commentary
The Greek philosopher Heraclitus observed that since water flows constantly, it’s impossible to step in the same river twice. This observation led him to write, “The only constant in life is change”, which rang all too true for investors looking back at the first quarter of 2022. They left behind the serene waters of 2021 and were soon swept up in the torrent of news about slowing economic growth, a suddenly ultra-hawkish Federal Reserve, near double-digit inflation, a horrific war in Ukraine, and widespread global commodity supply shocks. It didn’t take long for markets to cascade lower in response to the deluge of troubling news. The S&P 500 was off 14.7% from its early January high and the technology-laden NASDAQ had plunged 22.8% at the depths of the market drawdown from its all-time high attained in late November.
In our special February 2022 Market Volatility Letter, we listed market-rattling events over the last century and we explained how these occurrences triggered investors’ fear mechanisms which invariably caused them to sell when widespread panic was greatest. In time, the markets rose again – sometimes sharply – leaving many cash-heavy investors far behind. Research has shown that most individual investors achieve low long-term investment returns as a byproduct of this engrained, emotionally-driven act of buying high and selling low.
With veiled threats of a potential global conflict emanating from world leaders, rumors of mortar strikes causing a radiation leak from the infamous Chernobyl reactor No. 4, and fears of potential widespread food shortages resulting from Russia’s invasion of Ukraine, the panic in the investment markets during the first quarter was palpable. With nuclear war being discussed openly and the opportunity for strategic errors high, selling would have been ostensibly understandable. However, as famed trader and long-standing CNBC contributor Art Cashin said in 2009 of the Great Financial Crisis: “Never bet on the end of the world. It never ends, and if it does, who will you settle the trade with?” These wise words cleverly capture our often-cited sentiment that if markets fall irreparably, then more pressing challenges will garner our immediate attention.
While Russia’s assault on Ukraine justifiably captured much of the headlines during the first quarter, other critical events transpired and significant data was released that we consider germane to the future direction of markets. Most notably, the Federal Reserve raised interest rates for the first time since December 2018 in response to runaway inflation, reversing the Fed’s long-standing zero interest rate policy. Domestic inflation soared in the first quarter to 7.9%, hitting its highest level in forty years – just as we had anticipated might occur.
Clearly, the Fed had to start raising interest rates to address inflation, but the 0.25% increase seems feeble given the size of the problem. For context, the last time inflation ran this hot was February 1982. The Fed, then led by famed inflation hawk Paul Volker, hiked interest rates to 15.0% in response. Those punishingly high interest rates eventually tamed inflation, but as a result caused the second longest recession in the 20th century, drove the unemployment rate to nearly 11%, and triggered a 27% decline in the S&P 500. It took tremendous conviction and fortitude to intentionally put the country through such a difficult time, but Volker’s foresight gave rise to nearly two decades of high growth, low unemployment, and some of the best stock market returns in history.
Four decades later, we find ourselves in a similar predicament. However, while the core problem of inflation is the same, the circumstances around it are now vastly different. Namely, the US federal government’s level of indebtedness has ballooned from 32% of total output (Gross Domestic Product) in 1982 to 123% today. And unfortunately, debt levels are predicted to increase markedly. According to President Biden’s newly released budget proposal, deficits will grow by an additional $14.4 trillion over the next ten years, increasing the country’s total debt level to north of $40 trillion. Spend first and pay second has been a consistent trend in Washington for decades regardless of the administration in charge.
So, how does a ballooning national debt limit the Federal Reserve’s ability to restrain inflation? That’s the trillion-dollar question and worth some contemplation. Currently, the fourth largest line item in the Federal Budget is interest paid on debt, which as of this writing is $429 billion, equating to approximately a 1.42% yield on the nation’s $30.3 trillion in outstanding debt. Now, the last time inflation was this acute, the interest rate on all national debt was roughly 5.5%. Should rates return to that level, the equivalent annual interest expense alone would reach nearly $1.7 trillion. This would exceed the largest budget items of Medicare/Medicaid, Social Security, and defense. To summarize, as interest rates rise, interest paid on US debt will increase alarmingly whenever Congress turns to the capital markets to raise the funds necessary to meet its new and existing financial obligations.
Admittedly, this synopsis is simplistic, but our point here is that the Fed may be incapable of raising interest rates to a high enough level to defeat inflation without straining the country’s already stretched budget, courtesy of sky-high levels of national debt. Moreover, with 50% more debt set to hit the ledger over the next decade, materially higher rates could significantly impair the nation’s finances.
A proper analogue to the effects of increasing rates on high leverage can readily be observed in the housing market. The national average for 30-year mortgage rates rose from 3.30% on January 1st to 4.90%, according to the Bankrate 30-Year Mortgage Index. If a buyer’s maximum monthly payment for a home was $2,189.78, the level of affordability declined from $500,000 to $413,000, a 17% reduction in purchasing power simply because of higher interest rates. Extrapolate this phenomenon over other leveraged transactions, such as vehicle purchases, home equity loans, municipal borrowing, corporate debt issuance, foreign government financing, etc., and it’s easy to see how central bank tightening could stall economic growth.
It has been our long-standing conviction that central banks would choose inflation over a major economic disruption. Over the last few years, Peak has steadily increased its exposure to more “inflation friendly” assets with the expectation they could outperform should higher prices persist. As of recent, these expectations have come to pass and appear ready to continue in 2022. This isn’t surprising since these investments are positively correlated with inflation.
In closing, we hope you found this quarter’s discussion interesting and informative. If you have questions about the content or simply would like to touch base with us, we’d love to hear from you.
Peak Financial Management
Additional information, including management fees and expenses, is provided on our Form ADV Part 2, available upon request or at the SEC’s Investment Advisor Public Disclosure site, here. With any investment strategy, there is potential for profit as well as the possibility of loss. We do not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. Past performance is not a guarantee of future results.