Trending Topics

This Month’s Trending Topics

Federal Reserve/Inflation
We’ve received many questions around what the Federal Reserve is trying to do and why stocks and bonds are dropping as a result.  

After COVID shut down much of the country, the government and Federal Reserve flooded the system with extra money.  Much of this money was given to individuals who still had their jobs and really didn’t need it.  At the same time, supply chains were slowed down due to the shutdowns resulting in less product.   This was the problem, too much money and too little supply.  The result - inflation. Something we hadn’t seen in many years.   

The Federal Reserve’s main priority has always been price stability/inflation.  Many Federal Reserve officials initially used the term “transitory” as they believed inflation was temporary and would work itself out of the system.  They were definitely wrong.  In order to bring down inflation, money either needs to come out of the system or demand needs to slow. In a system so heavily reliant on debt, interest rates are the method of choice for slowing demand. The first step was to raise interest rates, which they are doing at a much faster pace than previous cycles. How does this slow down the economy/bring inflation down?  

1.    Housing - Housing/rental rates are the largest component of inflation. Low rates helped fuel the housing boom which in turn pushed rents higher.  Many borrowers were able to lock in 30-year rates below or near 3%.  At the same time, demand was soring.  Raising interest rates is designed to bring down, or at least slow housing demand, thus dropping prices and rents.   A $400,000 mortgage for 30 years at 3% fixed results in a payment of around $1,686 monthly.  That same $400,000 mortgage at today’s rate of 6.5% results in a payment of around $2,528 - a $842 monthly increase.  Either house prices come down, or the holder of the new mortgage now has $842 less per month to spend on other products and services.  
2.    Corporate debt - Many companies borrowed money the past few years at very low rates and used the money to buyback their own stock, which contributed to the price increases.  With rates much higher now, companies may be hesitant to use this strategy moving forward.  Some companies also have debt coming due that they don’t have cash on hand to payback. This will cause them to borrow more to pay-off the original debt but now at a much higher rate.  This will have a negative impact on future earnings as their interest expense will be higher.  Companies always want to show earnings growth to shareholders. When their expenses increase, they often look to slow spending or cut employees.  This trickle-down effect may eventually bleed into the overall economy as the companies they buy from are now selling less, laid off employees typically spend less, which results in slower overall economic activity.     
3.    Consumer credit - Many consumers use debt to finance purchases whether it be credit cards or a loan from a bank.  As rates rise, borrowing becomes more expensive.  Either you pay more in interest or don’t borrow money to make the purchase.  If you pay more in interest, then you have less to spend on other things.   If you don’t buy, then demand drops. If you lose your job, you typically don’t make large purchases.  Prices don’t tend to go up as fast when spending is declining.  

The Federal Reserve has also started reducing their balance sheet or engaging in quantitative tightening.   Just as you have a balance sheet of asset and liabilities, so does the Federal Reserve.   During COVID, they Federal Reserve purchased bonds to inject money into the system and bring down interest rates.   The majority of bonds they purchased were U.S. government bonds and mortgage bonds.  This allowed the government to borrow more money at lower rates, which they used to fund the stimulus programs.  This also pushed mortgage rates down, allowing home owners to buy and refinance at lower rates.   The result was an expansion of the Federal Reserve balance sheet to around $9trillion and more money in consumers pockets.    

The Fed has stopped buying bonds and will begin to sell at some point. Now, when the government issues new debt, there is less demand.  The same is true of the mortgage market.   With less demand, buyers of new debt can demand higher rates. This is another way interest rates are impacted without actually raising them. The intended result is the same, less demand and a slowing economy as rates move higher.  

The result on asset prices has been significant. Bond prices have dropped as rates have gone up.   Stocks dropped and are making new lows as investors fear the Fed pushes too far and we end up in a severe recession.  Just as bond investors now demand a higher interest rate, equity investors are no longer willing to buy stocks at the same valuations they entered the year with.   

Moving forward
2022 continues to be a challenging year as the stock market reached new yearly lows, inflation remains high and interest rates are increasing.  Market volatility and pullbacks should be expected and are common, but the added pressure on bonds as interest has increased is something many have never experienced.   Bonds, which are usually the “safer” part of a portfolio, are experiencing their worst year ever.  

These times make “staying the course” even more difficult as you watch your portfolio falling as everyday costs continue to go up.  The stock market will continue to experience volatility, both up and down.  We can’t predict when there will be a recovery, but unless there is a total economic collapse, we still believe businesses will make money and the markets will continue to grow over the long term.  

Please reach out if you have questions or would like an update on your current portfolio positioning.  

This material is meant for general illustration and/or informational purposes only.  Views expressed in this newsletter may not reflect the views of Royal Alliance Associates, Inc.  It is our goal to help investors by identifying changing market conditions.  However, investors should be aware that no financial advisor can accurately predict all of the changes that may occur in the market.   This material should not be relied upon as investment advice.  Investors should note that there are risks inherent in all investments, such as fluctuations in investment principal.   International investing involves special risks including greater economic and political instability, as well as currency fluctuation risks, which may be even greater in emerging markets.  There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. This article contains forward looking statements and projections.  Past performance is no guarantee of future results.  Neither Royal Alliance Associates, Inc nor its representatives provide tax or legal advice.  If you don’t wish to receive marketing emails from this sender, please reply to this email with the word REMOVE in the subject line.