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In this episode, we have Ronald Blue Trust CEO and chief investment officer Nick Stonestreet and head of investments, Brian McClard. They share some insights on the current economic landscape. They talk about why the market is struggling, how international events are affecting investors, what may lie ahead, and how this could affect you. Let's listen in now.
It's been another tumultuous couple of weeks. We're seeing continued interest rates being hiked by the Fed. What's going on?
Yeah, it has been a crazy year for markets. Maybe if I back up, actually kind of revisit how we get here, because this is the cumulative effect that investors are feeling. You know, if you look going into June of this year, the first half of the year, stocks were off about 25% or so. And that was because inflation expectations kept creeping up. And the concerns that the Fed was going to hike rates significantly enough that it was going to do something to the economy. But then in June, what we had is, you know, we had growth concerns really creep up. And but this this caused people to think that maybe the Fed would be put on hold or maybe they were close to done hiking.
And so, believe it or not, this bad news of a recession actually gave hope to the markets and they started to rally significantly. So this massive selloff turned into a reversal rally of about 17%, which lasted through the middle of August. But at that time, we saw some economic resilience, we had an inflation print that came in. We'll probably talk about that. And maybe it wasn't as as positive as people had hoped.
And so the market started to selloff again because the Fed was reiterating that it's here to fight inflation. And so it's really the story that inflation continues to be stubborn and the Fed continues to hike.
Yeah.
And I think last time we got together, we talked about the stubbornness of inflation. I think, you know, probably for me early in my career in the eighties, being a financial analyst in Brazil, when the rate of inflation went from 3% a month to 24% a month while I was doing financial forecasting, I think I've been able to see different bouts of inflation. And certainly those times are not a road map for these times at all. Very different circumstances. However, the idea of the stubbornness of inflation is something that we've talked about for really the last year. And on the last podcast we talked a good bit about that. We're seeing that stubbornness and two things are happening is that are concerning. One is that inflation is being persistent, which we kind of thought would happen. But there seems like an absolute resolve from the Fed to hike rates that's going to slow the economy and keep fighting inflation.
But on the other side, we see, you know, policy decisions that just throw more logs on the fire of inflation. And so it seems like there's this disparity between Fed action and in policy decisions.
Well, and that's why markets are caught in the middle. But certainly the Fed seems very intent on not repeating the mistakes of the Fed of the 1970s. You know, there was a stop and go mentality. You're moving from kind of a fixed rate regime to more of a floating rate. And there is frankly even a doubt within the Fed that monetary policy could even affect anything. We're not seeing that now. We're seeing a Fed who is insistent that they are going to keep hiking rates until inflation comes down, so much so that they're even using the same language. You'll hear Powell say keeping at it, which is actually the name of Volcker's book. Volcker, the Fed chair who shepherded that massive rate rise and rates back in the late seventies.
Yeah.
So there's this unyielding resolve to keep raising rates. Where do you think that plays out?
You know, because the next thing that comes to mind is as rates increase, you know, we've still got industrial production indicating pretty well we've got unemployment still fairly low. If the economy starts to hit a hard landing in the form of recession, what do you think? What do you think's the next kind of shoe to drop?
Yeah, I think that's a right way to think about it for sure. We're seeing those mixed signals in terms of are we there? The the front end is definitely softening. We've seen that with the interest rate sectors, as you know, with autos, housing. And so those are the first things to roll over. We're seeing that very clearly. Like you said, spending and consumption are soft, but they've not displayed any conviction as far as the downside. And also, like you said, what we're waiting to rollover are corporate earnings and employment. But when you look at where employment is is as strong as any we've seen. And I think that's part of was giving the Fed the conviction to stick at it and kind of what you're talking about with inflation being a little bit stickier. So we're waiting for those to happen.
The problem is those are a little bit lagging, too, in terms of their signaling. So the Fed doesn't have great signals here. And even then, once once those do roll over, that's usually signaling the tail end of a recession. And the Fed probably doesn't have leeway to lower rates yet because again, they have to have conviction that inflation is through.
So that brings us back to the question of, okay, inflation really has a couple of really important questions around it. One is, how far is it going to fall? And two is how fast? Because you're speaking to it being a little bit stubborn. And so the first question of how far I mean, we're above 8% year over year right now.
Before COVID came, they couldn't even get inflation above 2% for the decade of the 2010's. And so, you know what your conviction level? Do you think that inflation can come back down to 2%, or do you think there's some things that could keep it from getting down to those pre-COVID levels?
Yeah, I think it's you know, I think it's a matter of when. And so when you have a persistence of inflation, which we're going to see, I know we've gotten some data points. You know, I saw the Social Security recipients are probably going to receive a 10% raise this year. Close to that, I don't know what the final number will be. And so you've got 70 million people getting a 10% raise. You got a lot of working people that are not going to get that kind of raise. Employment still strong.
It's interesting. I think I think as it moves through the economy, we're we're going to see more issues with corporate earnings. I think that that shoe drops next and then employment will will drop after that. How it plays out in the timing of it, it seems like the Fed's willing to, you know, hurt the economy, slow it way down in order to fight inflation. And but then you start thinking of the painful impacts of that as well. And we think that that's coming. We think there's going to be some real issues around the painful impacts of inflation.
One of the pressures that we'll see on corporate earnings and maybe we could talk globally for a couple of minutes is the dollar. So, you know, sometimes people think, oh, strong dollar, that's so great. Well, it's great if you're taking a trip to the UK this, you know, in the next few months because the dollar pound, you've seen what's happened to that in the last few weeks but overall dollar strength and how that puts our you know, standing as far as a global competitor and what that could mean to earnings. Maybe you could talk a little bit about that.
Yeah, strong dollar definitely tightens financial conditions globally. It restricts growth and it precedes corporate earnings, sell off profit margin fall off, and then recessions ultimately and we've seen a very strong dollar over the last year, if you look at it across currencies, up about 18% on average across a lot of currencies. And so this is definitely going to be something that causes some some difficulty going forward. And I would expect it to come home to roost and coming home to roost, meaning coming through corporate earnings as well.
Absolutely. Absolutely.
It will come through corporate earnings for sure. Yeah.
And I think that that earnings slowdown, if we're pricing the equity markets off of corporate earnings, which is ultimately what you priced them off of.
Right. It's a stream of future cash flows that could mean, you know, more more trouble in the equity markets as we go forward. Yeah.
And so that that brings upan interesting question as to what is priced into equities? We've had such a horrible year for both stocks and bonds. And so the question as well, is a recession already priced in?
And I guess I would argue that largely what we've seen so far to date has really been more tied to just the the readjustment in interest rates. So in other words, has been a valuation adjustment down. We've not factored in yet this potential recession risk. And so there's still the chance that we escape that.
Right.
There's still the potential that maybe the combination of a strong economy with the Fed really timing it. Well, that, you know, we get through this without a bad recession, recession, in which case we would see probably the bottom in stocks where we are. But if we had a recession, which is a very good likelihood, we could see some more near-term pain in stocks and bonds.
Yeah, I think that's a good point. You know, we're coming off of a low interest rate kind of sugar, high.
Right.
And so that that's over for a while. And then the global backdrop that we're we're up against is one of of concern in a couple of areas. I think, you know, one, everybody's still watching war in Ukraine. And maybe we could talk a little bit about the energy sector and some of the things happening with decarbonization and some of the macro picture effects on the global economy now.
So thoughts on that?
Yeah, absolutely. I do have some thoughts and you're really getting to the heart of the question, why can't we get inflation from 8% back down to that 2% pre-COVID level? And, you know, first of all, let me say that one of the biggest culprits I would say to us being where we are is because, you know, when we experienced that $2 trillion hole in our economy, that 9% drop in GDP due to shutting things down because of the onset of COVID, monetary and fiscal response was to the tune of about 10 trillion.
So we took $10 trillion to plug a $2 trillion hole. And so we've just got to work through that. Right. And so the initial thought might be, hey, once we just finally get through all this, get the spending out of the way, get everything cleared out, we should be able to get back to that 2%. And in fact, there are some long term forces that would suggest, hey, longer term, there's no reason why inflation can't get down because of the the increasing debt, because of the aging demographics.
But what you're bringing up is very important is that through COVID, some things changed in the world. For one, I think Russia's relationship with the rest of the world and they're a major fertilizer supplier, energy supplier, their relationship has changed, which potentially could be a little bit inflationary. Too, I think it uncovered maybe too quick of a pace of decarbonizing or, you know, an energy transition policy that is maybe a little bit unsustainable in terms of keeping prices at the same level as before.
And so if we continue that pace, and that's a risk to keeping inflation a little bit higher, and then let me just throw one other thing in the mix there. And that's the idea of we can call it different things, slowbalisation or near shoring. In other words, sort of this mistrust of supply chains in other countries and just relocating supply chains, maybe not from where it's most economically efficient, but maybe to where it's most politically expedient to do so.
Yeah, I think those are really interesting points when we and as we look at this global backdrop and we see the knock on effects of Russia's aggression in Ukraine, you know, we're first we're seeing the horrific part as the Ukrainians have retaken land and they start to uncover the mass graves and you see signs of torture and sort of, you know, just the awful things that you kind of thought were happening are now being literally unearthed. I think this idea that decarbonization and the the way the Europeans have approached that created a vulnerability, a reliance on on Russian energy. And I heard this morning one of the toughest items to get in Europe right now are electric blankets. So people are already starting to prepare for a cold winter where there's going to be energy shortages. And now there's a big shortage of electric blankets. That's a little bit of a haunting comment.
And then the other part of kind of this global knock on effect that we have from China is the zero-COVID policy. So we've seen this ramp up, shut down, ramp up, shut down. And and the ramp up, you know, for a factory, it can take months. So you just the supply chain remains. Last time we talked a little bit about it remains disrupted with this really crushing zero-COVID policy in China. And it starts to bring the question of do we bring more to the US? Do we bring more near nearby and I think last time we mentioned, we think that's going to be a longer term trend and probably be accelerated.
So we've got this backdrop of global issues. We've definitely got domestic local issues. And then the question starts to become, what does that mean for my portfolio? Right. And so as director of investments here, Brian, what is what does that mean for our clients’ portfolio?
Yeah, that's where the question really comes to bear and that's where we have to make decisions to really improve the possibility of of navigating these successfully. And it certainly means that right now is more uncertain than what we've seen historically. So because of that, we believe that portfolios need to be more broadly diversified than in other times.
But I think there's a few other things, too, that we can actually look to to gain some some confidence and maybe in some some unfamiliar ways. One of them one of the things I would take heart in is the fact that a lot of these crises are known. And believe it or not, that's that's an important thing. You know, it's it's it's known, which means that it's priced in, which means people are doing something about it. Too, the fact that they are in a crisis level means, you know, that policymakers and market participants are doing something about this that take the energy transition in Europe. They're actually taking steps now. Right. You've heard the quote that, you know, once we've exhausted all other possibilities, well, we'll finally do what's right, that kind of a thing.
Right.
And so sometimes it takes that right will kick the can down the road until we have to do something. And so it's a painful time. But these are things that will translate to more robust profiles for investments, for countries, for balance sheets going forward. And so that's a good thing. But it does mean that in for this time things are more painful. And so one of the key aspects of investing is time. You can't cram too much into a short period of time and not expect pain.
You know, for instance, we talk about interest rates on mortgages are six and a half percent range. While many folks will look and say, oh, six and a half percent, you know, my first or second or third mortgage was was it six and a half percent. That's nothing. Yeah, but you don't get there in three months, when interest rates are at 3%. Through time, that's not a problem. And so that's the reason we focus so much on time when we look at how to allocate investments in clients' portfolios.
Yeah, I think that is so accurate. Brian. And one of the unique aspects of the way we look at portfolios through time based lenses and you know, our clients can take heart that they're always encouraged to keep cash on hand for, you know, a year or even two years of expenses and then be able to allocate to short term, intermediate term, long term and ultra long term so that they have different portfolios for different time frames. And right now, if if you've had your cash on hand, you're you just got a raise. So Treasuries two year Treasury hit 4.2% yesterday. So there's a little bit of a silver lining in that. And then as the clients look at the short term, there's even been some, you know, net asset value decline in your short term portfolios, which is unusual, but it's still a part of stability. Then you look at the intermediate term where a lot of bonds have been in the portfolios and those have taken a significant hit.
But again, those portfolios are now getting a raise in the in the form of a higher coupon. So even though you've lost some money in bonds, you're going to start earning that money back and in higher coupons. And then the place with equities in your 10 and 15, 20 year portfolios, that's the place that's getting hit in time will allow recovery there. So I think, you know, sticking to your plan, positioning on time based on when you need your money back is something we've always talked about and never seemed more relevant than it does today.
Yeah, that's absolutely right.
And to maybe add some some context to that, you know, bonds and stocks are having a really horrible year. But anyone who invest in stocks, which are a long term investment for one year, are missing the the the correct application of stocks to the time horizon. Right. And bonds, same thing. So we've not seen such bad returns in the bond market as we've seen this year in a very long time. But it's also interesting to look back over the last hundred years, believe it or not, even take ten year treasuries.
They have a negative one year return about 18% at a time, which is significant. But if you look at a more appropriate timeframe for bonds, say, over five years, and then you add a well diversified mix of bonds, we've not seen them earn less than 0% over the last hundred years. And that's not to say that they won't ever. Right.
Yeah, but the point is, is to take an appropriate time frame perspective when you're looking at your investments.
Yeah. And I think, you know, for our clients there's, there's more probably difficulties to come in this. I don't think we're going to be getting out of some of these structural issues with inflation of potential recession time, you know, a lot of these issues, we're not going to get out of them tomorrow. It took us a while to get here. We got to keep burning off the sugar high of low interest rates and a lot of government spending. But in two years from now, I think we'll have a very different picture. I think a lot of these issues will have worked through the economy and we'll be out on the other side of robust corporate earnings and have a much better picture going forward.
So I think it's a stay diversified, stay close to your plan. And yeah, we're going to have to ride this one out a little bit.
Well, and that's a very important point. And what you're pointing to is the fact that we're not on the precipice of something cataclysmic. The business cycle hasn't been repealed. After winter come spring, there's always a spring and we will be in that time frame. Right. It's okay to worry during this time because worrying means that you're you don't have to worry as someone once said, right. If you worry, you don't have to worry because that means you're doing something about it. You've made a plan, you've prepared. Now you have to endure these things that are inevitabilities as part of the business cycle. But like I said, there is always a spring and there's lots to worry about in the short term. But long term I think we find that oftentimes there are pleasant surprises.
Yeah. And I think just continuing to stick with the advisors and have those meetings and have those discussions around cash flows and planning, it's a critical time for that reevaluation. But what we've always seen is that, you know, we do have some people that jumped out of the market in 2008, 2009, because it got so painful and they're still looking at a good time to get back in. And so it really is a matter of sticking to your plan long term, allocating those buckets correctly and we'll get through this.
Absolutely. Thanks.
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