As you may have noticed over the years, Longwave’s first newsletter of the year usually comes out around the end of January rather than the beginning. The reason is that December is often uneventful. Indeed, we ended 2021 on a bit of an economic high note with consumer and business confidence high and jobs plentiful. Stock markets and home prices were buoyant. On the local front, the average person felt the wealth effect of stimulus checks and the pay-raise trend.

This January however has certainly been a wake-up call!

The inflection point was signaled at the December 15th, 2021 meeting of the Fed, when a majority of members forecast three interest rate hikes in 2022 (rather than in 2023 or 2024 which had been previously expected). They also indicated an accelerated removal of government stimulus. Prior to that the Fed had been pumping $120 billion into the economy since the beginning of the pandemic. It had been thought they would remove that stimulus slowly but at this meeting, they indicated that all stimulus would likely end by April 2022.

Once the markets got past the Christmas and New Year celebrations, the significance of this pivot started to sink in.

As you may know, the main role of the U.S. Federal Reserve is to create Goldilocks conditions for the economy – not too cold and not too hot. When the growth is weak (i.e. cold), the Fed injects cash into the economy and lowers lending costs to banks; savings that are passed on to consumers. If the Fed pumps too much money into the financial system however, the consequence can be an economy that runs hot, characterized by speculation and inflation. These can also be a drag on the economy by eroding consumers’ purchasing power and confidence.

Today, prices are rising at the fastest rate in 40 years and consumers are feeling the pinch. The Fed has taken notice.

It’s only been a month since that Fed meeting, but there have already been some major effects. Unsurprisingly mortgage rates jumped. Bonds, which don’t like rising interest rates either, have fallen. Many future oriented technology stocks (especially 2020 high-flyers like Zoom, Netflix, Peloton) that rely on borrowing at low interest rates, fell by 20% or more.

Interest rates have been generally low for over a decade. Could this pivot be an inflection point that signals major changes ahead or will the Fed get inflation under control and create healthy economic growth? Is this something we should worry about for our wallets and our portfolios?

Covid & the Economy

Inflation has been shaped by Covid more than anything else, so nothing is likely to shape 2022 as much as the ongoing pandemic. Today, Omicron is raging yet vaccinated people are mostly immune from the worst effects of classic Covid. This gives scientists hope that as more people either get vaccinated or survive the virus, the health crisis will start to subside into something more mundane like the annual flu.

Either way, the likelihood of new lockdowns is low. With that backdrop, surveys report that employers are very optimistic about the near future (although the shortage of qualified workers continues to be a drag on growth). Employees are switching jobs in record numbers. Given that the service economy (restaurants, hotels, entertainment) has barely even begun to rebound, we feel this trend should continue. A strong labor market is a bullish indicator for the economy.

Additionally, given the extreme measures that China and parts of the US are taking to fight the pandemic, there will continue to be shortages of the things that consumers buy everyday: cars, washing machines, chicken, fruits, etc.

Our favorite definition of inflation is “too much money chasing too few goods.” I don’t think we could describe the current conditions any better. Strong demand, tight supply and wage pressure suggest inflation should persist. As we mentioned above, to combat inflation, the Federal Reserve will cut stimulus and raise interest rates. This should help cool inflation but risks cooling the economy as well.

Your Portfolio

2020 was a year of great confusion and uncertainty. What few understood at the time was why the stock market was doing so well while the economy was in such bad shape. As we’ve said in previous newsletters, the stock market and the economy do not always move in lockstep. We could’ve easily had a continued economic recovery in 2022 and a much less frothy stock market. This is partially because stocks (like everything else) are already quite expensive and partially because the Fed is ending the period of easy money.

In an economy that continues to heal, this does not mean that all stocks will suffer equally. Companies whose stock prices are reasonable with strong profits should outperform and that is how we continue to position our portfolios.

One area that has not done so well in recent years is overseas stocks. US out-performance is a trend that has persisted for the better part of the last 10 years. This is partly because of US government stimulus (and debt) and partially because overseas economies simply cannot match America’s ability to create leading companies like Google, Netflix, Amazon and Tesla. In 2021, China cracked down on its technology champions and as a result their stock market fell by 30%. Today, China, and most other non-US countries are still providing stimulus to their economies so perhaps this will be the year that cheap overseas stocks start to make up ground on expensive US shares. In any case, we continue to remain diversified.

For many Longwave clients, bonds make up 20-50% of their portfolios as a safety net against volatility, so that is also something we think about quite a bit. As we all know, when interest rates go up, bond prices go down. In 2021, the US bond index fell by 2%. At Longwave we hedged against higher rates using shorter duration bonds, higher yielding corporate bonds, and municipal bonds when possible. For 2022, we are maintaining this positioning given our expectations for rising rates.

Also in 2021 we started converting many of our DFA Mutual Funds into DFA ETFs (which we discussed in our previous letter) to save on portfolio expense. Beyond that, we do not see major portfolio changes in our immediate future. We do however continue to look out for surprises and sudden changes in sentiment. Of the 13 recessions during the last one hundred years, 11 of them coincided with rising interest rates. If the Fed raises interest rates too quickly, that will raise borrowing costs for consumers, homeowners, business owners and companies all at once. If the Fed miscalculates the resilience of the economy, high prices and high borrowing costs could throw a wrench into this recovery.

Taxes

Another area that affects our household budgets is taxes. The stock market likes Washington gridlock and with the Senate split 50/50, boy do we have it. Although Biden has promised higher taxes to pay for his social agenda, it will be hard to pass given opposition from red-state Democrats. Later in the year, the US will be holding mid-term elections which tend to favor the opposition party. The Republicans will, of course, block Biden’s choice legislation while Biden will return the favor. In other words, the legal and tax framework of the country will probably be stuck in the mud this year, and perhaps for 2 more years after that. The upside is that tax rates and rules will be somewhat predictable for a while.

Your Wallet and Financial Plan

With portfolios inflated, salaries up and home values high, people will continue to spend money in 2022 even as things continue to get more expensive. For clients who are retired, higher account balances should be able to keep pace with higher living expenses. If inflation is temporary as we expect (2-3 years), then we likely don’t have anything to worry about. If, however, inflation persists, then we must consider how that impacts our financial plans.

When we create retirement projections, the rate of inflation is an important input in those calculations. US Stocks have just enjoyed their best three-year run in more than two decades while inflation stayed low. Moving forward, we face the possibility of investment returns coming back to historical averages and a small risk of above trend inflation - these would be headwinds for retirement.

At this point, one month of choppy stock markets and Fed saber-rattling do not make a long-term trend. However, we believe this will be an important year to monitor economic forecasts and inflation. If larger trends do seem to be emerging, we will want to revisit the assumptions we made in past retirement projections to make sure you will remain on track.

In 2022, let’s revisit your financial plan and stress test it for these different possible conditions. The best financial plans are dynamic, adjusting as financial circumstances change. There are always changes we can make to help us navigate towards financial success such as portfolio or spending tweaks. It’s easier to deal with an unknown future if you’ve planned out what those adjustments might be in advance.

As we head into this new year, we retain our Longwave values of optimism because we focus on the long term; we continue to look to what we can control rather than what we can’t and as always, we are in a constant, transparent dialogue with you. In the depth of winter, we remember that spring is right around the corner.

The Goldilocks Balance: Can The Fed Get It Just Right?