Winds of Change?

By: Mark D. Troutman, PhD, CFP®

The band The Scorpions was formed in 1965 in Hanover, Germany at a time when music caught the hearts and minds of listeners worldwide. By the mid-80s, the Scorpions had risen to prominence in the world of rock-n-roll with future mega-bands such as Metallica, Def Leppard and Iron Maiden standing in as their opening act .

In 1985, they released several hit songs including “Send Me an Angel” and “Wind of Change” [1]. The latter very popular hit celebrated the changes signaling the end of the Cold War. Most notable was the band’s tour through the Soviet Union, a development unheard of just a few years earlier. This remarkable sign of the times eventually drove people behind the Iron Curtain to bring down a wall. In June of 1987, Ronald Reagan delivered his now famous “tear down this wall” speech in Berlin. Many historians believe this speech marked a seminal turning point in the Cold War. Indeed, this was the start of something big!

Much like in 1987, the financial markets today are also signaling the coming winds of change – in the form of inflation driven by a combination of supply and demand effects more persistent than was first believed. In previous articles, we have indicated that we were watching the recent rise in inflation pressures closely as the rebirth of inflation carries with it, significant investment implications. In our estimation, times have changed – and the Winds of Change have turned  conditions away from low interest rates and easy money to persistent and higher inflation.

Given the prospects of persistent and higher inflation for the foreseeable future, the question now is not whether interest rates will rise, but how fast will they rise and when will they peak? This rising interest rate environment calls for a different approach to portfolio construction. In this article, I present the base case for the different approach based on economics, and in an article next week, we make the case for “The Great Rotation” and discuss the implications on asset allocation and portfolio composition.

It is worth noting that while market conditions drive a change in portfolio composition, they do not alter the long term strategy of wealth accumulation founded through investments in high quality equities coupled with prudent asset allocation and rebalancing, consistent risk management, cost management and tax efficiency.

What conditions have changed? A combination of policy change, supply constraints and demand shocks have raised the risk of more persistent inflation. Two years ago, we were at full employment. The sudden COVID pandemic caused businesses to shut down and drove up unemployment that reduced consumer spending. Countries closed borders, which disrupted supply chains. The US government responded with massive stimulus and the federal reserve shifted its policy to support employment and worried less about price stability.

We find ourselves now with supply side impacts that are more persistent than first suspected. Some supply chain disruptions such as microchip shortages are likely to persist for some time, as new capacity will take time to build. Other disruptions such as port backlogs and energy shortages will sort out more quickly as higher prices provide incentives for suppliers to bring idle capacity back online.

But some supply constraints – most notably labor shortages – face more uncertain paths to resolution. Workers have been slow to return to labor markets, and demand for goods has produced an extraordinarily tight jobs market. This forces employers to compete for workers with higher wages and drives up overall labor costs. The labor force since the start of COVID is 4.1M workers smaller than February 2020, a time of near full employment. Most departed workers fall into two categories [2]:

• Older full time workers who decided to retire. These workers are unlikely to rejoin the workforce on a full time basis.
• Younger workers, often women, who serve ongoing caregiving demands such as illness or school age children. These workers may rejoin the workforce as the effects of COVID subside and wages rise.

What is not in short supply in this picture is demand, which has been stoked by unprecedented fiscal ($5.3T) [3] and monetary ($4.7T) [4] stimulus. While these demand effects are beginning to fade, there is an enormous spending momentum that is competing for limited supply.

These effects combine to raise the risk of higher and more persistent inflation. In large measure, the view that an end to COVID will resolve these price pressures through restored capacity, untangled supply chains and returned workers (a supply side approach) is sound. But the persistent inflation causes damage and runs the risk of outlasting patience to wait for market resolution.

In labor markets, the risk is “wage push inflation” where workers demand wage increases in response to rising prices and tight labor markets give workers bargaining leverage. Companies have already begun to raise wages as they compete for workers in an extraordinarily tight workforce.

Near term inflation places the Federal Reserve under pressure to shift from an emphasis on full employment to an emphasis on controlling inflation. The Fed has curtailed the growth of its balance sheet and signaled a rise in interest rates. These conditions have begun to flatten the yield curve and impacted financial markets. A risk in the weeks forward will be a Fed that makes the policy error of raising rates too aggressively, crushing demand and triggering a recession.

As stated earlier, our basic strategy of building wealth has not changed. Rather, what has changed is the selection of investment vehicles we favor. In particular, the era of low inflation, market slack and plentiful, cheap money are likely behind us for the immediate future. These conditions favored the performance of “growth” stocks that provide high returns in a low growth economy [5].

Conditions of rising inflation and interest rates favor a “value” based approach [6]. Under these conditions, companies that can impose price control on their supply chains along with the ability to impose price rises on their customers to offset higher input costs generally perform better. Also, companies with future cash flows undervalued relative to market competitors will fare better. In addition, we’re looking for income producing assets that perform better than bonds, as bond prices fall when interest rates rise. In this category, real estate and companies that produce essential commodities appear more attractive.

Stated another way, these methods seek to purchase rising future cash flows at a discount and find alternatives to fixed debt payments that will be repaid with dollars of inflation reduced purchasing power.

Therefore, we are engaged in an ongoing effort to seek companies with growth opportunities at discounted prices and a market position that allows them to control their input prices while raising their own prices. We also seek fixed income alternatives that preserve underlying capital values. We will continue to emphasize low cost and tax efficiency, so our clients build wealth to meet their goals.

Good strategists change their tactics when the wind of change blows, but they stay focused on the long term goal. The facts have changed. So, we’re changing tactics to protect and grow your wealth. ■ 

Footnotes:

[1] Send Me An Angel, Scorpions November 1, 2009, https://www.youtube.com/watch?v=1UUYjd2rjsE

[2] The Employment Situation, Bureau of Labor Statistics January 2022, https://www.bls.gov/news.release/pdf/empsit.pdf

[3] Here’s Everything the Federal Government Has Done to Respond to the Coronavirus So Far, Peter G. Peterson Foundation March, 15, 2021, https://www.pgpf.org/blog/2021/03/heres-everything-congress-has-done-to-respond-to-the-coronavirus-so-far

[4] Assets: Total Assets (Less Eliminations from Consolidation): Wednesday Level , FRED Economic Data February 2, 2022, https://fred.stlouisfed.org/series/WALCL

[5] Growth Stock, Adam Hayes January 10, 2022, https://www.investopedia.com/terms/g/growthstock.asp

[6] Value Stock, Tim Smith December 4, 2021, https://www.investopedia.com/terms/v/valuestock.asp