The title of this post is a bit of a double entendre in both the sense of the way the economy is unfolding as well as how my own personal situation is changing.

First, it’s worth mentioning the economy. As measured by the stock market, this year has been dismal. The cash flush exuberance of the loose monetary policy post pandemic has given way to the painful bite of inflation. Both the Fed and economists from the most respected institutions have had to eat a big piece of humble pie in the past year.

When inflation was starting to pick up at this time in 2021, many economists talked up the “transitory” nature of inflation and the “base effects” of comparing the bounce back economy inflation to the short deflationary period of the pandemic. Yet in since the end of 2021, inflation has persisted at an elevated rate between 7%-8% on an annual basis. For the privileged few of us who are versed in economic history, watching how the public reacts to inflation in real time is like watching a slow moving car crash. You know what is going to happen but are powerless to stop it.

One of the first realizations that workers are coming to, is that wages will struggle to keep up with the actual inflation rate. Wages are often a lagging indicator and despite a hot job market, workers as a whole may struggle to negotiate pay that matches in the increase in inflation rate. What this means is that if raises are 2-4% but inflation hits 8% then workers essentially received a 4% to 6% pay decrease.

This hurts consumers directly. The outcome is usually that consumers scale back purchases, substitute purchases with inferior goods, or take on debt to finance them. With rates going up, many could take on ever more expensive debts to finance their lifestyle and consumption habits. This could eventually show up as a slow down in consumer spending, which tends to drive the US economy and could be a harbinger of the next recession to come.

The other broad effect is it worsens inequality. Those with assets are often seeing values rise or even top overall inflation. Housing and commodities are examples here of where the rich can benefit. The increase is amplified if you count assets that have been financed by fixed rate debt, for example real estate that is financed with a fixed rate mortgage. Now not only has the value of the asset increased but the debt that paid for it just got cheaper. Certain real estate markets are particularly hot (Florida and Texas for example) and are seeing double digit growth in rents and property values, is it any wonder that institutional investors are rushing to buy homes even with mortgage rates touching 6%?

How Markets Are Reacting

The question being posed by economists now is how high must rates go in order to kill off inflation? As crazy as it sounds, I still am hearing optimism from some media outlets and commentators that inflation fell in April to only 8.3% from 8.5%. This isn’t comforting given that it’s a full 6% above the Fed’s target of 2%. This question really hasn’t been posed for over 40 years and the answer at that time doesn’t bode well for the future.

At that time, Fed rates had to rise well above the headline inflation rate to kill off said inflation. In 1981 rates hit 19% and produced a “double dip” recession, meaning 2 deep and harsh recessions in a row. If inflation persists at this 8% rate, could we be actually be looking at 10% rates a few years down the road? This would produce a massive shift in the investing world which many are likely unprepared for.

We are already seeing the signs of what a few percentage point rises in rates are doing. Bonds are tumbling. Normally they are supposed to offer a safe haven for stocks, investors look towards their predictable cash flows and inverse price performance compared to rates to see some gains when stocks are stumbling. However, with rates rising, the higher rates rise, the worse their performance will be in price terms.

Stocks, being discounted by a rate which is ever increasing, will naturally see their prices fall as well. The current generation of investors is accustomed to seeing rates rise as a result of the Fed not wanting to overheat the economy, not to solely kill off inflation. In the former scenario, which has played out often over the past 40 years, bond prices fall but stocks actually don’t perform that bad eking out moderate gains, even as rates rise. Investors see the rising rates as a sign of strength of the economy. This is not this case this time around.

Although tech now makes up over 20% of the S&P 500, it’s down 16% so far this year while the Nasdaq is already in bear market territory. The respite has been in value stocks, heavier in financials and energy, as well as consumer staples. If rates get high enough though, even these stocks won’t be immune from their values falling. Why take the price fluctuations of Proctor and Gamble, as good a company as it is, if you can achieve a guaranteed return of 5% or 6% by buying US government bonds? This is the choice investors could be facing down the road if rates really need to rise to levels like that to kill off inflation. This is something this generation of investors, even those in their 40’s, have never seen.

And Crypto? I hate to say I told you so to the noobs but it’s actually painful to watch. The “inflation hedge” talking up of crypto is laughable now. More and more holes are being poked in the crypto investment logic such as what differentiates Cardona from Ethereum from an investment point of view? Is crypto actually that secure given a raft of fraud and theft? And lastly, the cumbersome nature of transaction verification makes crypto unsuitable for large volume transaction business.

Funny enough, while attending a banking conference last week, I noticed a palpable change in the mood of bankers there. 3 years ago, many of them worried about crypto and innovation eating into business such as transaction banking and securities. These new innovations seemed unstoppable and destined to take over. Yet the fall of crypto has seemed to inject a new found confidence in traditional banking and there was definitely a sense of “back to business” across the board. This optimism may be misplaced however, going by the average age of attendees, many are likely looking to survive the next 5-10 years, not the next 30. Despite the short term win, it seems banking is still not hip for the young innovators anymore.

Light Through Poking Through the Clouds

I want to stress however, that every situation offers opportunities. The media and meme investors may be all doom and gloom right now but there are going to be returns that arise out of this situation which could have keen investors doing well for many years.

The first is that fixed income is likely to make a comeback. Note however that I’m not talking about current fixed income investors but future ones. One of the big losers of the low interest rate environment has been conservative, cash flow oriented fixed income investors, these tend to be retirees or those approaching retirement age. With higher future rates could come cheaper annuities, higher income in bond portfolios with more predictable cash flows. One of the hallmarks of the 40 year rally in bond prices has been that retirees have had to take ever more risk onto their portfolios to make ends meet. This meant less bonds and more stocks which brings with it more instability. If rates rise substantially, the pendulum could swing the other way, allowing for more stable and conservative cash flows to fund a retirement with.

In order to take as a stage of the current rate environment, investors can purchase 2 year treasuries which now offer yields of 2.61% compared to 0.16% a year ago. Although these are at risk of falling in value should rates rise above 2.5%, they are also easy to hold to maturity and guaranteeing that 2.6% return. Longer maturity bonds look to incur even heavier losses if rates rise further and inflation persists. This will constitute a radical departure from a fixed income point of view for portfolios which have been winning over the past 40 years. Portfolio managers may see gains concentrated in shorter term bonds and will continue to dump longer maturity ones.

Another bright spot could be foreign shares. Higher rates in the US will make shorter term returns murky for emerging markets, which may see their currency values decline versus the dollar. But other developed markets which are seeing inflation, but not to the level of US inflation, could benefit. Euro area stocks and Japanese stocks are pretty fairly priced, offering decent yields and have fundamentals that look solid, something investors haven’t had to take a look at for a few years. Yet I have been calling for foreign shares and emerging market shares to outperform for a few years now, only to be disappointed. Geopolitical uncertainty continues to weigh on foreign shares despite many markets with reasonable valuations. I don’t believe this situation will last forever, which is why I stay invested in the sector hoping for mean reversion to start to poke its head out.

Personal Changes

Finally, my own personal situation is seeing changes as big as the markets and world economy at the moment. I am writing this while flying out on my first trip to Europe in almost 4 years in order to meet my brother for the first time ever.

I have been debating what direction to take this blog in for some time now, especially since I slowed down my writing frequency to once a week due to health and family issues but now could be a good time to take it in a different direction.

For the life of this blog I have remained anonymous. My friends and family know that I write this blog but I liked the model of keeping it anonymous to the general public so as to protect the integrity of my day job and employer. I have worked for large corporations for the past 15 years and I wanted a space to be able to freely express my views on the markets, social issues, personal finance, motivation and even politics without having to be in the position of being a spokesperson representing my employer. Some Economists have run afoul of this with the likes of the Chinese government and seeing their entire organization punished for their off hand comments as a representative of a large global institution.

Yet now I have made a serious career pivot into a small tech firm from a large global bank and have the opportunity to adjust my approach. Not only could that change my writing style but also how I share my thoughts and knowledge for your entertainment and consumption. I am now considering mediums like YouTube and Tik Tok for the first time and would be excited to reach a different audience in a different way.

I also have to keep in mind that although finance is a popular blogging topic, that at the end of the day this is my blog and I can take it in the direction I like. If it veers off from finance from time to time that’s ok. When I am under a lot of pressure, I tend to write more about motivational topics to inspire myself as well as others. I also enjoy sharing the challenges I face on a daily basis with readers as many of them share with me their own struggles, which I think helps many to understand and appreciate they aren’t the only ones struggling with this thing called life.

So don’t be surprised if you see some additional content in addition to my weekly blog posts. Change is inevitable but embracing it helps you enjoy the journey.

Oh and back to that double entendre with the 40 year itch. As I approach 40 this year my perspective has changed a lot since I started writing this blog. For those few that regularly read it I hope you have enjoyed watching my writing and outlook change. Part of my year 40 resolution will be to do what I can to continue writing this blog. It has been a great outlet for me and helped improve my patience, communication and helped me to organize my thoughts. If you don’t have a hobby it never hurts to just start something and see where it goes. Half a million words later, I am still here and having fun with it.

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