Q3 2022

October 3rd, 2022

If you compare this past quarter’s closing values to what was reported at the end of the June quarter, you’ll likely see further deterioration in account values. The stock and bond markets continued to decline this past quarter. I’d like to talk about what is going on in both markets.

Let’s start with the bond market. To start, we have not seen material declines in bond prices for many years. The 40-year decline in interest rates has insulated the bond market from any sustained price declines. Now, as interest rates rise, prices for bonds have fallen. This is expected.

As you know, we’ve felt interest rates have been artificially low for many years. Over the past 14-years they’ve been kept low by central banks to combat a series of shocks to the economy. They assessed each shock as requiring ever lower interest rates, but as each crisis passed, central banks lacked the discipline to reverse policy and let interest rates rise again.

This has helped the financial markets and specific areas of the economy. As an example, low rates have been a boom to real estate prices.

I was trying to find the word that best characterizes the power ascribed to central bankers. I think “omnipotent” best encapsulates it; they are often described as having unlimited power. They do not.

The check on central bankers is inflation. If they overplay their hand on “easy money” policies (which includes low interest rates), inflation will eventually undermine their efforts. That is likely what we are now experiencing.

With inflation taking hold, it’s critical the Federal Reserve do everything in their power to stop it. That means raising interest rates and stopping their interventions into the bond market.

Fortunately, we’ve seen them become aggressive in raising interest rates. Unfortunately, they’ve been less aggressive in ceasing their purchases of bonds. We suspect that is why long-term interest rates have not been going up as fast as shorter-term rates.

I stated at the outset, we’ve seen the prices for bonds fall this year. It is entirely tied to rising interest rates.

We are not particularly concerned with falling bond prices. Remember that all bonds have an important feature called a “maturity date”. At some point in the future, the bond’s issuer is required to pay you back the par value of the bond.

When we buy bonds, we know what they cost and what they will pay in interest. This allows us to calculate the return that’ll be earned on each bond purchased if it’s held to maturity. When we hold a bond to maturity, daily changes in its market value have no bearing on the return earned on that bond.

What allows us to hold bonds to maturity is our understanding of when and how much you need from your account(s). We do everything we can to align the maturity of your bonds with our projections of when you need money. Doing this allows us to hold the bonds to maturity.

I’d also state that rising interest rates are good for people with savings. It allows us to reinvest money allocated to bonds at better rates. For many years, savers have been penalized by the low interest rate policies of the Fed, we are glad to see things starting to normalize.

One thing you might consider is taking advantage of these higher rates by more aggressively managing your excess cash (if “excess” cash is a thing). With the banks still paying very low rates on deposits, moving unneeded money out of savings and checking accounts and letting us buy bonds with the money should increase the interest you earn on that money.

I’ve talked about how stopping inflation is critical at this juncture. I want to embellish on this a bit. For those of you that remember the 1970’s, it stands as a good example of why inflation needs to be stopped.

The Federal Reserve was not aggressive in addressing inflation throughout the 1970’s and as a result it became embedded in how people behaved. I’ll skip over a complete rehashing of what happened, and simply state that the economy descended into what became known as a “wage-price” spiral. Workers whose fixed pay did not keep up with the cost of living, began demanding higher wages simply to keep up. Higher wages forced companies to raise prices and the spiral of inflation took hold. Immeasurable effort was expended on planning around the effects of inflation, to no one’s benefit.

Wage pressures are already building in today’s economy. It’s not insignificant that the rail workers came close to striking this past quarter as they renegotiated their contract. Wages were at the heart of the dispute. I do not blame the workers. Their cost of living is increasing, and they should not be forced to bear all its impact. We need instead to end the reason for these wage demands: out of control inflation.

The other aspect of the 1970’s that we should remember is that it was a terrible decade for stocks. Inflation changes how people invest; it shortens everyone’s time horizon. If the value of the currency is not stable, investors are less willing to think long-term.

When we look at the stock market this past quarter, I think we must dissect what is driving stock prices lower.

The stock market today is grappling with two things: recession and inflation. I stated last quarter that I believe we are already in a recession, and it is likely to be with us for a while. However, the recession we are seeing is entirely manageable. I discussed last quarter how high inventories at the major retailers, a collapse in the housing market, and lost consumer (and business) confidence already have us in a recession. We still haven’t seen this impact manufacturers, but we will.

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These things are normal, a part of a recession. Alone they would not have us worrying about stock prices. As inventories normalize, economic actively will pick up and things recover. The stock market will strengthen, and we’ll be on to the next bull market.

However, if inflation sticks with us, I expect a different result. A timely recovery in the stock market is not assured.

My current assessment is that we are going to see several more quarters of volatility. I believe at current prices, stocks are reflecting the recession, but I do not believe they fully reflect any probability of sustained inflation. In other words, I believe investors believe the Fed will get inflation under control. We’ll see.

On a final note, the performance of stocks this past quarter bears some commentary. As I stated, from June 30th to September 30th, stocks were down. But during the quarter, from June 30th to early August, the market staged an impressive rally. The rally showed us that if investors have any confidence that the end of the economic downturn is in sight, stocks will be going higher.

In July, as companies reported earnings, the market did not hear an across-the-board collapse in business activity. The declines (indicating recession) were limited to specific segments of the economy. This was better than had been expected and translated into a more positive outlook. Stocks rallied.

I think this coming quarter will show us a more broad-based decline in activity, and I believe the market sold off in September is in recognition of this. Nonetheless, I believe that if this remains an inventory led recession, the light at the end of the tunnel is out there and the market will recover.

My Very Best,

Mark Hoonsbeen, CFA
Principal
Nicollet Investment Management
800 North Washington Ave, Suite 150 Minneapolis, MN 55401
Phone: 612-915-3033
Email: markh@nicolletinvest.com