The recent past and present have been challenging for investors
In 2020 stock markets were roiled by the COVID pandemic and lockdowns. On a single day, March 16th, the S&P 500 fell 12%! The US stock market declined 34% peak-to-trough before eventually recovering and pushing to all-time highs.
The Fed took the Fed Funds rate back down to 0.00-0.25% in response to COVID and kept it there in the face of rising CPI inflation. The Fed justified its dovish policy by projecting inflation to be “transitory”. Wrong. Inflation continued to increase through 2021 and into 2022.
The Fed realized its policy error at the beginning of this year with inflation raging and the Fed Funds rate still stuck in a uber-dovish, stimulative range of 0.00-0.25%. The Fed expectedly raised the rate, raised it again, and again. (As of the time of this writing, Fed Funds is ranging from 3.75-4.0%.)
Markets responded…negatively. What proved most challenging was the simultaneous sell-off in stocks and bonds. Investors had grown accustomed to investment-grade bonds acting as a safe haven during stock market corrections. Not this time. Higher inflation and interest rates, and the risks associated with each, caused the bond market to fall. (It’s the inverse relationship between bond yields and bond prices.) In fact, 2022 has been shaping up to be the worst year for the US bond market in recorded history.
Higher interest rates cool economic activity
The Fed uses blunt monetary policy tools, like the Fed Funds rate, to spur or slow economic activity, depending upon the situation. It does this to fulfill its primary mandate of price stability. Price instability, caused by high inflation, erodes consumers’ purchasing power.
Higher short-term interest rates are a boon to savers but a bane to borrowers. Consider businesses that rely on adjustable-rate lines of credit to meet payroll, pay for inventory, etc. Higher borrowing costs translate into spending delays and cuts, to include personnel. Liquid investments, like stocks and bonds, may have to be sold to raise cash. Business and investment activities are intertwined – they’re both negatively impacted.
Why subject ourselves to this?
Like the cycle of life, the economic cycle rolls on. And we investors continue to invest in the future for our future.
We defer consumption today, opting instead to save and invest in order to have sufficient funds to pay for things in the future. We take investment risk for higher rates of return than can be achieved through bank savings alone. Over time, the higher rates of return and compounded growth magnify the benefit.
We invest in businesses by providing financial capital (debt, equity). Businesses, in turn, use the capital to finance their growth. We provide debt to government entities to finance capital projects. These projects, in turn, generate revenues and/or increase the tax base.
At the macro-level, as long as the earth keeps spinning and people buy and sell, economic activity remains. And no matter the environment, there…will…always…be…investment…opportunities. Our job is to find them.