Pretzel Logic refers to reasoning that bends back and twists until it does not make sense. (Pretzel Logic also is a fantastic, bluesy song by Steely Dan that refers to time travel.) A great example of this is happening right now: Inflation and interest rates are increasing for the first time since the 1970s while the stock market is reacting by making new highs. Any Major Dude Will Tell You, markets typically react poorly to both rising inflation and interest rates. The market making new highs appears to be a nice, chocolate coating on top of that bended, twisted pretzel.
Let’s untwist some of this and nibble a little of the chocolate off the top.
The Pandemic is mostly to blame for our current situation. In response to the COVID economic shutdown in March 2020, the Federal Reserve immediately cut interest rates and flooded the market with liquidity. Additionally, the Federal government issued stimulus checks and forgivable loans. This worked well—perhaps too well.
Demand for goods increased, while at the same time, supply chain problems made producing those goods difficult. Labor shortages caused by COVID exacerbated the problem, and this combination put upward pressure on prices. Last year inflation increased by more than 6 percent over 2020, the highest level since 1981.
The Fed knows well that to combat inflation it needs to increase interest rates, and it began allowing interest rates to rise by tapering its purchase of bonds in November 2021. In addition, the Fed has signaled that they may begin increasing short-term interest rates in 2022 by raising the discount rate.
Increases in inflation and interest rates usually cause the stock market to decline, à la 1974 when the S&P 500 lost 29 percent (and Steely Dan released Pretzel Logic).
Why does this chocolate-covered market seem to defy logic?
We entered the pandemic with a healthy economy at close to full employment. The stimulus applied to the pandemic was large and spread liberally. Stimulus added to a healthy but temporarily stunned economy caused a big increase in economic growth. This is a very different scenario from the 1970s when there was inflation with a contracting economy, when the term “stagflation” was coined.
While the inflationary forces are more than transitory, there are long-term deflationary forces at work that should keep inflation under control in the long term. An aging population, globalization, and technological advances are three key factors that should dampen long-term inflation.
Our chocolate pretzel market is defying logic in a very nice way. We believe the stock market may continue to do well in 2022, although not as spectacularly as in 2021. We have positioned our stock portfolios with modest tilts toward a continued recovery by favoring U.S. value, small companies and real estate.
We believe interest rates will continue to increase in response to Federal Reserve policy and increased inflation and have positioned our bond portfolios to guard against rising interest rates.
We believe that the most important decision an investor makes is their policy allocation between stocks and bonds. We take inflation expectations and concerns into consideration when we help clients make this important policy decision. In our opinion, the best way to hedge against the long-term effects of inflation is to own equities in your portfolio. While they will be more volatile than fixed income, they should provide returns higher than the inflation rate in the long term.
We wish you much health, happiness, and chocolate coatings in 2022. If you have any questions or concerns, Rikki Don’t Lose That Number, please contact your wealth advisor or me.
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