Perceptions vs Reality in a Downturn | Sanderson Wealth Management

In today’s world, you don’t have to look hard for financial commentary; however, when the economy is struggling and emotions are running high, there’s a fine line between staying informed and succumbing to information overload.

Recently I sat down with John Gullo, Sanderson’s Chief Investment Officer and Chief Operating Officer, to gain his perspective on inflation, the markets, and the economic outlook. We strip away political bias and media hype to get to the heart of the matter. We hope this provides a clearer picture of what’s transpiring around the financial landscape, and what Sanderson is doing to put our clients in the best position possible.

Without further ado, let’s jump into the conversation.

John Gullo: There’s no question that inflation is high. We’ve seen it surpass 9% this year when typical inflation on goods and services is 2%, but I think the real question is, how did we get here?

If we rewind several years, we had the financial crisis in 2007 and 2008 where the whole financial system nearly collapsed. At that time, we worried that banks were going to fail, and millions would default on their mortgages. In order to get us through that terrible period, the Federal Reserve did a few things. First, they brought short-term interest rates all the way down to zero. The low interest rates made it extraordinarily cheap to borrow money and easy to spend it.

Another action they took was something called quantitative easing. This was a theory and had not been previously tested. Essentially, quantitative easing involved buying bonds and pushing cash back into the financial system. To put this into perspective, the Federal Reserve’s balance sheet was about a trillion dollars before the financial crisis. Very quickly, it ballooned to over four trillion. Fast forward—the financial crisis subsided, and we recovered. At that time, the Fed started to raise interest rates and began the process of normalizing things. Then COVID-19 hit.

To combat the pandemic, governments shut down large portions of the economy, and tell everyone to stay home. The economy begins to freefall. So, what does the Fed do now? They go back to their playbook, bringing interest rates back down to zero and buying bonds to push money into the system. This time, the federal government jumps in with forgivable PPP loans, checks going out to households, enhanced unemployment benefits, etc. When the pandemic receded and the economy reopened, everyone ran out to buy goods and services—except there was nothing to buy because most people hadn’t worked for months. When we combine supply chain shortages, a lack of finished goods, high demand, and access to cheap financing, we get remarkably high inflation.

Unfortunately, the story doesn’t end there. When inflation was already picking up in early 2022, Russia invaded Ukraine. On a humanitarian level, it's awful. Additionally, it caused energy prices to spike. Remember, Russia is a huge producer of both oil and natural gas, much of which is exported to the European Union. Again, we see inflation rise.

Now, we’re all wondering how long this will last. Recently, we saw readings of 8.2%, making everyone think things are improving; however, that figure is deceiving because if we remove food and energy (two things we all need) inflation actually increased from the prior month. In other words, all goods and services outside of food and energy are now going up because it costs more to ship items to where they need to go.

John Gullo: One of the biggest challenges for businesses right now is finding and retaining talent. Our unemployment rate is low and we’re still creating hundreds of thousands of jobs each month. What we don’t see in the news, however, is that there are 10 million open positions right now, but only 5.8 million people are actively looking for work. So, there’s a mismatch there for employers. If you have a business that’s hiring, you must lure talent away from competitors, which often requires higher compensation. Simultaneously, you know competitors are trying to poach your people. Plus, employees are dealing with higher prices, so they expect raises. That leads to wage inflation, which further increases the cost of goods. That’s the spiral we’re in now.

John Gullo: The Fed has contributed to this problem; they recognize that 0% interest rates can’t stay. So, they’ve been gradually raising rates. The first increase came earlier in the year. It was a quarter of a point, just a baby step. Next, we saw a half-point increase. After that, there were three increases of three-quarters of a percent. Historically, we don’t see the Federal Reserve moving rates by three-quarters of a point at once, yet it happened three times this year. Additionally, on November 2nd the Fed will announce its next interest rate decision and there is the potential for yet another three-quarters of a percent increase.

Another interesting thing the Fed is doing is telegraphing their moves in advance. We see press conferences after every Federal Open Market Committee meeting, which didn’t frequently happen in the past. They are communicating what they’re going to do before they do it. The reason is, they don’t want the market to get surprised and overreact when something changes.

We know everything in the financial world is interconnected, so how are inflation and the Fed’s actions affecting the economy?

We’ve touched on what’s happening here in the U.S., but what’s happening around the world, and how is it affecting the global markets?

John Gullo: The situation in the U.K. is a bit unstable at the moment. First, there is Brexit, which we haven’t heard much about recently, but it is still happening. The United Kingdom is leaving the European Union, the details of which have yet to be resolved, and the uncertainty is hurting their economy. On top of that, they are on their third prime minister in less than 6 months. Clearly, there are issues that need to be worked out.

The situation in Ukraine will be a serious problem for Europe this winter. They won’t have enough energy to heat homes and power factories. There’s discussion about cutting energy consumption by 15%, but that’s not easy to do and will have economic consequences.

Finally, there’s China, its zero-COVID policy, and its leadership. Unlike most developed countries that now deal with COVID through a combination of immunization and natural immunity, China will shut a city down at the inkling of an outbreak. Citizens are required to stay home, and factories are forced to close until millions of people are tested and cleared. As you can imagine, this policy is draining on the economy and tourism. In addition, President Xi Jinping was reinstated as general secretary of the Chinese Communist Party for an unprecedented third term, and there was a major reshuffle of the party’s senior leadership. Only time will tell what this will mean for the Chinese people, their economy, and the global balance of power.

How do all these factors influence the U.S. equity markets?

John Gullo: We’re experiencing substantial volatility right now. The financial markets love cheap money. Corporations can borrow money to buy back shares, purchase assets, or pay out special dividends, which all drive up stock prices. Consumers take out loans to buy property. The real estate market benefits from cheap financing. Now that we’re in this period of rising interest rates, it’s painful for stocks.

Next, let’s look at bonds. In a traditional 60/40 portfolio, we always think of bonds as being boring but necessary. Interest rates and bonds have an inverse relationship. Essentially, as interest rates rise, the price of a bond goes down. Typically, that doesn’t happen when stock prices are falling because investors get scared of stocks and rush into bonds, causing the value of bonds to go up. Right now, we have stocks and bonds dropping in value simultaneously. So, we don’t have the balance of performance in the portfolio we’re used to seeing.

If the traditional portfolio management strategy isn’t working right now, what can Sanderson clients expect going forward?

John Gullo:  We often tell clients to prepare for the storm when the sun is out. It’s when times are good that you position your portfolio for the rough patches. That’s precisely what we’ve done for our clients over the past several years. We’ve added alternative strategies to portfolios, to help reduce downside risk. We have introduced private equity, which can be less sensitive to changes in the public markets. We’ve also shortened our bonds inside the portfolio, so we’re holding shorter-term bonds that are less sensitive to interest rates. Over the past few years, we’ve done a lot of rebalancing, essentially trimming profitable positions that have increased in value and increasing safer assets that have not kept up. Again, we prepared when things were good, so we don’t find ourselves hammering storm shutters in the middle of a hurricane.

What are additional strategies we can look at for clients nearing retirement?

John Gullo: For clients in the spending phase, we set aside cash. We often have six months' worth of spending in many portfolios sitting in cash. We also utilize shorter-term bonds that we sell when times are bad. We’re looking to sell assets in the portfolio that haven’t been beaten up, and usually, there are a few years of distributions sitting in safer assets, and that allows the risky assets the time they need to recover. We do not want to be forced to sell securities at depressed prices.

For clients in the opposite position, those that are active savers right now, we’re taking advantage of the dislocations. We are strategically purchasing over time, a strategy known as dollar cost averaging.

In addition, we’ll look at opportunities to take advantage of the volatility, such as selling tax loss harvesting. For example, if we own an S&P 500 fund, we can sell it at a loss and buy a similar asset that also owns U.S. large company stocks. As a result, the investment portfolio will have changed minimally, but you now have realized a tax loss that can be used to offset gains elsewhere when it’s time to file your tax return next year. So, we’re trying to do what we can in the current environment to profit from it.

Considering everything we discussed today, what are you looking at for the rest of the year?

John Gullo:  What’s top of mind for me is inflation. We’re interested in where inflation goes and how the Federal Reserve responds. I’m also keeping an eye on jobs. If the labor market is going to be strong, that allows the Fed to raise interest rates.

Internationally, we have to wait and see how the war in Ukraine plays out. This unpredictable situation is going to affect energy prices and consumption in Europe. We’ll also look to China to see if they pivot with their zero-COVID policy.

As we approach the end of 2022, this is the time we start strategizing and exploring new opportunities, thinking through what tweaks we can make to the portfolio to better position our clients for the next several years to come.