“I can calculate the movement of the heavenly bodies, but not the madness of people.”
-Sir Isaac Newton
This month marks my 25th year in the financial services industry. I went to work for my Uncle Bob’s company, then named Keeling Financial Services, for a “trial run” in September of 1995 not knowing that a quarter century later I would be running that company – under a tweaked name – with total investment assets of over $130 Million*. It’s been a very eventful 25 years, for me personally and for the world at large. I don’t think anyone foresaw the pace of technological change, the shifting political dynamics, or the series of booms and busts that have manifested themselves over all that time. You hope with experience comes wisdom, and while I can’t tell you I’ve learned enough to see the future I have learned enough to know what I don’t know and approach this work with more humility in that knowledge than I probably would have twenty or even ten years ago. So, what does this combination of experience and humility tell me?
Back in those early days I was imputing a client’s financial data into a DOS based computer program that produced our financial plans. One of those statements really stands out in my mind, it was a mortgage statement with only a couple of months of payments left. The mortgage principal and interest payment were something like $115/ Mo. and the interest on the loan was only 5.5%. Both of these numbers astounded me. The fact that you could buy a house and make such small payments, and that you could get a mortgage for such an unbelievably low interest rate. At the time rates were 7.5-8% having dropped in the preceding years from low double digits. I never thought I would ever see a mortgage payment or an interest rate that low again; I was only half right. 30-year fixed mortgage rates hit the high twos about a month ago and have consistently been no higher than 4% for a couple of years now. That’s great if you’re buying or refinancing a house, but what about everyone else?
The danger with low rates for a long time was always thought to be inflation. From the mid-1970’s to the early 1980’s inflation was running an average of almost 9% per year. This was called the “stagflation” era when we had high inflation coupled with low economic growth resulting in people having less actual spending power even if they were still fully employed. The generally accepted way in which inflation was “broken” was when Chairman Paul Volker and the Federal Reserve, raised interest rates rapidly. Think of it this way, inflation is caused by too much money chasing too few goods. By raising interest rates the Fed is essentially taking money out of the economy so that condition no longer exists. This worked, it worked so well that annual inflation has barely gone above 4% for almost forty years. So, the opposite is supposed to be true, if the Fed lowers rates it will cause some inflation in an almost zero inflation world – which would actually be good for businesses and workers (but not retirees, as I’ll get to.) If the prices you can charge go up, if the salary you make goes up, and the interest you have to pay on your mortgage, car payment, business loan, is going down then people should be in a better financial position lessening the impact of a recession or at least juicing economic growth. After the financial crisis, just lowering rates and “in effect” creating new money in the economy wasn’t sufficient so the Fed actually began “really” creating new money in the economy by buying up bonds in the open market. After a brief period of stopping this and then selling off some of those bonds, the Fed has once again began purchasing assets in the open market to try and stem some of the financial impact of Covid-19. In this process they have made some very interesting announcements; first the general consensus of the Federal Reserve Board is that the Fed Funds rate will be kept under 0.5% until at least 2027, and second, and perhaps more important, as inflation has been so much lower than the Federal Reserve’s target of 2% over the past many years, the Fed will allow inflation to rise not until it gets to 2%, but until if “averages” 2% over some time period of which they are not very clear.
But we’ve had plenty of inflation over the past decade no matter what the Fed wants to say. It just hasn’t been nice and spread out across the economy and in my view the way the Fed calculates that inflation is greatly misleading. The Federal Reserve uses an inflation gauge called the Personal Consumption Expense or PCE, rather than the Consumer Price Index, or CPI that we all see quoted in the news. The CPI itself isn’t a great inflation measure, but let’s leave that aside. The PCE takes the inflation rate of various things; cars, housing, clothing, medical care etc. each quarter. So far so good, these numbers are all pretty accurate in and of themselves, but it’s where the sausage gets made that things go a little awry. The PCE takes that Housing number and makes it 27% of a person’s expenses, in reality housing is closer to 32% of the average person’s expenses. It also uses the Medicare and Medicaid reimbursement rate increases to determine health care inflation – Medicare and Medicaid’s reimbursement rates are set by the Government and informed by Government inflation data. Basically, it’s a snake eating its own tail, the inflation rate is set by the increase in Medicare and Medicaid reimbursement rates, and Medicare and Medicaid use that inflation number to increase their rates each year. In reality, the cost of health care is going up far more than is captured in these numbers, and as health care becomes a larger and larger part of the average person’s yearly expenses it should therefore become a larger part of the inflation rate – but it does not. So, the Fed is going to use a flawed number to gauge what actual inflation is, and allow that inflation number to go much higher than their 2% target to “make up” for the low inflation of the past. But what does the low inflation of the past have to do with anything? We’re in the middle of a pandemic induced financial crisis – any benefit anyone has gotten over the past ten years of low inflation doesn’t somehow isolate them from higher numbers in the future. As stated, this lower number is really a myth anyway.
For retirees this is an even bigger problem. I’m always fond of saying that in the past people were cheap and things were expensive and now things are cheap and people are expensive. I don’t say this like it’s a bad thing, I think as a society it’s a good thing, but it is a fact. Pre-WWI it wasn’t unusual for a professional person; a lawyer, doctor, accountant, to have a live-in maid and perhaps a valet. You could easily afford a maid, usually a youngish, un-married woman who would work for room, board and a very small salary. But that same maid, along with “the woman of the house” would also be in charge of darning socks, mending shirts, sharpening knives and polishing silver – because those things were very expensive, the same family that could afford full-time staff couldn’t afford more than two pairs of socks and perhaps only one pair of shoes for each person. Much began to change in the early part of the last century, and that change accelerated after WWII. The cost to manufacture everyday household items; clothes, shoes, toothbrushes and then eventually televisions and even tools, dropped to price points were almost anyone could afford to have lots of socks, lots of shoes and a couple of televisions in the house; but the cost of hiring people to fix your plumbing, take your blood, balance your tires or cut your lawn has gone up and up. When the Fed talks about letting inflation run higher than their mandate, not only is that generally unclear; “how much? For how long?” it also should be troubling for all of you. As it is during retirement that you begin to spend more money on services and less money on things.
I bring this up rather than the stock market because it matters more. I know that sounds strange, but bear with me. The stock markets can go down and have periods of bad performance. With Covid and an election coming up the stock markets could be more volatile than normal; they could even begin to understand what’s going on with the economy and go down. But that doesn’t concern me. The money my clients need to pay their bills for the next several years is not in the stock market. Short-term money is in short-term investments. The stock market is long-term; and whether a vaccine becomes available in October or February, and who wins the election in November has very little impact on where the stock market will be two more Presidential elections in the future. Your balances might look bad, you may lose money on paper – just like everyone did back in March and April – but if you don’t need that money to buy the groceries this month it’s not actually a big deal. What is important is the money in other places, the bonds and cash where we keep the short, and medium-term money. Those are the accounts where interest rates are important and those are the accounts where these low rates have been and will continue to harm your earnings. If you put $1 Million dollars into a ten-year U.S. Government bond as of this writing, you get less than $550 / Mo in income. If the Fed lets inflation run at say 2.5%, and you have to pay taxes on that bond return, at the end of the year you would have lost $20,000 in purchasing power. Now of course there are alternatives to U.S. Government bonds – not as safe by any means – but alternatives. There is also of course, the real inflation rate and if the Fed is going to let their rate, which already runs about 0.5% behind the CPI and doesn’t take into account the percentage of income that retired people pay on services and medical care, run high then even with these other alternatives it’s going to be next to impossible not to go backward in your short and medium term investments after inflation and taxes.
Back to that 25 years of experience and knowing what you don’t know. Late-20’s me probably would have taken it at face value that the Federal Reserve’s recent actions were going to cause runaway inflation and even as I’ve criticized the Fed’s inflation gauge in this article and think it isn’t reflective of the true lives of my clients, it’s not like inflation has been crazy either. Sure, it’s probably been a point or two higher than the Fed’s estimates, which over time is a big deal, but it hasn’t even approached the rates we saw twenty or thirty years ago. What I’m getting at is, my experience tells me the Federal Reserve saying it’s going to let inflation run high and then inflation actually running high are not the same thing. They’ve been trying to get the inflation rate up to that arbitrary 2% number for a decade now and haven’t succeeded. You see The Fed doesn’t control the inflation rate; they control other things that they hope will influence the inflation rate. But what The Fed does control are interest rates. So just like my story about never expecting to see mortgage payments and interest rates that low ever again was half right, my story above may only be half right as well. Interest rates are sure to stay low, but whether inflation runs higher because of it is anybody’s guess. But even at a 1 or 1.5% inflation rate, today’s interest rates barely keep you even in a diversified bond portfolio. This means perhaps looking outside the box with the “medium” term money; allowing yourself to lose some purchasing power on the short-end in exchange for lower risk, keeping the long-term money in the stock market and hoping as it always has in the past, it will be higher ten years from now than it is today, but taking that 3-7 year money and looking at other options. I’m not going to go into those options here, for my clients we’ll talk about it individually as time goes on and for those of you who are not yet clients, we’d be happy to discuss this topic when we finally get to meet with you.
I hope everyone had a great summer. It was an unusual one to say the least, but it did allow me some time to do something I’ve never done before. See the article below for more information
*As of 9/10/20