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Piece of Mind Thumbnail

Piece of Mind

By Scott Poore, AIF, AWMA, APMA
Chief Investment Officer, Eudaimonia Group

This week's musings has it roots in one of the more under-rated rock bands of all time - Boston.  The band, which actually did originate in Boston, MA, recorded 6 albums over a span of 47 years, sold more than 75 million records, and as late as 2017 is considering recording a 7th album!  One of their hits, "Piece of Mind," is a song that most listeners don't even know the title, but can easily recognize the opening guitar riff when it comes on the radio.

Click on the Boston icon to sample "Piece of Mind."

Markets are volatile and the Fed is sending mixed messages.  The lyrics to "Piece of Mind" seem apropos to the current economic environment on multiple levels.  Let's explore the state of the markets and the uber-wise lyrics penned by Tom Scholz, founding member of the band.

"Now everybody's got advice they just keep on givin'
 Doesn't mean too much to me
Lots of people have to make believe they're livin'
Can't decide who they should be

I understand about indecision
But I don't care if I get behind
People living in competition
All I want is to have my peace of mind"

I Understand About Indecision.  Apparently, the Fed understands the concept of indecision perfectly.  On May 4th of this year, just over a month ago, Fed Chairman Powell stated that a 75 basis point rate hike was not being "actively considered" by the committee.  What did we get on Wednesday - a 75 basis point rate hike.  It would appear the the committee went from not actively considering 75 bps to implementing 75 bps in a relatively short time frame.  What changed?  

Well, last Friday's print of May CPI showed inflation continuing to rise.  When asked on the amount of rate hikes needed to rein in inflation, Chairman Powell stated Wednesday, "we'll know when we get there."  Wow - how's that for confidence building?  The Fed appears caught in an indecision loop between avoiding a recession - something Powell has publicly stated as a goal - and fighting inflation.  In order to fight inflation, the Fed is going to have to put on the brakes to the economy (i.e., raise interest rates).  If the Fed raises interest rates, we are likely to head into recession.  The Fed can't have it both ways at this point.

Real wages (inflation-adjusted) are down since the beginning of 2021, while inflation is up.  The consumer is already making conscious decisions to curb spending on discretionary items in favor of essential items.  This week's PPI (Producer Price Index) didn't provide much relief.  While the PPI did show some shift lower on a year-over-year basis, input costs are still higher than consumer costs (2.2% difference), giving a runway for CPI to increase from current levels.  According to the AG Economy Barometer, sentiment among farmers has shifted dramatically lower.  The barometer has declined 45% since the pandemic began to recede and is at the lowest level since 2016.  According to the survey used to calculate the barometer, 56% of farmers plan fewer machinery purchases compared to one year ago.  In the same survey, 66% of farmers are planning fewer building purchases from one year ago.  It's very possible that the PPI has not finished making new highs as input costs look to edge higher.  Now that trade has been cut off from Russia and China is engaging in financial combat, material costs are on the rise.  The chemical substance "urea" is used in all Diesel vehicles manufactured since 2010.  The substance is injected into the exhaust stream and used to reduce diesel emissions.  Diesel gas vehicles will not run without this substance - meaning transportation of goods will increase.  The #1 exporter of urea is Russia and the #2 exporter is China.  The cost of raw materials increasing may be far from over.

Now Everybody's Got Advice They Just Keep On Givin'.  Jamie Dimon, CEO of JP Morgan, stated earlier this month that there was an "economic hurricane" on the horizon.  He warned investors to "brace yourself" and stated that the bank was going to be "very conservative with our balance sheet."  While this analyst has no doubt of the coming recession, the latter part of his comment is more concerning to me.  The CEO of the world's largest bank in terms of market capitalization and the 5th largest in terms of total assets basically stated that they were already shifting to cash & cash equivalents.  Dimon also stated, "I kind of want to shed nonoperating deposits again."  What does this mean?  I believe will be facing a "liquidity event" similar to 2008, but perhaps different.  The primary area of concern is the Overnight Repo market.

The Repo (Repuchase Agreements) market has existed since before the "dot.com" crash in 2000.  Large Banks and lending institutions trade repos overnight to meet short-term borrowing needs and to raise capital.  In 2008, that overnight market "froze up" and liquidity quickly dried up, leading to the 2008 Financial Crisis.  In the wake of the pandemic, the Repo market has been largely non-existent, while the Reverse Repo market has exploded.  Banks are no longer lending to one another as they were in the Repo market, but instead are lending directly with the Fed in the Reverse Repo market.  This was not a major concern until March of last year when the Fed began lending in the hundreds of billions.  As of two days ago, the overnight Reverse Repo market had ballooned to $2.2 trillion!  Initially, it was thought that the Fed was trying to help tamp down inflation by reducing the flow of loans to help keep the "speed of money" low.  The unintended consequence now may be a false sense of liquidity.  If Dimon / JP Morgan, and subsequently other banks, decide that they want to make their balance sheets more "conservative" and reduce "nonoperating deposits," the direct lending with the Fed could end and the emperor would truly have no clothes.

Financial Planning Note:  Clients that are young should not be overly concerned about the current market environment.  Since 1950, the U.S. has experienced 7 recessions (8 if the current economy slides into recession).  That means we average a recession every 9 years.  The average 30-year-old client will probably experience 3-4 more recessions before they retire.  Economies expand and economies contract.  If you fall into this younger group of clients, you should work with your financial advisor to invest for the future, not what has happened over the last 150 days.

Clients that are retired or about to retire need to remain calm.  If you fall into this group, you should speak with your financial advisor to make sure there is sufficient cash in your portfolio to meet monthly/quarterly needs.  Review risk tolerance expectations with your advisor and understand that the economy will recover at some point.  Losses in accounts are "unrealized" until shares of investments are sold.  Manage the current risk environment by reducing exposure to risky assets and increase bond exposure if needed.  However, like all things in life, this too shall pass.