riptide-financial

A Walk Down a Dangerous Fed Induced Memory Lane

steve@firstdownfinancialinc.com (Stephen Vettorel) — Wed, 19 Oct 2022 16:44:41 GMT

I would like to tell you a tale that might teach us all a lesson or two about what’s coming, a walk down FED memory lane if you will... As many of you know the 70s were characterized by deeply negative real interest rates as well as rampant inflation rates. Borrowing boomed, both public and private. So did asset bubbles. Because financialization of the economy had not yet benefitted from de-regulation, asset bubbles were more localized. Farmland in places like Nebraska and Kansas and oil rich land in Oklahoma. Farmland, mineral rights, rigs were used as bank collateral.

Land prices rising led to more valuable collaterals that led to more borrowing that led…you know the gig. Oil rigs were booming in the same way. Investments going through the roof on cheap borrowing. Mineral leases, energy loans, you name it.

You know how this ended. Volker doubled FFR to break the psychological vicious cycle of price and asset inflation. The need to shock and awe was the result of years of negative real interest rates as Fed stood by idly watching the economy spin in price/asset bubble frenzy.

Volker succeeded as you know, and inflation was brought back under control, but farmland prices crashed by almost 30% and oil tanked from $ 120 / b to…$ 25 /b over a few years. And as a result, > 1600 banks collapsed in the aftermath of this asset bubble popping.

To put this number in perspective, the Global Financial Crisis saw a total of less than 400 US banks collapse over 2008-13. Asset price collapses => bank collapses => contraction of credit. Unemployment hit 10%.

Let’s break down the mechanisms at play. Fed enabled and encouraged lending growth. Animal spirits led to unbridled speculation on the value of assets. Banks played their role in facilitating the self-reinforcing nature of this speculation.

Then the music stopped. Levered players got wiped out. Late buyers got wiped-out. Collateral value collapsed. Banks went bust. All throughout that inflationary/asset bubble cycle there was a prevalent school of thought that blamed inflation on…supply cost push. Sounds familiar?

Lots of organizations got blamed. Unions for fueling wage-price spirals. Middle Eastern oil cartels for juicing up oil prices. Price and wage controls were imposed then failed. Sounds familiar?

But Fed’s own research advanced an explanation based around the notion of « monetary policy neglect » which refers to this obstinate policy of negative interest rates in the face of evidence of excessive lending and demand fueled price pressures. Sounds familiar?

This gets us too today. Are there any similarities in the way Fed has conducted monetary policy during this bout of inflationary burst? Fed used same policy tool as in the 70s by maintaining large negative real rates in the face of a shift in the fiscal paradigm.

Negative real rates with trillions spent directly on stoking demand (totally including mis-timed tax cuts). But that’s not all. This time Fed introduced a new policy since GFC and that’s QE. It did many rounds of it but then went unhinged in ‘20 with the COVID shock.

While QE is unambiguously not directly inflationary, it does have an incidence on persistency of inflation. If I was to lay out very simply, it would go like this. QE has a very powerful signaling effect. You have the largest player in the market with unlimited B/S buying unholy amounts of a certain asset. That signals that the price of such asset will be supported well into the future. As it happens, that price is the reverse of the cost of capital.

As a result, and given the absolute certainty that this cost will be kept under control into the foreseeable future, what does any rational economic player do? Load-up on debt and buy assets. Or load-up on debt and spend if you are a government.

And so, debt (corporate + sovereign) went into the stratosphere. This did fuel an asset bubble as many channels directed proceeds of leverage into assets. Buy-backs are an example. Leveraged loans another. Margin loans. Mortgages…you name it…

Enters inflation. We did specify that Fed went ballistic just as demand side was being stoked by unholy spending. So, there are clearly elements of monetary policy neglect at play. Anyway. Enters inflation when sovereign and corporate debt has increased a lot.

Take your pick whether you want to measure in absolute or as % of GDP or whatever. But corporate and sovereign debt increased a lot. So comes a time when inflation is rising fast and rational economic player will develop serious doubts as to the system’s collective ability to repay all this debt. So, it starts making sense to dump all this load of debt and buy some more assets (resources, physical, energy and consume more). This is the point when the pile of negative yielding debt contracts massively. That tipping point is now.

Debt will continue to be sold until it reaches a level that is deemed sustainable. Fed’s awakening after slumber will only reinforce this dynamic. That’s a long way from here. Now will that lead to a pop in various asset bubbles? Yep. We are certainly seeing that now in the stock markets 25+% decline. Will we see bank failures? Yep.

But there are obvious differences. Mostly, bank lending was far from unbridled this time around. That’s because banks are in a better reserve and regulatory place than they have ever been in a while, and that can be credited again to Volker and Fed Corollary, a lot of the dirty work got lifted by a swath of shadow banks that are less regulated. In return these get financed by traditional banks but not through traditional loans. Think Archegos blowing up but costing banks money after all.

Last difference is that current bubble proportions are biblical as financial markets got infinitely more complex and inter-connected, with lots of illiquidity and counterparty risks built in.

As I always mention on my weekly podcasts, I could be wrong. But I feel that walk down memory lane could be quite brutal this time around. Seek safe assets to protect your wealth!

Bond ALERT! Safe Growth Alternatives

steve@firstdownfinancialinc.com (Stephen Vettorel) — Tue, 03 May 2022 19:36:17 GMT

“As interest rates rise, they can have an adverse effect on a bond strategy”

With consumer interest in fixed indexed annuities skyrocketing, can FIAs supplement a bond strategy as part of the “Rule of 120”?

As clients get older often tolerance for financial risk decreases. With less time to recover from market losses, it may be important to educate clients about risks and diversification.

The Rule of 120 (previously known as the Rule of 100) says that subtracting your age from 120 will give you an idea of the weight percentage for equities in your portfolio. The remaining percentage would typically be in a more conservative fixed income investment like bonds. Typically, in the form bond funds or an individual bond ladder. So, a 60-year-old client should have 60% in equities (120 – 60) and the rest in bonds (40%).

Bonds have typically been the go-to income play and are often seen as a way to add some stability to a retirement strategy while generating some income.

However, increasing bond holdings as a way to balance a portfolio or to reduce exposure to volatile equity markets might not be the only move.

As interest rates rise, they can have an adverse effect on a bond strategy, especially the value of an individual bond before the maturity date. Bonds have historically been seen as a more conservative investment to protect against market downturns-typically designed to deliver regular dividends, and in the instance of individual bonds it's held to maturity generally return the original investment or principle. But now, with rising interest rates those bond instruments also come with additional risk which we have certainly seen in Q1 2022 decline!

Strategies that offer income and growth potential

Fixed index annuities (FIAs) can add diversification to your clients’ portfolios and help offset rising interest rates. FIAs can support these financial objectives because many of these products have interest crediting strategy options that are tied, in part, to equity indices (such as the S&P 500) that offers some upside potential while providing downside protection against market losses. And with more consumer interest in guaranteed lifetime income, strategies that offer opportunities to build potential for a larger retirement income stream could fit with your clients retirement goals.
So while the Rule of 120 may still apply, bonds might not be the only answer to consider when creating a more balanced portfolio for your clients. Explore fixed index annuities as a strategy to help them mitigate downside market risk and offer potential upside market growth.

SEQUENCE OF RETURNS RISK: IS YOUR PORTFOLIO IN THE RED ZONE?

steve@firstdownfinancialinc.com (Stephen Vettorel) — Wed, 01 Dec 2021 18:33:08 GMT

Do you use the appropriate retirement income strategies to reduce sequence of return risk?

In football, the space within 20 yards of the opposing team’s end zone is known as the Red Zone. The goal is so close the offense can taste it. But the defense knows they’re in trouble, so they step up their game. Scoring in the Red Zone can be very difficult.

The same can be said of saving and planning for retirement. The closer the end zone (retirement), the more difficult it can be to make progress toward the goal, and any fumbles in the market could mean big trouble.

How many individual investors understand the dangers of the Red Zone, a.k.a. the “Fragile Decade,” that 10- year period surrounding retirement in which the sequence of events and decisions made will have the greatest effect on retirement outcomes?

Even if they’re aware of the Fragile Decade, do they understand that the right strategy for success in the Red Zone may look different than what they’ve done the last 25 years? If you fall into this category, there’s a good chance you’ll need to craft a more custom retirement income approach around these critical years.

Investors approaching their targeted retirement date in five years or less need to identify not only items such as how much income they’ll need, when to enroll in Medicare, and how to optimize social security, but they should also adjust their asset allocation in order to minimize sequence of return risk.

There has been extensive research on sequence of return risk and which retirement income strategy makes the most sense for pre-retirees and retirees (probability-based or safety-first?). The work in this area is invaluable as investors approaching retirement should assess their ability to retire using numerous factors and modify risk exposure as their human capital moves closer to zero.

While advisers employ various types of retirement income solutions for clients, a solution we often find useful is a rising equity glide path. While it’s not for everyone, it can be used to:

- Reduce portfolio volatility

- Employ academic evidence for a valuation-based approach

- Help investors who can’t afford to take significant equity market risk

- Assist investors who desire a probability-based approach, but fear and behavioral reasons loom The challenge is this may seem counterintuitive to many. We want to help our clients understand today’s environment, their own individual risks, and show them how our advice will improve retirement outcomes.

When determining an appropriate asset allocation or glide path approach, it’s important to be mindful of key considerations and individual objectives:

1) Would a steep equity market drop in the near-term have a significant impact on you as you are approaching retirement?

Most of you would probably say yes; however, your adviser may be the only one who knows the real answer. It’s their job to educate and understand whether this would be the case and how to structure your individual retirement income solution accordingly.

2) Will you have the ability or desire to maintain a flexible spending approach in retirement to account for market fluctuations and other conditions?

Often this depends on your view of essential vs. discretionary needs. Some individuals may view all of their needs as “essential” given how hard they have worked to be able to retire. Your adviser can also help you understand why maintaining a flexible spending approach can help improve your outcome given the current interest rate environment and market conditions.

3) Is your adviser able to effectively communicate this type of approach with you?

This kind of discussion needs to be approached deliberately and cautiously. Whether someone is using a total return, bucketing, or rising glide path strategy, individual investors may not understand the difference. That’s where your adviser comes in. They can help you understand how these types of approaches may improve your outcome in retirement.

With the large number of individual investors currently living in the Red Zone, it’s important they are not exposed to excessive or unnecessary portfolio risk. Advisers are your offensive line, watching out for obstacles and danger. This is a significant opportunity to create customized solutions for you at a time when you need it most.