We have experienced a dramatic seesaw in both inflation and interest rates since the onset of Covid.

Both inflation and interest rates plummeted in early 2020 in reaction to the steep drop in economic activity from the government enforced shutdowns and Covid-instilled fears.

In early 2021, inflation changed direction. It began to rise in reaction to shortages in goods that stay-at-home consumers demanded. The Federal Reserve (Fed) was slow to respond with higher rates in 2021, believing inflation was “transitory”…that it would end quickly when supply chains were repaired.

Yet when inflation continued its upward momentum into 2022, the Fed relented and began to raise rates in April of that year. Inflation peaked at over 9% in July of 2022, but the Fed, way behind the inflation curve, continued its steep rise in interest rates all the way to July of 2023. By then it was obvious that inflation was trending down.

This allowed the Fed to pause further rate increases and assess if they had already done enough. They have maintained their rate target of 5.25%-5.5% ever since. Until Chairman Powell’s press conference on December 13th, the Fed maintained a “hawkish” tone that it was ready to raise rates again.

At that meeting, Powell surprised the world by discussing rate cuts in 2024. It was an indication that holding rates above 5% for much longer may do more harm to the economy than good for inflation.

Throughout this entire seesaw of inflation and interest rates, the Fed predicted that the long-term neutral rate was 2.5%. In other words, once this bout of inflation is in the rear-view mirror, the Fed Funds rate would likely average around this level.

A base rate of 2.5% is 0.5% above their inflation target of 2%. This spread over inflation is close to its average spread since 1926 according to Stocks, Bonds, Bills, and Inflation Yearbook (2023). This would provide a return slightly greater than inflation yet not be so high as to discourage economic activity.

Of course, the rate would likely go much lower during periods of economic stress and much higher in periods where the economy is growing well above its non-inflationary potential.

With a stable base rate of 2.5% on short-term deposits, bond yields should also normalize. In other words, yields on Treasury bonds would increase as maturities lengthened. Again, turning to Ibbotson, a normal spread for the benchmark 10-year U.S. Treasury bond would produce an average yield of just above 4% if the base rate was 2.5%. (As noted in our December 2023 Commentary, the long-term average of that bond since 1790 is 4.35%!)

All of this hinges on the Fed hitting its inflation target of 2% (on average). How realistic is that? After all, the Fed could not get inflation up to its 2% target for over a decade before Covid (it hovered between 1% and 2%). Then, it went way above its target with the dislocations of Covid. Inflation peaked in mid-2022 and has trended down ever since.

While there are no guarantees, there is room for optimism that the 2% inflation target will be more easily met over the next decade than it was over the last.

In my Perspective, Inflation and Interest Rates (January 2021), I noted the three forces that restrained inflation over the prior decade were demographics, digitization, and globalization. These were powerful deflationary forces in that prior decade.

Both demographics and digitization (technology, including AI) remain potent deflationary forces. Chart 1 illustrates the close relationship over time between the US birth rate and the inflation rate (averaged over 10-year periods).

On the other hand, globalization has greatly diminished in favor of re-shoring and near-shoring. While this new direction is overdue to secure needed resources, the higher costs associated with these are inflationary.

Other longer-term inflationary forces have arisen in the last several years including higher real wages and the costs of mitigating climate change. (Keep in mind that most of the costs of building a renewable energy source to replace an existing fossil fuel energy source are inflationary. They do not add to ec1onomic output, they simply replace what already exists.)

In other words, there may be a balance between inflationary and deflationary forces that gives rise to a slightly higher but stable inflation rate (2%) in the future. This would allow for the interest rate picture that the Fed envisions.

We have experienced a dramatic seesaw in both inflation and interest rates since the onset of Covid.

Both inflation and interest rates plummeted in early 2020 in reaction to the steep drop in economic activity from the government enforced shutdowns and Covid-instilled fears.

In early 2021, inflation changed direction. It began to rise in reaction to shortages in goods that stay-at-home consumers demanded. The Federal Reserve (Fed) was slow to respond with higher rates in 2021, believing inflation was “transitory”…that it would end quickly when supply chains were repaired.

Yet when inflation continued its upward momentum into 2022, the Fed relented and began to raise rates in April of that year. Inflation peaked at over 9% in July of 2022, but the Fed, way behind the inflation curve, continued its steep rise in interest rates all the way to July of 2023. By then it was obvious that inflation was trending down.

This allowed the Fed to pause further rate increases and assess if they had already done enough. They have maintained their rate target of 5.25%-5.5% ever since. Until Chairman Powell’s press conference on December 13th, the Fed maintained a “hawkish” tone that it was ready to raise rates again.

At that meeting, Powell surprised the world by discussing rate cuts in 2024. It was an indication that holding rates above 5% for much longer may do more harm to the economy than good for inflation.

Throughout this entire seesaw of inflation and interest rates, the Fed predicted that the long-term neutral rate was 2.5%. In other words, once this bout of inflation is in the rear-view mirror, the Fed Funds rate would likely average around this level.

A base rate of 2.5% is 0.5% above their inflation target of 2%. This spread over inflation is close to its average spread since 1926 according to Stocks, Bonds, Bills, and Inflation Yearbook (2023). This would provide a return slightly greater than inflation yet not be so high as to discourage economic activity.

Of course, the rate would likely go much lower during periods of economic stress and much higher in periods where the economy is growing well above its non-inflationary potential.

With a stable base rate of 2.5% on short-term deposits, bond yields should also normalize. In other words, yields on Treasury bonds would increase as maturities lengthened. Again, turning to Ibbotson, a normal spread for the benchmark 10-year U.S. Treasury bond would produce an average yield of just above 4% if the base rate was 2.5%. (As noted in our December 2023 Commentary, the long-term average of that bond since 1790 is 4.35%!)

All of this hinges on the Fed hitting its inflation target of 2% (on average). How realistic is that? After all, the Fed could not get inflation up to its 2% target for over a decade before Covid (it hovered between 1% and 2%). Then, it went way above its target with the dislocations of Covid. Inflation peaked in mid-2022 and has trended down ever since.

While there are no guarantees, there is room for optimism that the 2% inflation target will be more easily met over the next decade than it was over the last.

In my Perspective, Inflation and Interest Rates (January 2021), I noted the three forces that restrained inflation over the prior decade were demographics, digitization, and globalization. These were powerful deflationary forces in that prior decade.

Both demographics and digitization (technology, including AI) remain potent deflationary forces. Chart 1 illustrates the close relationship over time between the US birth rate and the inflation rate (averaged over 10-year periods).

On the other hand, globalization has greatly diminished in favor of re-shoring and near-shoring. While this new direction is overdue to secure needed resources, the higher costs associated with these are inflationary.

Other longer-term inflationary forces have arisen in the last several years including higher real wages and the costs of mitigating climate change. (Keep in mind that most of the costs of building a renewable energy source to replace an existing fossil fuel energy source are inflationary. They do not add to ec1onomic output, they simply replace what already exists.)

In other words, there may be a balance between inflationary and deflationary forces that gives rise to a slightly higher but stable inflation rate (2%) in the future. This would allow for the interest rate picture that the Fed envisions.

Since at least the 1970s, most Americans were brought up believing “white collar” jobs were preferable to “blue collar” jobs. This became so ingrained that many parents who held good blue-collar jobs wanted “better” for their children.

This was institutionalized in the late 1970s when liberal educators remolded our entire K-12 education system around the college preparatory track. The stated purpose was to prepare every student for college enrollment. The entire curriculum was rebuilt with this objective.

It is as if those in charge felt we no longer needed to prepare our kids for careers as factory floor workers, hairdressers, welders, waiters, sales clerks, or all the other trades that make up well more than half of our workforce.

Because of the elevated status of college degrees, many jobs that could be accomplished with far less formal training started to require a degree. This in turn led to a dramatic increase in college enrollment, college costs, and student debt.

During this same period, there was a dramatic decline in union workers. See Chart 1. In the first half of the last century, it was the unionization of the blue-collar labor force – particularly in manufacturing – that provided wages and benefits that often exceeded those of many of the white-collar workers of that day.

The decline in private sector unions is closely tied to the decline in manufacturing employment. In the late 1940s, manufacturing accounted for 32% of all jobs compared to 8.5% today. Many of those remaining manufacturing jobs migrated to “right to work” states in the south. Employers in these states had much more flexibility in setting pay and benefits.

In the more recent decades, globalization and technology have also had a profound impact on the decline in U.S. manufacturing jobs. Private sector unions fought rearguard actions to preserve as many jobs as possible with pay packages that would not accelerate the union’s decline.

This multi-decade cycle of the ascendance of white-collar work over blue-collar work may be over. The pandemic shined a bright light on the so-called everyday people without whom life crawls to a standstill.

Private unions appear to be in the ascendancy as qualified blue-collar workers, after years of neglect, have become scarce! The recently passed legislation to boost infrastructure and manufacturing within the U.S. has run into this roadblock. For example, Taiwan Semiconductor had to push back plans for their new facilities outside of Phoenix citing a lack of skilled workers to build the facilities.

In addition, private unions have won major new concessions this year in a wide variety of companies and industries including UPS, longshoremen, and the airlines. The current UAW strike reflects new extremes in union demands.

Many companies such as Target, Amazon, and Kroger have seen the writing on the wall and have voluntarily raised wages dramatically. Virtually all frontline workers have received much more recognition and pay since the onset of the pandemic.

At the same time, white-collar workers may be going the opposite direction. The Challenger Report tracks all layoffs in the U.S. Recently it reported that we may be facing the first ever “white-collar recession”. They noted that most layoffs this past year have been among white-collar employees.

Research from Goldman Sachs suggests that 25% of American jobs could be automated by AI, compared to approximately 18% globally. See Chart 2. A very high percentage of these lost jobs will be from white-collar employment. Whereas there is no AI replacement for your electrician, plumber, mechanic, delivery person, etc, those that work with and distribute data are much easier to replace.

Daily changes within our economy are imperceptibly small except in highly unusual circumstances like the impact of Covid. Yet our economy is always in a state of change, driven by powerful long-term economic forces.

Today, the dominant factors steering our economy are demographics, social strains, government policies/debt, geopolitical realignment, technology, and climate change. These forces will shape our future.

Demographics. The world population is getting older as people live longer and have fewer children. The decline in the (traditional) working age population will continue. See Chart 1. Without a pickup in productivity, economic growth will slow, and standards of living will stagnate.

Social Strains. For much of the past three decades a disproportionate amount of income and wealth creation went to a smaller percentage of people, particularly those with capital in either the private or public markets. Most of today’s wealth resides within the Boomer generation (and this is concentrated in the wealthiest 10%). See Chart 2. Also, low income wages stagnated as many jobs moved offshore while minimum wages barely budged. This has strained social cohesion.

Government Policies/Debt. Government spending has skyrocketed. Given the flood of new money coming from the Infrastructure, Chips, and Clean Energy bills (on top of Entitlements and Defense increases), it is not likely to fall off. And of course, so much of it is borrowed (deficit spending) that the interest bill to the Federal government is soaring.

Geopolitical Realignment. Francis Fukuyama’s The End of History in 1989 suggested that after the fall of communism, Western liberal democracy had “won” and may be regarded as the final evolution of human government. For a time, this notion gained wide acceptance. Yet history did not end and there has been a rapidly growing divergence between liberal democracies and autocratic governments, particularly since Xi Jinping became president of China.

Technology. Advancements in technology over the past several decades have irrevocably changed the way we live and work. From the personal computer to the internet, email, smart phones, Zoom, and on and on. Now we are told that AI (artificial intelligence) will change our world even more dramatically than its precursors and at a faster pace.

Climate Change. Climate change is real although the causes extend far beyond fossil fuels. For example, just the increase in carbon dioxide from California’s 2020 wildfires was estimated in Environmental Pollution (10/22) to be twice the total of all California’s reductions over 15 years.

How might these disparate trends interact to mold our future?

Efficiency to Resilience. This is the force behind reshoring and increased defense budgets. Interest rates will be higher, inflation will likely be higher too as we turn from free markets and free trade toward industrial policies and managed trade. In addition, the impact of weather events – flooding, wind damage, extreme heat, droughts – will take ever greater resources just to fortify what is in place. This implies higher inflation and higher interest rates than we recently enjoyed.

Reductions in Inequality. Entitlement reform is essential if we are to pay for the increased demands on government. (Reduction in benefits to the wealthy and higher paid will be necessary.)

Wages will likely continue to rise across the bottom half of the income spectrum as a shrinking workforce increases labor’s bargaining power. Income taxes are likely to be even more progressive along with higher estate transfer costs.

New Global Powers. China may “hollow out” as it suffers from a rapidly aging workforce (a result of the one-child policy) along with the rise in capital flight and out migration by some of the wealthiest and brightest. The Middle East and Africa are likely to gain increasing power due to younger demographics and commodity wealth. India should benefit from its young, tech savvy workforce.

AI, the Wild Card. While many worry about a tragic Terminator type of outcome, there is real promise in areas like education, health care, and routine back-office services. If we are to have the long-awaited productivity boom, this will be the source.

The earth’s climate has changed many times over its history from bitter ice ages to much warmer periods. One statistical relationship holds true through all these periods, the higher the temperature, the less ice in the arctics and the higher the ocean level. So one variable, temperature, changes the configuration of all land masses.

The level of interest rates plays a similar role throughout the economy and the markets. Higher or lower interest rates change the entire financial landscape.

Almost all lending rates are tied to the Fed Funds Rate, the rate for overnight lending by the Federal Reserve (Fed). One example of direct ties are margin loans for our clients at Schwab which are often quoted at 2.0% plus the Fed Funds Rate. An example of indirect ties are 30-year fixed mortgage rates which have no direct ties to the Fed Funds Rate, but have sharply risen for borrowers.

Carrying Costs. Higher interest rates raise the carrying cost of anything bought with credit… homes, automobiles, commercial buildings, capital equipment, inventories and so forth. See Chart 1.

As rates go up, fewer things are either affordable or make economic sense thus dampening economic growth. For example, a new business expansion that made good sense when the prime rate was 3.0% no longer works with its current 8.0% rate.

Less growth means less demand for goods and services which reduces inflation. This was the stated goal of the Fed as it raised the Fed Funds Rate over the past 12 months from effectively zero to now 4.75%-5.0%. It is working as inflation has steadily declined.

Housing is a good example. Home sales plummeted in 2022. As a result, the average home price came down (over 12 months) for the first time since the financial crisis. The ripple effects of less new housing are extensive – appliances, landscaping, furniture, and much more, all rise or fall with the housing industry.

Rollover Costs. After a decade of extremely low interest rates, most individuals and companies had financed their debts at very low interest cost, whether that be mortgages, bond issues, or virtually any other type of loan.

After the steep rise in interest rates over the past year, any debt that comes due, and needs to be rolled over, will jump to a much higher rate. This will reduce the cash available for other purchases, salaries, or capital investment.

Commercial Real Estate (CRE) will have its highest dollar amount of rollovers in a generation this year. Already, major property owners such as PIMCO and Brookfield have walked away from properties they owned. Obviously, there will be more foreclosures and bankruptcies ahead. Banks will also be much more hesitant to rollover CRE loans. See Chart 2.

Hurdle Rates. Higher interest rates directly impact the risk/reward equation within investment choices. The higher the rate on “risk free” money market accounts, the more serious the competition (hurdle rate) they offer to other investments. Less risk taking by investors means less investment in economic activity.

Portfolio Declines. As the yields on newly issued bonds rise, the market value of previously issued bonds fall. It does not matter whether the bonds are super “safe” U.S. Treasury bonds, corporate bonds, mortgages, or municipals. This is what caused 2022 to be an especially bad year for virtually all bond investors.

Summary. The higher costs of carry and rollovers, as well as foreclosures, mostly occur when loans mature or new projects are deferred. This is why raising interest rates has a lagged impact of 6-12 months on economic activity. Even if the Fed is close to – or even at – the end of its rate rising, the impact of today’s rates will continue to slow the economy throughout 2023.

Fortunately, most of the economic impact is from the interest rate itself, not from the credit quality of the borrowers or the underlying investments. This means that as interest rates come down, much of the constrained economic activity can resume. The question then becomes, when does the Fed believe its inflation objective is achieved enough that it can begin that process.

I find myself using this phrase often lately. Whether it is in stocks, bonds, investment real estate, money market accounts, gold, cryptos, or cash under the mattress… money must be somewhere. The concept of “money” is more of an accounting mechanism for balance sheets and income statements.

Every choice has its own characteristics which include:

• Upside potential (moonshot or steady eddy)

• Downside risk (erosion or wipeout)

• Liquidity (ease of selling at the current estimate of value)

As most clients know, I did extensive research on asset class performance in the late 1980s. I developed our proprietary Historical Risk/Reward Charts as a way of comparing the risks and rewards of each investable asset class to each other.

With this analysis in hand, I developed “ideal” asset allocations to meet the wide variety of investor objectives which were first presented in 1990.

Our Historical Risk/Reward Charts are updated annually to present up-to-date guidelines as to the risk and reward of each asset class and asset allocation since 1972. Within each Historical Risk/Reward Chart:

Risk is defined as the percentage decline during bear markets (such as the one we are in today) as well as the length of time the portfolio was “underwater” (the total months of decline plus the total months to full recovery).

Reward is defined as the average annual return the portfolio delivered above the annualized riskless rate of 30-day Treasury bills for the same period.

Table 1 shows the risks and rewards of Tanglewood’s four primary Investment Policies (IPs) as shown in their most recent Historical Risk/Reward charts (1972-2021). (A copy of these charts are provided in each client’s Tanglewood/Black Diamond Portal.)

Chart 1 contains both asset class and Tanglewood IP composite performance for the period 1/1/99 through 12/31/21. This is not an arbitrary period, 1999 is the first year that Tanglewood’s performance was audited in accordance with GIPS standards. Both gross and net returns are shown for our four primary IPs — Conservative, Moderate, Growth and All Equity. Expanded performance information is provided on page 11.

Our performance calculations were verified over 17 years before dropping the audit in 2017 due to its increasing cost. However, we continued to follow the same procedures in calculating performances. We recently made the decision to resume our outside audits which will begin with where we previously stopped.

Money has to be somewhere and the asset classes in Chart 1 are the primary portfolio choices. This provides an excellent backdrop for our performance.

A very important confirmation of Tanglewood’s performance relative to that predicted by our Historical Risk/Reward Charts can be derived from the chart. The rewards of Tanglewood’s net returns over this period are almost identical to the rewards shown in Table 2. We delivered the expected returns over this period net of all fees and costs.

For example, Tanglewood’s Conservative indexed benchmark shows an annual reward of 3.4% since 1972 (Table 2). Since 1999, Tanglewood’s actual Conservative composite has provided a reward of 3.5% (Conservative’s 5.1% net average annual return is 3.5% greater than the average 1.6% return from treasury bills over this period.) Tanglewood’s Moderate, Growth and All Equity composites are equally close to those of their expected returns.

Disclosures

There is a big difference between a “loss” from investments and a “decline” in current market value. Yet while a portfolio is experiencing a steep drop, like the one during the first half of this year, they both may feel the same.

I define a loss as a permanent impairment of market value whereas a decline is a lower market value that is temporary and fully recovered within a reasonable period. A portfolio loss often requires a change in lifestyle or a reduction of (anticipated) spendable income. A portfolio decline should require no adjustment to current plans.

One of the characteristics that often distinguishes the two is diversification. For example, owning one real property is subject to many local considerations, all of which can change and become more detrimental. Many single properties have experienced permanent losses in value over time.

On the other hand, owning a portfolio of real properties that includes many property types (apartment, office, retail, self-storage, etc.) – particularly if over several geographic areas — has rarely led to permanent loss unless excessive debt was used to purchase the properties.

This leads to a second source of losses, leverage. Many a worthwhile investment has turned into a loss for the holder because of too much debt on the asset. Leverage is a double-edged sword. It enhances returns during good times but can destroy them in down cycles. Limiting or avoiding leverage may be the single best way to avoid a permanent loss.

Owning the total U.S. stock market, despite its periodic declines, has provided enviable long-term returns, averaging roughly a 6% annualized return above inflation in every 35 year period over the past two centuries according to Jeremy Siegel’s Stocks for the Long Run.

Chart 1 illustrates the U.S. stock market’s annual returns from 1825 through 2020. The annual returns are categorized by ten percent increments. For example, on the bottom left of the chart is the year 1931 over the -50% to -40%. This indicates that it is the only year with an annual decline greater than 40%. There are only two additional years (out of 196) that had declines greater than 30%. The year 2008 was one of them which shows how brutal the Financial Crisis was while one was in it.

If the total U.S. stock market ends 2022 where it was at its recent low, down 23%, it would be only the seventh year out of the 196 in the -20% to -30% category.

As shown on the chart, the market has provided a positive return in seven out of every ten years, and a negative return the other three. Almost the same percentage has held true in this century through 2020. There have been five down years and sixteen up years.

Taking it one step further, portfolios built around professionally researched asset allocations can be tailored to limit the degree of decline during major bear markets.

Asset allocation makes further use of diversification by using multiple asset classes. This is what our Investment Policies have accomplished in the real world of investing for 32 years.

One final way of looking at market declines is through the path of travel. The total U.S. stock market was virtually the same price in late November of 2020 as it was at the end of June 2022. However, this price was at an all-time high back then. From November 2020, the market continued to climb reaching its cycle high at the very beginning of this year. Since then it has retraced those additional gains back to the November 2020 price.

Everyone was more than delighted with today’s price just a year and-a- half ago. If the market had declined first (after that November 2020 high), and then recovered back to today’s price, most investors would be ecstatic today…and yet it is the same price. The difference is only how we got here. For our perception, the path of travel is often more important than the price.