Rough Waters Ahead?

Let’s dive into a few of the scary headlines over the past couple of weeks and then talk about the recurring theme of this year, inflation.

The Debt Limit

Is the US seriously considering defaulting on its debt obligations? It seems like we have this drama play out every couple of years.

What used to be the normal act of raising the debt limit has now become a political bargaining chip.

The stock market is currently pricing in that the US will raise the limit because a default on the debt would throw the country into a terrible recession, sending the stock market into a tailspin.

The irony here is that the money has already been spent, and both Republican and Democratic administrations have perfect track records of adding to the debt over the past two decades.

My take is that Congress will make the right decision and raise the limit instead of shooting itself in the foot. Of course, this may add some unnecessary anxiety until it is resolved.

China Risk

China has been in the news recently for a myriad reasons. The China based real estate company Evergrande appears to be headed for a $300 billion default.

At the same time, the Chinese government has outlawed for-profit education tech companies and now has an outright ban on cryptocurrency.

Evergrande brings back frightful memories of Lehman Brothers in 2008, and the risk that a default could ripple through the market, causing a chain of additional defaults.

At this point, it seems like the company will be able to raise money, and the situation doesn’t seem to pose an existential risk to the global market.

In other news, the Chinese government recently wiped out close to $100 billion in market cap overnight by outlawing for profit education tech companies. Everyone is wondering, what’s next?

The most terrifying reports are of human rights violations against the Uyghurs, which are an ethnic minority of Muslims located in the Xinjiang region.

According to Amnesty International, this includes forcing over a 1 million Uyghurs to internment camps to face imprisonment, forced labor, torture and genocide. Yes, this is actually happening in 2021!

Impact Fiduciary has recently cut its exposure to China and other countries involved with human rights violations by switching from the iShares ESG Emerging Markets fund to the Freedom 100 ETF.

The Freedom 100 ETF is a human-rights-focused fund that selects only the emerging market countries that have the most personal freedom. The objective is to avoid countries with abhorrent human rights violations.

This includes avoiding countries that don’t provide due process, freedom of expression, equal rights to women, or LGBTQ rights, and those that are complicit in slave labor, interment (re-education) camps, and other violations.

Freer countries have lower poverty rates, higher life expectancy, lower infant mortality, lower economic inequality, higher gender equality, and higher per capita GDP (related to lower poverty rates).

Impact Fiduciary’s goal is to invest in a better world and support the countries that share similar liberal values. There is also a strong economic argument that freer countries should attract more capital and perform better over the long-term with less risk.

Inflation

Is inflation a problem? Recently, over the past few months, there has been a fierce debate among economists and talking heads over inflation.

What exactly is inflation? Inflation is the general increase in prices over time and the loss of purchasing value. Remember when you could buy a candy bar for 50 cents?

Inflation currently stands at about 5.3% as of the end of August. This is over 60% higher than the 3.24% historical average. However, if you rewind to last August during peak covid, the inflation rate was only 1.2% so in this context it isn’t that high when averaged over two years.

The head of the Federal Reserve, Jerome Powell, believes inflation is transitory and mostly due to supply chain issues. The other side of the debate believes that high inflation is the new normal and that it could spiral out of control, potentially upending the pandemic recovery.

Why is this dangerous to the market? If inflation remains persistent then the Fed may be forced to increase interest rates sooner than expected in order to minimize the damage.

Higher interest rates can be a major headwind to stocks especially more growth oriented companies since a higher interest rate takes a bite out of future cash flows and increases the cost of doing business.

What else is driving inflation besides supply chain issues and low interest rates?

Remember, all the money printing last year due to the pandemic? The Federal Reserve increased the money supply from 15 trillion to 20 trillion in just one year!

This is an unprecedented peacetime increase in money supply and the cash is still working its way through our economy.

Cost of Living Increase

How does inflation impact your salary? It’s always a good idea to understand the effects of inflation on your paycheck. Say you start out with a salary that is $100k in 2020 and in 2021 you receive a pay raise of $3k.

You might not want to pop the champagne too soon. In this scenario you are receiving a 3% raise but you are actually getting paid less in real dollars if inflation is running at 5%. In reality, you are getting a pay cut for doing the same work!

You should always remember to ask for a pay raise each year and at the minimum it should be keeping up with the current inflation rate.

So, how should you manage cash, and how much is too much? You should always have an emergency fund of three to six months of living expenses as well as enough money to cover any planned short-term purchases.

However, if you have more than that, you may be doing yourself a disservice. In the long run you are much better off putting the cash to work in assets that provide protection against inflation. Real estate, crypto, and stocks have been a great way to hedge against inflation over the past decade.

Final Thoughts on the Market

Inflation could be temporary or it may be the catalyst for sending the market into a correction or even a bear market. It’s always hard to guess what will happen in the short term and it really shouldn’t matter.

Plan for the Worst but Hope for the Best

I always recommend zooming out and thinking about the big picture. Before investing any money, you should imagine how you would feel if your portfolio was down 10% or 20%. It may not be ideal but would you be able to ride out the volatility?

Taking yourself through this mental exercise can be invaluable when the long awaited correction or bear market takes hold and you realize it’s not the end of the world.

Are We in a Correction?

Corrections are a healthy part of the market cycle and are defined as a 10% decline or more from a recent high. According to Investopedia, they happen every 1.8 years and the typical correction is usually down around 13%.

It’s hard to say if we are headed for a correction or if we are currently in one. In most cases, the best course of action is to stay the course.

Think of market volatility as the price of admission for getting higher returns on your money over the long-term.

Overall, I’m extremely optimistic about how Impact Fiduciary’s portfolios are positioned to benefit from and help accelerate humanity’s march toward a more sustainable future.

Despite the challenges we collectively face, we are living through a time of amazing innovation and I believe this will translate into fantastic growth and prosperity over the coming years.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Patrick Dinan, and all rights are reserved.