Greetings, everyone!
For this quarter’s post, I have written a slightly longer piece to try and make some sense of what’s going on in the economy. The economy has been in the news a lot lately, either touting that it has been strongest we’ve had in recent memory or because of the sharp decline in stock prices throughout October. To really figure out what has been happening, it’s important to look at the health of the larger economy over time. That means we won’t be talking about the effects of things like tariffs, tax plans, or earnings, which are blips on the radar compared to the real workings of the economy. My goal in writing this is to shed light on why recent economic events have taken place and try to project where we go from here.
Let’s start at the last time the economy was really bad: 2007-2008. The U.S. was going through a recession that threatened the very existence of some of America’s oldest (and richest) financial institutions. The stock market has crashed over 30% and average Americans were losing homes, retirement savings, and nightly sleep. In response, the newly elected Obama administration enacted a relatively extreme measure known as Quantitative Easing (QE). QE essentially means that the U.S. government borrowed large amounts of foreign money to purchase trillions of dollars of government bonds and securities from banks and citizens. All those trillions of dollars then stimulate the economy when people go out and buy things or invest in companies.
By borrowing this money and throwing it into the economy, there were a number of pros and cons:
- Pro: The market made a huge recovery and had two good years in 2009 and 2010. This immense growth has basically continued for the next decade and is the largest reason we have the strong economy we have today.
- Con: Government debt ballooned. Without money being invested in government securities, the U.S. couldn’t pay the interest on the money they borrowed, and the debt grew to levels never-before-seen.
- Pro: Economic statistics like unemployment and wages improved considerably, meaning more people could start to gain back losses from 2008.
- Con: Fixed investments like savings accounts and certificates of deposit offered very low returns as interest rates severely declined.
I’d like to focus on that last “con” for a minute: interest rates. When the government put these trillions of dollars back into the economy, they intentionally lowered interest rates to make fixed investments less attractive. The hope here was that people would take money out of savings accounts and bonds and put them into companies to help the economy. If you were fortunate enough to buy a house over the past decade, you probably did so at an extremely low interest rate. Alternatively, if you put your money in a savings account or fixed annuity after QE took place, you probably received lower than average returns. All things considered, the lowering of interest rates had a huge impact on our economy rebounding after the financial crisis.
That brings us to today. While QE was likely the main reason we have such a strong economy today, those benefits don’t last forever. As the economy has continued to grow, so has inflation on the US Dollar. While we have seen wages go up for the past few years, inflation has actually driven the value of those increased wages down. This is what we call Real Wage Growth, which has been stagnant if not falling recently. It works like this: let’s say your boss decided to give you a 10% raise every year. If everything else stayed the same, you would probably be pretty happy! But now let’s say that every time you get a 10% raise, the prices for milk/eggs/gas/etc. went up by 15%. It’s easy to see how that raise you get every year doesn’t mean as much anymore. This is what we’re starting to see: people are making more money, but it isn’t keeping up with the increase in prices of everyday goods.
So what do we do to solve this? It all comes back to something we talked about earlier: interest rates. To bring our wage growth back to sustainable levels, the government tries to reverse some of the progress made from QE by raising interest rates. Raising the level of interest rates makes those fixed securities more attractive, so money flows out of the stock market and into things like government bonds and savings accounts. This will cut down on the impact of inflation, but also causes the stock market to lose value.
This process of raising interest rates has been well documented over the past year. The Federal Reserve, the governing body in charge of changing rates, has raised rates three times in 2018, with another raise reported to come by the end of the calendar year. When the Fed does raise interest rates (or even implies that they might raise rates), the stock market tends to go down. This seemingly inverse relationship between interest rates and the stock market should make sense: interest rates go up, people take money out of stock market to put them in fixed securities, stock market goes down.
Understandably, it’s never fun to watch the stock market slip double-digits in a single month, especially for those who invested through 2008. What I can say about the recent volatility is this: it’s actually a good thing. Similarly to how our government has checks and balances, our economy does, too. In this case, the Federal Reserve is that check. Without the recent actions taken by the Fed, the substantial gains we’ve seen over the past decade would lose a lot of their value and the long-term success of the U.S. economy would not be nearly as strong.
So what can we expect from the economy assuming that rates continue to increase? First, more market volatility. As more money exits the stock market to be invested in fixed assets, the economy will likely start to slow and the markets dip. Second, the federal deficit should start to go down. With more money going into government securities, there is an opportunity to use that influx of funds to pay off the immense amount of debt our country is in. Finally (and this may be the more important expectation), everything will be ok. These changes are not new to the world’s economies and the U.S. has gone through processes like this numerous times. I understand the anxiety caused when the markets are deep in the red, but sometimes a day of losses is exactly what the economy needs to stay strong into the future.
As always, if you have any questions or comments regarding this post or your portfolio, please give our office a call or email me at engstrom@centralwealthmgmt.com.
Opinions expressed are as of the current date and subject to change without notice. Central Wealth Management, LLC shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions contained herein or their use, which do not constitute investment advice, are provided as of the date written, are provided solely for informational purposes and therefore are not an offer to buy or sell a security. This commentary is for informational purposes only and has not been tailored to suit any individual.