AAF Wealth Management Quarterly Update
2021 was a year of big expectations, big headlines, and even bigger returns in the world’s financial markets. With hopes of putting pandemic lockdowns in our past, 2021 looked capable of ushering in a new era.
There were no shortages of headlines to divert our attention away from the economy. From political changes, to headlines talking about Non-Fungible Tokens (NFTs) and meme-stocks, signs were present early that 2021 would be a memorable year. While the public focused on the vaccine rollout during the spring and consequently looked forward to the “great reopening” of the economy, little attention was being paid to something lurking in the background that would come to dominate the news headlines during the second half of the year. By summertime, it had become very apparent that our dollars were not stretching as far as they once had; inflation had become a household word once again for the first time in nearly 40 years. And, like objects in the rear-view mirror, inflation was closer than the Fed would have had you believe.
Milton Freedman once quipped, “Inflation is always and everywhere a monetary phenomenon.” And to no one’s surprise, the trillions of dollars generated through various governmental stimulus packages enacted since March of 2020 eventually took hold causing prices to rise throughout society. In retrospect, it is not very difficult to see how a nation that generates 70% of its GDP from consumer activity would likely drive prices higher as lockdowns ended and personal consumption restrictions were eased. As the ‘Great Reopening’ of the US Economy took shape, a global supply demand imbalance quickly became a problem for the global economy.
It would not take long for consumers to feel the pain, and as we saw from December’s Bureau of Labor Statistics’ Consumer Price Index (CPI) reading, the cost of living increased 7.0% on a year over year basis. It cannot be underestimated how impactful this inflationary force can be on the American consumer. Assuming the current rate was to continue, below are a few estimates of how “real” purchasing power would decrease over various timeframes for a $500,000 nest egg:
- $500,000 @ 7.0% = $465,000 after 1 year
- $500,000 @ 7.0% = $402,178 after 3 years
- $500,000 @ 7.0% = $347,844 after 5 years
These figures are meant to provide context on how inflation can erode a consumer’s ability to make ends meet on a fixed income. Whether that spending occurs at the gas pump, when buying a new vehicle, or in the grocery store is immaterial; with a backdrop of higher inflation, nearly all items are likely to increase in cost.
There may be reasons to believe that some reprieve is possible as supply chains mend, consumer demand slows, and labor imbalances even out. A reduction in the level of governmental stimulus would certainly curtail inflation as well. At the same time, there may be other longer lasting cost pressures that compete with those that may ease. Wage inflation, higher energy prices, and industrial related natural resource/commodity costs associated with the “Build Back Better” Act could keep certain input costs high.
As one of the most talked about initiatives in the US and globally, for that matter, the efforts to move toward more environmentally sustainable power systems are likely to persist, and as such, will keep a bid under the price of required industrial inputs as the world continues to seek new ways to divest itself of fossil fuel usage and attempts to move more toward a more “electrified” way of life. The global drive to achieve sustainability, coupled with how the US Federal Reserve continues on with its monetary policy, will have a real impact on your investments.
What This Means for Your Investments
The most immediate need from a portfolio construction standpoint is to adjust our expectations as to what role fixed income will play in a portfolio. In the past, fixed income investments (bonds) held a dual mandate of providing some measure of cushion from the volatility of the stock market, while also providing some measure of performance that exceeded inflation. While we do still believe fixed income can provide that buffer to reduce portfolio volatility, it has become more difficult to achieve the second mandate of providing inflation adjusted returns. Since Jerome Powell’s testimony to Congress during the first week of December, the yield on a 10-year Treasury bond has moved from approximately 1.30% to about 1.73%. While .43% does not sound like a big move, it does have an outsized impact on fixed income returns over the long run, as bond prices normally move inversely with changes in yield.
One of the most important investment concepts that individuals should consider as they construct a well-balanced portfolio is the idea of diversification. The benefits of diversification extend beyond the ability to mitigate risks associated with being overly concentrated in a certain area of the market or a particular single investment.
Diversification, if conducted properly, allows for the reduction of risk and increase of performance by minimizing the covariance different investments have with one another. In doing so, performance can also be maximized along an efficient portfolio frontier, so to speak. As we stated earlier in this letter, 2021 was a tremendous year for the market as noted by the S&P 500 Index’s nearly 29% return. That said, most of the index’s performance was driven by just eight companies who comprised better than 25% of all the dollars invested in the index. Said another way: eight names garnered twenty-five cents from every dollar invested in the index, where the remaining 492 other companies had to split the other seventy-five cents. This is not necessarily a sustainable, nor repeatable, process that we would expect in the future.
This is not all to say that we have thrown in the towel for 2022 and believe it will be a year of negative returns for the markets. To the contrary—despite the noise of rising interest rates, a less accommodative Federal Reserve, and new covid variants—there are many reasons to be optimistic as we head into 2022. Corporate earnings, albeit slowing from year over year comparisons to 2020, are still strong. Interest rates are very low by historical standards, even if they’re showing signs of moving upward. And consumers are flush with cash as individual bank account deposits approached $3Trillion in value at year end.
In short, we recognize that the market’s performance in 2022 may well prove to be very different than that of year’s past as leadership may begin to change for various reasons. And unquestionably, a backdrop of higher inflation requires a new way of thinking about investment portfolios, and more specifically, one’s allocation to bonds. The need for selectivity has never been more important as the business cycle moves from the expansionary phase in 2020 to more of a “mid-cycle” phase in 2021 and beyond.
AAF Wealth Management advises investors in retirement or near a spending goal to assess short term cash needs. Ensure you are not over allocated to cash as inflation will eat away at the value of that money over time if we continue to see sustained higher levels of inflation.
Assess your fixed income composition to blunt the impact of rising rates on the fixed income part of the portfolio. This can include using individual bonds, underweighting fixed income within the portfolio, and expanding upon the type of fixed income used within a portfolio to lessen the impact of rising interest rates on the principal.
Reallocate your portfolio with a different focus in mind given the changes that have occurred since Covid-19 first made headlines in 2019. Those stock investments that flourished under lockdown conditions have begun to give way more toward reopening themed names, dividend centric plays, and more “value” oriented companies.
Financial planning is the heart of what we do here at AAF Wealth Management. Whether helping to implement an investment policy statement or architecting a family plan for a financial goal, we believe in being proactive in addressing the challenges that may arise. Developing a plan and staying disciplined is the key to achieving long term financial success.
AAF Wealth Management’s goal is to ensure our clients’ total financial picture is aligned, and that we are taking into account personal concerns and considerations as we help our clients in reaching their goals.
About AAF Wealth Management
AAF Wealth Management is a boutique Registered Investment Advisor (RIA) firm serving high net worth individuals and families. As an affiliate of AAFCPAs, Inc., we leverage shared knowledge with New England’s preeminent CPA and Consulting firm to provide insightful planning that considers the full range of tax implications to our clients’ financial lives.