Jeremy Strickler

Credit Contraction

The early part of 2022 has given us declines in both stocks and bonds. That is happening because we are a in a credit contraction. Whether you think about rising interest rates, or the Federal Reserve bank or other central banks shrinking their balance sheets, those are both forms of the same thing: money is less available, and it is only available at higher prices. That is a credit contraction, money is scarce-er.

Normally, as the economy grows, we usually create new money. And certainly, part of the return on stocks is driven by inflation and monetary expansion. For the purposes of this discussion, please think about “credit” as money. It’s pretty easy to see it that way when interest rates were 1%, or you could buy a home for 3% interest. If you can get it, that money is almost free.

When credit expands, there’s more money available to buy assets, and prices usually rise: there are more bidders at the auction.  The system argues for owning assets and frankly, for borrowing money to buy assets, especially real estate: inflation generally pushes up asset prices, and it generally devalues the money you owe, making it easier to pay back in the future.

However, there are times when the money system needs be tightened up, and too much inflation is often a reason.  That’s what’s happening now: a form of quantitative tightening after a period of very loose money supplied to the markets to bring the economy out of recession due to covid. This is happening in the United States, which affects the entire world, and other central banks are also pulling money out of the system by selling bonds or allowing them to mature without re-purchasing more bonds or mortgages.

In general, stocks and bonds usually offer diversification from the other asset class. Stocks generally go up in a calendar year about 75% of the time, and US government bonds usually give a positive return about 80% of the time over the past 30 years. 

However, typical diversification strategies are unlikely to work in the near term: stocks and bonds can go down at the same time when the money supply contracts, and you can look back at periods in 2018 and 2008 for examples.  This credit contraction is also likely to catch up to real estate, with housing expensive, and interest rates between 5 and 6% after being close to 3% a year ago.

This is very frustrating for investors, and frustrated people tend to make more reactive decisions and forget the long term trends.

In my opinion, this is the biggest financial contraction we’ll see since the financial crisis. I don’t mean it’s going to be as bad,  it’s just that it’s a bigger tightening following a big expansion.  Investment managers will tend to scramble around looking for returns in this environment. Commodities? Hedging strategies?

Some of those may work, but I think it’s more important to put things into the larger context: most of the time you are trying to make money, but sometimes, you are trying to keep it. If you can hang on to most of your money during periods of weakness, the investments you can buy later are getting cheaper in dollar terms and can deliver good returns. Later.

In my opinion, this is the basic understanding investors should have this year.  If you have small losses, that’s ok. It can set you up for good returns later. Investment returns don’t come in straight lines, like interest being added to your CD. Investment returns come in bunches, with some losses at times: 3 steps forward, one step back is about the ratio.

Sometimes the steps back are small, and you don’t need to adjust your strategy all that much. Normally, it’s the right thing to hang on to assets. But sometimes the risks are larger, and the simplest decision we can make is to trade away some of the hypothetical upside to keep more money safe. Most of our clients are just fine with that. They’re not trying to beat the markets, they’re trying to live a happy life.

So, put things in context: Your best assets in the near term are cash in US Dollars and just a little Patience.

It is not too late to adjust your portfolio to the proper levels of risk for your personal situation. We’ve been telling you this for more than 6 months, but it’s not too late. Bear in mind, this is not an all or nothing proposition. We will continue to hold stocks through the cycle—at lower weightings than last year. Most of our clients will hold more cash, reducing both stock and bond holdings. We will use alternative strategies.

But there’s no substitute for knowing where you are and what’s going on. If it looks like a duck and quacks like a duck, it’s time to duck.

This material is provided as a courtesy and for educational purposes only.  Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.