Letter to Investors: The Allegory of the Cave and Shadows on the Wall
Updated: Aug 24, 2022
The shadows on the wall may not be an accurate representation of the reality of global monetary and fiscal policy.
Dear colleagues, clients and friends,
At some point in our lives, many of us were told the story of Plato’s cave. For those who may not recall, The Cave describes a story of a people who live in a cave, chained to the wall. They face a blank wall, and against that blank wall, shadows are cast by objects that pass by the fire behind them. The prisoners of this cave see the shadows, name the shadows, and the shadows constitute the prisoner’s reality. They never see the object, only the shadows. In reality, the shadow is only a fragment of what exists and what we would perceive through our senses. And in Plato’s writing, it is the role of the philosopher to understand that the shadows are only shadows – they represent a lower level of reality.
Today, most of what we hear and see around the economy and inflation are shadows on the wall. I have commonly said that my least favorite part about the current state of markets and the economy, is that its direction is currently dictated by the words and actions of one man, Jerome Powell. He is the Chairman of the Federal Reserve and is the primary representative of the central bank of the United States. Each time he opens his mouth, each time he writes an opinion, people react. Will he raise rates? Will he stop raising rates when the economy slows down? If he stops raising rates and commits the Fed to buying bonds, will that stop the markets from falling?
Instead of earnings, or competition, or management teams, entire sectors of the market move based on the anticipation of the next announcement from the Federal Reserve.
And while we will explore some of this conversation, it is important to recognize that this particular topic – what will happen to markets and the economy based on Federal Reserve rate hikes – is a shadow on the wall. While we care about the impact that these decisions have, it is often looked without context to a broader story. How often have you heard the question, “why does the Federal Reserve have so much influence over the market and the economy”? This question addresses the objects that are creating the shadows.
Record Jobs Growth and a Strong Economy:
We’ve heard this before, plenty of times. Turn on the tv, or scroll to your favorite investment guru on Instagram, and you’re likely to hear a lot about this. Supported by strong job growth and strong consumption, it is assumed that the economy can handle a few rate hikes to get inflation under control.
When we take a step back, and include things like record deficit spending, the context of the current numbers begins to take shape. In 2020, the global economy was shutdown. To avoid the spread of this new virus, we would need to keep people from interacting with each other. And since an economy is essentially the interaction of individuals through transactions, this meant shutting down the economy. When an economy shuts down, there are a few things we can expect. We can expect there to be massive amounts of unemployment – after all, how are businesses supposed to pay employees when they aren’t legally allowed to operate their businesses to earn revenue? With the increase in unemployment and the tragically low level of savings Americans have available, we would expect that there would be a continued economic domino effect, with people unable to purchase the things they need in order to survive. The nice-to-haves will no longer be purchased as the few dollars that people have will go toward things that are viewed as necessary, such as food, housing and utilities. So, in order to avoid this catastrophic result from shutting down the economy, our leaders in Washington devised a plan to save us – keep paying people, even if they aren’t working.
One might imagine that we have a US Treasury, so the money must come from there. In reality, our coffers are empty. There is nothing in the US Treasury but a promise to pay back the money they borrowed, plus interest, supported by their taxing authority of the American people. So with an empty treasury, how did we propose to support the entire economy? By printing money – or digitally creating money – out of thin air. No taxes levied, no treasures stolen from abroad. Just zeros added to a screen.
And with the money continuing to flow to the economy through government programs, we began to see a shift in the economic outlook. No longer were conditions bad for economic growth, they were now reporting numbers consistent with strong economic growth. Jobs were being added. Never mind that these jobs were being added in industries directly affected by the stimulus packages – the shadow, job creation, is what was important. And because of all of the new labor demand, competition in the labor market was heating up. Wages started to grow, and at a faster rate than we had seen in years – something that was considered missing in the economy for a decade. Never mind that wage increases weren’t enough to cover the loss of purchasing power, or that in the prior decade, companies had been paying increasing costs per employee through government mandated benefits and as a result, there was little wage growth – remember that only the shadow, increasing wages, is what was important.
So now, this booming economy (another shadow) was a problem. Because the economy was so strong, THAT was the reason for all of this inflation – not to mention COVID shutdowns! And now, with inflation continuing to eat away at the stability of Americans, it was finally time to do something – it was time to raise interest rates. And, it was said, that it would be a soft landing as we bring inflation to heel – but, we were told not to worry as the “strong economy” and the “strong labor market” would carry enough strength to handle rate hikes to tame record inflation not seen since the 80’s.
In summary, we had a weakening economy in 2019, we shut down the economy in 2020, we printed trillions of dollars in 2020, 2021 and 2022, we have a strong economy (not in any way dependent on the trillions of dollars we printed) and because that economy was so strong, we now have inflation in the form of price increases that we will be able to handle without hurting the economy. This, my friends, is a shadow on the wall. This is why people are surprised about the chaos in the stock market, in the bond market, in other alternative markets. This is why CEO’s of investment banks and the Head’s of their Economic department have “predicted” a recession “as early as 2023”. Meanwhile, we are staring at a second consecutive negative print for US GDP, which would mean we are currently in a recession.
The object casting these shadows is the money itself. It is the structure of government that sees no need to spend responsibly, but rather, only needs of people that can be met with government spending. Even if the money used never existed before it was spent.
Where do we go from here:
Naturally, information is great, but only in so much as it gives us access to a set of actions. So, given that the fate of the economy and markets rests on the decisions of one man (or one body, for those with a more technical mindset) – how can we approach this?
First, let’s consider what directions could be taken – either inflation, or the economy is the top priority, it cannot be both.
Inflation is the top priority: While Powell has said this himself, he has done so from a position in which he could claim the labor market and the economy are strong. If the data begins to refute this position directly, we will learn just how committed Chairman Powell really is. Assuming he says what he means, we can start to consider the outcomes. As inflation continues, the Fed will continue to raise interest rates. This increase in rates will make carrying debt more expensive and may disrupt the economy, leading to job loss. At its current rate, inflation will erode the purchasing power of households and the result will be purchasing more necessities and less nice-to-haves. What that means is that companies with low cash flow, who could see an impact to sales (think, who is going to buy a Tesla when they can’t afford to fill up their car with gas), with a large (especially variable) debt burden will struggle to stay in business. With falling sales comes a decrease in advertising spending, which will impact businesses who build their revenue from advertisements. In this environment, we encourage our investors to look for value-oriented companies with strong balance sheets and healthy cash flows. Dividend payors with a history of paying dividends in challenging economic environments can help to offset the volatility from the market. Commodities, managed futures and precious metals have historically benefited from inflationary environments – aggressive interest rate hikes could eventually take the wind out of the sails.
Economy is the top priority: We anticipate to some degree that if the economy struggles enough, it will be difficult for Powell to maintain an aggressive stance towards inflation. While this could come in varying forms (pausing rate hikes, lowering rates, buying bonds/stocks in the open market, etc.) the impact is relatively the same. We would anticipate the inflation to continue being a problem. If this is the case, then companies carrying a lot of low interest debt may benefit (growth oriented companies). Real assets, such as commodities, precious metals and real estate may experience a value increase in a similar fashion as 2020 or 2021. The winner in this scenario is inflation, and may signal a desire to move out of cash. We believe that the current levels of cash across the market is based on some anticipation of this scenario.
Prepare – have you ever heard the phrase, “when the tide rolls out, you see who’s swimming naked”? There is no way to predict when or if this tide will roll out – yet, if it does, the time to prepare isn’t after the tide has already rolled out. This environment, like any challenging environment, will put your long-term planning to the test. The planning that has been done leading up to these environments is what determines your outcome. Take this time to assess your cash flow, your balance sheet, and schedule a time to review any questions, concerns or opportunities that may be present for you.
Cash – Cash is king – kind of. While our purchasing power is decreasing, having sufficient cash to manage fixed costs will be critical to maintaining a long-term strategy. It is impossible to hold positions for the long-term if they need to be sold for cash to satisfy a near-term expense. If the Fed begins to show signs of losing the fight to inflation, then having cash on the sidelines to deploy to assets may help provide significant opportunity.
Fixed Debt Structures – while not easy to generate, a contractual line of credit with a fixed rate can help provide tremendous opportunity if the economy slides into recession/depression and market interest rates are high. These types of structures allow for arbitrage opportunity on the loan rates, as well as giving you liquidity to deploy for opportunities that may arise. Cash value life insurance not only provides protection through a death benefits, but can help satisfy cash reserves as well as provide contractually guaranteed maximum interest rates for loans.
Alternatives – Consider allocating your portfolio to positions that have different characteristics than the stock and bond market. Inverse funds can return the opposite of a market index (i.e. S&P 500¹) and give the potential for positive returns if markets fall. Consider allocating a portion of your portfolio to defend against a larger drawdown in the market. For long-term growth and downside protection, consider structured notes, which can allow for performance based on an index (i.e. S&P 500) with some level of protection to the downside (10%, 20%, etc.). This allows capital to stay at work in alignment with long-term expectations (2-5 years).
The Olivia Team
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 5280 CARROLL CANYON ROAD, SUITE 300, SAN DIEGO CA, 92121, 619-6846400. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly owned subsidiary of Guardian. WestPac Wealth Partners LLC is not an affiliate or subsidiary of PAS or Guardian. Insurance products offered through WestPac Wealth Partners and Insurance Services, LLC, a DBA of WestPac Wealth Partners, LLC. Olivia CA Insurance License Number - 0E57168, Olivia AR Insurance License Number – 2343024 | Combs CA Insurance License Number - 0I49903. | Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. | 2022-140466 Exp. 07/24
All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest rate, issuer, credit and inflation risk. Equities may decline in value due to both real and perceived general market, economic and industry conditions.
This material is intended for general use. By providing this content The Guardian Life Insurance Company of America and your financial representative are not undertaking to provide advice or make a recommendation for a specific individual or situation, or to otherwise act in a fiduciary capacity.
1- S&P 500 Index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the U.S. equities market. Indices are unmanaged, and one cannot invest directly in an index. Past performance is not a guarantee of future results.