In our note to you last quarter, we contemplated the possibility of increasing financial uncertainty on the horizon. Would the uptick in inflation be a temporary phenomenon or potentially something more daunting? While those questions remain largely unanswered, what has become abundantly clear is that the stakes are increasing. Prices have leapt even further over the last three months, with Core CPI increasing from 5.48% at the beginning of the year to 6.50% as of the end of March.1 Even more pressing is that Core CPI excludes food and energy costs, two critical areas of expense for most families. Food prices have increased 8.8% over the last 12 months and energy has increased by 32%, fueled greatly by Russia’s vicious attack on Ukraine.
We feel it important to point out that inflation isn’t always entirely a negative phenomenon and in fact may be preferable over its reciprocal: deflation. Inflation may be a signal that the economy is growing well, with consumers’ appetite and ability to purchase things at a strong level. Substantial spending boosts economic growth, often increasing wages and instilling confidence. Economically, these are generally good things. In contrast, periods of deflation may lead to families and businesses curtailing spending, hoping that delaying purchases will enable them to buy what they need for less money. As you might expect, this often leads to a sputtering economy as growth stalls due to a lack of consumption. But then why the worry about inflation? While modest levels of inflation are positive, as inflation creeps higher, the darker side of price hikes becomes a troubling reality. People on a fixed income, particularly retirees, are vulnerable to getting squeezed, which is an untenable situation that must be reconciled. Chairman of the Federal Reserve Jerome Powell has expressed as much, leading to the Fed initiating a tightening campaign.
However, additional factors compound the Federal Reserve’s efforts to manage inflation. Shortages of goods and services from disrupted supply chains due to COVID-19 have contributed to higher prices as much as absolute demand. Lockdowns meant people were traveling less both for work and for leisure, eating out less, and going to fewer entertainment venues, among other things. At the same time, work from home and fiscal stimulus packages increased the demand for certain items such as tech products, cars, and furniture. These changes resulted in an overall shift away from consumption of services and toward consumption of durable goods. The sudden increase in the demand for these goods and the global nature of the pandemic exposed vulnerabilities in the global supply chain. For several years, firms had moved from doing everything in-house to outsourcing parts of their production processes to other countries as a means to lower costs and increase productivity. The figure below shows an illustrative supply chain for a simple can of tuna!
As you can imagine, the more involved the product, the more complex the supply chain can be. Lockdowns in various countries thus made it harder to finish products, leading to shortages, hoarding, and higher prices.2 The lower labor participation rate post-pandemic and the spike in energy prices from the war in Ukraine made matters worse.
Thus far, consumers have simply shrugged off the price hikes and kept on spending, but there are levels at which higher prices affect confidence, instilling more of a ‘hunker down’ mentality. This possible consumer retrenchment, coupled with the Federal Reserve working to slow inflation, could ultimately cause economic growth to slip more than anyone desires, potentially even leading to an economic decline, or recession.
The United States has been through seven recessions over the last fifty years, with an average length of about 10 1/2 months. During these periods, unemployment often rises, and by definition, economic growth falls, with the average decline being 4.9%. The average decline, though, is highly skewed by the COVID recession, where GDP dropped by 19.2%. The COVID recession doubles the average of the declines over the last seven recessions.
Economies do not grow in a straight line, and periods of recession are nothing to be overly alarmed about, so long as we have appropriate time parameters assigned to our investment style. They have and will be part of the economic system. Trying to predict a recession, either its probability of occurrence or magnitude is a daunting and often unrewarded bet.
So, how does Cribstone make decisions in a period of such uncertainty? Our goal is to be steady thinkers, focusing on what we believe increases your long-term probability of financial success. Making frequent large bets on the direction of the economy, equity market, interest rates, or inflation is incredibly difficult to do with any accuracy. For example, the health of our economy certainly has not improved meaningfully over the last five weeks, and some might say that things have possibly gotten worse. Yet from March 7 to March 29, the S&P 500 rallied more than 10.04%. Some of this rally has been yielded back since, but markets are still up roughly 6% since the March low. Cribstone focuses on process, owning segments of the market, and companies that we believe will deliver financial rewards through a full market cycle, and we are very conscious that over short periods of time, markets can be very irrational.
We also focus quite persistently on risk. When we have years like 2020 and 2021 where the S&P 500 are up 18.40% and 28.71% respectively, we will rebalance your accounts by reducing exposure from these outperforming areas to return back to the risk targets that we have identified together. Unfortunately, for taxable accounts, this typically creates a negative impact on your tax return, as both most states and the federal government would like a share of your profits through the taxing of capital gains. We work very hard to manage the tax costs of your accounts to the absolute minimum, but need to balance that with the risk parameters that we have agreed upon. We are conscious that by letting risk run, when markets do pull back, you may see a level of decline that you are uncomfortable with from choosing to reduce risk at the worst possible time. This could be quite impactful to your long-term financial health, and something we desire to avoid. We of course always welcome a discussion about risk exposure and tax strategy and would be happy to address this in greater detail at our next meeting if helpful.
Lastly, we are tremendously excited to announce two new members of the Cribstone team. First, most of you have either met or spoken with Caroline Palmatier, who joined us last Fall. We knew then that she would be having a planned break in March as she welcomed a new member of her family. We are so pleased to announce that Caroline gave birth to Ari Thomas Palmatier, a beautiful and healthy baby boy. Everyone is doing quite well and we look forward to having Caroline back at Cribstone in May. While Caroline is out on maternity leave, B Roy has joined us to help us manage the workflow. I’ve known B for many years, primarily through her prior employer. B decided to take a short break from her retirement and has jumped right in during Caroline’s absence. We are tremendously pleased to have her.
We appreciate your relationship and are here to help in any way that would be meaningful to you.
Scott Upham, CIMA® CPWA®
Contributions were made to this letter by Amyn Moolji, CIO & COO, & Jeffrey Burch, Director of Wealth Management.
Cribstone Capital Management (“CCM”) is an SEC-registered investment advisor located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC-registered investment advisors. CCM may only transact business in those states in which it is notice filed or qualifies for an exemption from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website at www.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operation and fees is available from CCM upon request.