The Fed’s hitting the brakes on the economy: How will it affect my alternative investment portfolio?

"The captain has turned on the seatbelt warning. Would you like a soft-landing, a hard-landing or a crash-and-burn?; “This ain’t your daddy’s inflation”; 2021 Wave: Temporary inflation; 2022 Wave: Inflation pulls up a chair, gets comfortable and says it’s not leaving unless it’s kicked out; “From Covid-Hero to Covid-Zero…just like that”; Coming next.

(Usual disclaimer: I'm just an investor expressing my personal opinion and am not an attorney, accountant nor your financial advisor. Consult your own financial professionals before making any financial decisions. Code of Ethics: To remove conflicts of interest that are rife on other sites, I/we do not accept ANY money from outside sponsors or platforms for ANYTHING. This includes but is not limited to: no money for postings, nor reviews, nor advertising, nor affiliate leads etc. Nor do I/we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members. Info may contains errors so use at your own risk. See Code of Ethics for more info.)

So we’re halfway through 2022. And so far, it’s been a mixed year.

One one hand, it’s been a brutal year for many traditional investments. The stock market’s S&P 500 index has plummeted -19% from its January highs. Bonds are currently suffering similarly painful losses of -14.18% this year. And bitcoin has been pummeled with a stomach-churning -57.09% year-to-date.

On the other hand, many alternative investments have done very well (especially in comparison). For example, my own alternative portfolio has had an exceptional year so far (knock on wood). See more info here – “Deep dive into my seven-figure alternative portfolio” – for full details. And I’m not alone.

Why? It’s because many alternatives (like real estate) have their own unique cycles that aren’t directly tied to public market cycles. So this can provide some much needed diversification in a portfolio that contains both. But, there’s no such thing as a bulletproof investment. And alternatives aren’t any different. So a severe enough recession (or bad enough conditions) can suck the wind out of them too. That’s why I’m always keeping an eye on developing news… to see how upcoming events might affect my investments. And right now it’s a very unusual time. There’s a major threat to investments that hasn’t been seen in more than a generation. And this time around, it has new and unusually complicated causes.

And that threat’s called inflation (which I’ll talk about in a minute). But first, the most important thing about high inflation: it’s bad for the economy and for most investments. So, the Federal Reserve’s job is to control it. And they do this by hitting the brakes on the economy. Specifically, they raise interest rates and eliminate asset purchases (called quantitative easing or QE). This is called “tightening”.

But these are crude instruments for a delicate job. And typically the job has been too tricky to pull off smoothly.

"The captain has turned on the seatbelt warning. Would you like a soft-landing, a hard-landing or a crash-and-burn?"

The Federal Reserve has tightened 11 times over the last 60 years:

And according to Princeton’s Aland Binder, the Fed has only been able to pull off one soft landing (in the mid-90’s). There were several hard landings. And there’ve been three brutal crash-and-burns. See details here.

How will it turn out this time? Plenty of pundits are making different predictions. But at this early stage there are too many unknown factors and no one truly knows what’s going to happen. It’s a lot like trying to predict a hurricane’s path when it’s only just begun forming, far out in the ocean.

1. Will we get a soft landing? This would be the best outcome for most investments and the economy.

2. Or will the Fed be forced to engineer a hard landing (which wouldn’t be good for certain investments, but isn’t too bad overall).

3. Or will things get so out of hand that we see a crash-and-burn? That would be bad news for most investments.
   

And this question isn’t just important to alternative investments. It’s also crucial to public market investments too.

Also, how the landing plays out can matter a lot for certain alternative investments. For example, office real estate tends to lock the landlord into a fixed rate for a long time ( 5+ years). So a period where any inflation runs for too long can be especially painful.

On the other hand multifamily real estate tends to have shorter one-year leases which are adjusted at renewal. So if inflation is running hot, rents can be raised. And so an apartment can often withstand a moderately high inflation scenario with limited damage. And self storage real estate is arguably one of the most flexible real-estate asset classes against inflation with its monthly leases. And when the rent is raised each month, this can really minimize the damage.

However, while multifamily and self storage are inflation resistant, they aren’t inflation-proof. For example: if the main cause of inflation is from labor shortages and materials (rather than rent rises), then they won’t be able to raise the rent to keep up with their expenses. Also a very high and sustained bout of inflation will eventually cause new rent raises to hit the ceiling of affordability. And at that point these investments would have to eat the losses and suffer along with others. So the details can matter alot.

And that’s why this new series of articles will be monitoring the latest developments very closely.

Let’s start by looking at what inflation is, why the Fed is being forced to act and what’s happening right now.

“Inflation strikes back”

Inflation is when a dollar today is worth less than it was yesterday. This is bad for savers and for many investments, because it eats away at returns. And high, entrenched inflation can wreak havoc on every-day consumers and on the entire economy.

Inflation ran rampant for decades in the U.S. during the “Great Inflation” from 1965-1982. But then in the early 1980’s, Fed Chairman Paul Volker famously broke inflation’s back by engineering a severe recession and promising the Fed would do whatever it took to contain it.

And for 40 years, that worked amazingly well and inflation was tamed. And around 2015, inflation even got so low that the Federal Reserve was worried about the reverse problem: negative inflation or “deflation”.

But all this changed about a year after the Covid-19 pandemic hit. In March 2021, inflation overshot the Federal Reserve target of 2% for the first time in more than a decade. And since then, it’s accelerated upward.

Yesterday’s CPI release was unpleasant and said inflation rose a brutal 8.8% for June 2022 (up from 8.6% last month).

And the last several readings have been at the most painful highs seen in 40 years.

This kind of runaway inflation is crippling to many consumers, who are seeing increases on products and services across the board (and not getting high enough pay increases to keep pace). And it can also be damaging to the profit of many types of businesses, because it increases their expenses (while many can’t raise prices high enough to cover their costs).

And so the Fed has responded by hitting the brakes.

“This ain’t your daddy’s inflation”

But the tricky thing is that this time around, the causes of inflation are very different compared to past episodes.

And some of these differences could be with us for a while, which is potentially bad news. The longer these factors stay in place, the harder the Fed will have to correct. And the more that happens, the more the chance of a severe and damaging recession for consumers and investments.

So all of this bears very close watching.

What are the above-mentioned causes of the current inflation? There are many factors and they’ve happened in two waves. The first hit in 2021 and second in 2022.

2021 Wave: Temporary Inflation

In early 2021, inflation was almost entirely caused by temporary factors relating to the aftermath of Covid-19. First, microchip companies had to cut their manufacturing plants during the shutdowns to contain the economic damage. And this capacity usually takes the industry years to restart. So when the economy suddenly revived, microchips became scarce. And since microchips are in so many products, this caused shortages and drove up prices across the board.

Then, companies found they weren’t able to hire enough workers. Some were knocked out of commission by acute sickness or long Covid. Others re-examined life during the pandemic and retired or changed professions. Ultimately, the worker shortage resulted in delays and scarce services, which drove up prices. And when these shortfalls happened in supply chains, that caused ripple effects, driving up prices even more.

Over time, companies have had to pay workers more and more.

And when those companies had the pricing power to pass this cost on to customers, they did. And of course, that drove up prices even more.

Additionally, all consumers in the U.S. got stimulus checks to tide them over during the shutdowns, and many saved the money. So when the economy finally came back to life, many were ready to spend big after having felt deprived for more than a year. So demand soared and quickly outstripped supply. And this again drove up prices.

Most of the above factors (other than Long Covid) are temporary and short-term. And this led most economists to forecast that inflation would be temporary and would come down on its own. So the Federal Reserve felt it was better to let inflation deflate naturally, rather than try to force it down by deliberately slowing down the economy (and risk accidentally pressing the brake too hard, creating a recession).

But then 2022 came along. And two unexpected events hit out of the blue. The first was the Ukraine war and the second was the sudden failure of China’s previously successful Covid Zero policy. And that threw gasoline on the fire and the global economy into chaos.

2022 Wave: Inflation pulls up a chair, gets comfortable and says it’s not leaving unless it’s kicked out

On February 24th, 2022, Russia invaded its neighbor, Ukraine. And the two have been fighting a ferocious war since then.

Previously, Ukraine produced almost a fifth of the world’s high-grade wheat. But Russia blockaded the ports Ukraine uses to ship grain and mined the harbors. And Russia also targeted and destroyed many of the country’s silos. So this has caused a global food crisis, with millions now going hungry. And this has destabilized the governments of many countries (including Sri Lanka, where a few days ago a mob invaded the presidential palace and ousted the prime minister). All of this has caused food prices to rise and fed inflation.

Russia’s invasion of a sovereign country violated the international rules that have kept the peace in Europe for more than 60 years (since the end of World War II). So to punish Russia, the West imposed economic sanctions on it. Previously, Russia supplied 24.39% of the world’s gas (#2 producer in the world) and 14% of the world’s oil (#3 producer in the world). So the sanctions against Russia have caused energy prices to soar. And as of three days ago, crude oil is currently at $103/barrel which is one of the highest prices in 10 years.

And there’s the potential for more disruption. Much of Europe currently depends on Russian energy. If Russia were to cut off supplies in retaliation against countries providing Ukrainian military and financial aid, then it would cause the price of energy to soar even more. Also, no one knows exactly how long the Russian/Ukrainian war will last. Some analysts are forecasting it might last until the winter. The NATO Secretary-General said it could grind on for years.

However long the war goes, it will continue to kill more Ukrainian civilians and wreak more economic havoc.

So we’ll continue to watch the latest developments here, too.

“From Covid-Hero to Covid-Zero…just like that”

And unfortunately, the Russian invasion was not the only nasty 2022 inflation surprise. The other was the sudden failure of China’s previously successful Covid-Zero policy.

Through the early and mid pandemic, China had an enviable Covid-19 track record. While the West (and especially the U.S.) suffered from high levels of death and economic disruption, China took a different approach. It adopted a zero tolerance policy to Covid, called “Covid-Zero.” And it used a combination of intrusive surveillance, big-brother phone-apps, mandatory mass testing and involuntary quarantines to enforce it. These were often heavy-handed and could only occur in an authoritarian society. But it also managed to control the virus remarkably well. And polls show that Chinese people overwhelmingly approved.

By the end of 2021, Chinese deaths per million were virtually nothing, and were a fraction of every other country’s deaths (and more than 100,000 times better than the U.S.’s):

This “Covid-Zero” policy allowed the Chinese economy to open up much faster than the rest of the world and stay open. And it caused China to enjoy a quick, record-beating economic recovery. By mid-2021, China’s economy had already surpassed where it was pre-pandemic… even while the U.S. and most of the rest of the world were still trying to catch up. And China’s outlier strategy was poised to let it dominate world growth for years.

However, everything changed in 2022. Up to that point, the Covid Zero policy had prevented the more contagious Omicron variant from ever gaining a foothold in the country. But in late December, the first case of Omicron broke through the Chinese firewall and landed on the mainland.

And the Covid Zero playbook that had worked so well on the previous variants started to fail. The more contagious virus kept eluding the dragnets and spreading. So the authorities became even more heavy-handed. But Omicron still continued to spread: first to neighborhoods, then cities and regions, and eventually over the whole country.

The economically crucial manufacturing cities of Shanghai and Kunshan were locked down for more than a month. Eventually, Omicron spread to the capital city of Beijing (which the party had been trying its best to avoid due to an important, once-every-five-year political leadership selection committee occurring later this year). And even the capital had to be locked down.

The result was crippling to the Chinese economy. The most recent numbers show that last quarter’s 2022 factory output and retail both plummeted. Meanwhile, unemployment soared. So while Western economies were continuing to recover, China underwent an economic collapse and fell into a second contraction.

And since China is the manufacturing capital of the world, the shutdowns have caused problems across the globe for companies that are unable to get crucial parts. For example, Apple, Dell and others have suffered.

And this has caused shortages in the U.S., leading prices to increase (and feeding inflation).

Why not just drop Covid Zero?

You would think there would be an easy solution to this. China just needs to do what virtually every other country in the world has done: drop the idea of Covid Zero and learn to live with the virus.

But this hasn’t happened for several reasons.

First, the government has trumpeted its success with Covid Zero far and wide as proof that its political and economic system is far superior to the West (especially the U.S.). And China has loudly criticized the strategy of living with Covid as uncaring and barbaric. That rhetoric makes it hard to reverse course without very unpleasant political consequences.

And there are also logistical problems. The fact that 50% of their elderly population isn’t even vaccinated makes them much more susceptible to human loss from dropping Covid Zero, versus most other equally developed countries in the world

And those who are vaccinated in China have access only to homegrown vaccines, which aren’t as effective as the Western mRNA vaccines. And China’s vaccines fare even worse against the variants. Again, this is a self-created problem, because the government propaganda has heavily touted the homegrown vaccines as proof of their superior system, and criticized the Western vaccines as ineffective. So that also makes it really hard to backtrack and change.

Finally, the Chinese hospital system isn’t as developed as the West’s. And many believe China could quickly find its intensive care units overwhelmed across the country, even with more vaccinations and the low levels of hospitalization that the West is currently seeing with Omicron. And again this would cause mass disruption and political instability.

So China looks unlikely to change its policy drastically anytime soon. And if so, then the supply chain disruption and inflation caused by Covid Zero are unlikely to end anytime soon, either.

Whatever happens, we’ll continue to monitor the latest developments on this.

Coming next

So, the focus of this series will be on whether the Fed’s tightening will cause a soft landing, hard landing or a crash (and what this means for alternative investments once we start to get more clarity).

And we’ll be watching the latest developments directly related to tightening, such as inflation and the causes thereof:

• The Russian invasion of Ukraine (and effect on prices of energy, food, etc).

• China’s Covid Zero policy (and effect on supply chain disruption and price hikes).

• The microchip and worker shortages (and effect on prices).

• Consumer attitudes to inflation (which on its own can cause inflation to become entrenched)

• Other causes of supply chain disruption that cause inflation (for example, how the world is now divided into two competing spheres between China and the U.S., and the reversal of onshoring)

• Covid 19: new variants and the latest on how Long Covid (which cause worker shortages and wage inflation).

Additionally, we’ll be monitoring how the U.S. economy is holding up as the Fed hits the brakes, and looking at key indicators like unemployment, wages, retail sales, and consumer sentiment.