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Today we're going to focus on the practical. No more of this pie-in-the-sky economics theory, let's talk about some retirement financial planning issues.
Lots of people pay for financial plans that come in big binders. Almost no one actually reads the plan, from what I can tell, and some level below "almost no one" actually does anything about it if they have it. One of the problems with a Monte Carlo-type financial plan, where a bunch of inputs are plugged in and then you see some curves that tell you where you might be in 10 or 15 years, is that if you change one input even a little bit the scenario 15 years from now swings wildly.
Keep in mind: the concept of full retirement is extremely new in human history. It's only a couple generations old. This is in part due to the fact that people are living longer.
Let me share some observations that you can use in your own thinking. These are generalizations from many client meetings, so not all of them will apply to you.
All this inflation does have a benefit: we don’t have to hear from certain academics about Modern Monetary Theory anymore. You’re probably thinking “I don’t really care about the PhD path of an economist, I care that my grocery bill is up 20%+ in two years.” Stay with me.
Modern Monetary Theory was/is a dream cooked up by certain economists that a nation that issues its own currency can do so without risk or remorse. Magically, debt does not even have to be issued! The market will absorb the currency increase, and the Federal Reserve can always issue more currency to pay the debt. There is the small caveat that they have to pull back at the correct time if resources such as labor get too tight to avoid inflation.
Except it’s not a small caveat. It probably should have like fifteen asterisks and pink highlighter all over it. Because, as anyone who walks down aisle 7 of a grocery store and looks at the pricing stickers knows, they have little ability to time the currency pullback. And that craters the main theory, which may, in certain contexts, have had some validity.
As the money supply soared and America began to buckle under inflation, the Federal Reserve acted too late in 2022, assigning blame to “supply chain issues.” Here is a graph the Wall Street Journal published last week, showing overall expectations on rate cuts versus reality:
Both of these examples show the Federal Reserve's ability to predict macroeconomic events, such as employment and inflation, is low at best. If you can’t predict it, you can’t react in time, and you end up with eggs doubling in price in a year. On the bright side, an aspiring economist somewhere got a PhD for his or her innovative theory.
There are lots of people on this list that run, manage, or work in businesses who would say “I would never issue that level of debt, that is too risky. What happens when it rolls over at a higher rate, and you have to deal with the interest payments?” First, keep in mind that in Modern Monetary Theory, they are issuing currency, not debt. Something a business can't do. Second, a lot of businesses did issue too much debt, in part because the in
However, I don't think the line is as clean between currency and debt as many economists believe. It all gets rather addictive - whether you are printing currency or issuing debt, the short-term boost is fantastic. Your shareholders or voters think you're a genius. The fallout is less thrilling. As the Federal Reserve works to get that excess money supply out of the economy, with higher rates, the government is now facing this (note the interest expense line).
Graph source: WSJ 2/16/24
Theoretically this should lead to lower economic growth, lower asset returns, and a lower standard of living over time as interest expense consumes the nation's resources at a significantly higher rate.
1. Modern Monetary Theory is fantastically complex. As such its implications are not well understood. Remember the One Day In July mantra: if it's not simple, it probably won't work. That which is simple is understandable.
To start off the year let's look back at the Federal Funds Rate since 1950:
There are a few things to observe. The time period from 2008 to 2020 was unusual, with almost 10 years of free money in that window. Then, starting in 2021, we have a steep wall up, bringing us back to an area that resembles the long-term average.
Average in this case sounds good. And perhaps the economy can absorb the slope of the wall up. The issue is the ten years of free money before the reset, and how that is going to reflect on this year and the next couple of years.
When the cost of capital becomes free, bad decisions creep into businesses. The process happens gradually at first, when that sprightly investment banker shows up and makes a pitch to corporate management:
"Look, running a public company is hell. It's a regulatory nightmare, you have to watch every word you say, lawsuits are commonplace, you're hooked to quarterly earnings reports. You'll probably either quit or be fired in five years, so let us apply some financial engineering to this otherwise very mediocre firm and juice [list several financial ratios here], and hence the stock price."
And after a few whiskey sours the CFO decides this isn't such a bad idea and so eventually it happens. The market problem is that the firm's competitors then start falling behind. So pretty soon they have the bankers on speed-dial also looking for some low-cost juice.
And you end up with lots of debt in lots of average firms. These are called zombie firms, and it's like a capitalist version of The Walking Dead. The term, defined by the Bank for International Settlements, refers to firms that have not earned enough profit over the past three years to even cover their interest payments.1 At the turn of the millenium, about 2% of firms were Zombie firms. *Before* the interest rate wall in 2020, almost 20% were. If you cut the time period from three years to one, almost 30% of firms may land in the category today.2
Zombie firms distort the allocation of capital, and they drive inflation by funding projects and hiring for roles that make little economic sense. This creates a headwind for their competitors. Unique in American history, this headwind went on for a long time in 2008 - 2012, giving significant advantage to the zombies.
The cheap money party is over, and a major investing story in 2024 and 2025 will center on how this unwinds. One would think that with debt resetting and interest rates higher the scenario is bleak. But The Wall Street Journal is reporting today that the market for subprime debt remains strong. If the banking system stays healthy and the economy roars forward, this may be an orderly transition. If the economy turns down, the shockwave will be stronger.
But it's not necessarily a zombie apocalypse for an index tracking a large basket of stocks, because even if zombie firms do collapse into bankruptcy or scale back significantly, their competitors with lower leverage ratios may benefit.
Dan Cunningham
1. Keep in mind earnings numbers are relatively easy to manipulate.
2. Source: Deutsche Bank Research
Bennington, VT Financial Advisor
Available for meetings in Bennington, VT and surrounding areas.