Below, we put together a Q&A from some of the more common questions and answers we’ve received and shared in recent conversations as well as a few addressing popular topics in the financial media. We hope you find this helpful in gaining context within these challenging markets. We’d also love to hear from you regarding additional market questions or topics you want us to cover. You can get in touch with us by clicking on the Contact link at the top of our website. Let’s jump in.

Q: Why does this bear market feel different?
Because everything is down. Outside of cash and commodities, it’s a widespread selloff in stocks and bonds. In other words, asset classes that have historically been uncorrelated and offered a source of diversification are now correlated and selling off together.

Q: What are the primary factors driving this selloff?
The market is trying to reconcile inflation and threat of recession. Each of these issues can fuel a risk-off move on their own; when you combine them in the same market environment it drags everything down.

Q: Does the Fed print money? Was that the cause of inflation?
No, the Fed does not print money; through their quantitative easing program (QE) they print bank reserves. Bank reserves have limited use; such things include settling inter-bank transactions and satisfying regulatory requirements for high quality liquid assets. Banks cannot lend bank reserves out. Reserves do not make it into the private sector. The consumer cannot go into a bank and withdraw reserves and go buy groceries or a new car. No real economic money is put into the system from the Fed printing bank reserves. QE, alone, does not cause inflation. It didn’t even exist in its current form in the U.S. until the Great Financial Crisis of 2008.

Q: So why does the Fed even do quantitative easing (QE) if they just print bank reserves?
The intention is for banks to rebalance their portfolios into riskier assets. Under QE, the Fed buys bonds from banks (think US Treasuries among others). That means banks lose bonds and get bank reserves in return. The issue however, is that bank reserves are not an ideal asset to hold when compared to other assets that qualify under high-quality liquid asset (HQLA) regulatory purposes. With reserves at the Fed piling up, banks are incentivized to rebalance their portfolios and buy even more Treasuries or mortgage-backed securities, for example. You may be thinking, isn’t the Fed also buying these same bonds during QE? Yes, they are, which means QE creates an intense demand environment for these high-quality bonds thereby suppressing rates (and usually volatility) which encourages market participants and consumers to expand credit and increase the flow of capital in the economy.

Q: If the Fed doesn’t create money, who does?
Governments and/or commercial banks. The government can print money and put it into the system. This happens with deficit spending like the Covid relief programs of PPP and EIDL loans as well as direct stimulus checks, extending unemployment benefits and pre-funding the child tax credits.

Banks create money whenever they expand their balance sheets by making loans/extending credit. If a person goes into the bank to get a $300,000 loan/mortgage the bank does not go to the vault and pull out cash that is sitting there. Rather, they create a note that says the borrower will pay them back over time. The borrower gets a $300,000 asset in their account – money was just created. From the bank’s perspective, that $300,000 in the borrower’s bank account is a liability because the borrower can pull it out and use it (putting money into the system). The asset for the bank is the loan note. This is how banks print money.

Q: What happened to cause inflation?
In response to Covid the Federal government injected a lot of liquidity into the financial system through relief programs as we described above. The Fed moved the Fed Funds Rate to zero and ramped up QE to further stimulate demand. Couple this with essentially a worldwide shutdown and you find an at-home consumer with money to spend and an inelastic supply chain unable to respond. In other words, we faced a severe shift in the supply/demand curve and that consequence is always prices rise.

Q: Why is inflation still high?
There are many factors in play here but in large part it is oil. The price of oil permeates the entire economy, well beyond high gas prices. To illustrate, only 45% of a barrel of oil is used in the production of gasoline, the rest is used in a variety of applications such as diesel, jet fuel, plastics, make-up, waxes, rubber, asphalt, tires, paints, solvents, and much more. Factoring the high price of oil as input cost for so many things in our economy becomes easy to see how that bleeds through to inflation measures.

Q: Why is the price of oil so high?
In short, it’s a supply and demand imbalance. If we look closer, demand isn’t the problem – the lack of supply is. To the point, the U.S. is producing less oil today than it was prior to Covid. There are a number of reasons feeding into this lack of production. In no specific order, here are a few culprits:

• Political winds have shifted away from fossil fuels to the point of disincentivizing and restricting production.

• ESG prominence has restricted capital flow to many areas within oil & gas.

• Shareholders are demanding fiscal discipline through a return of capital and dividends which means not as much money is being reinvested by oil companies for future production.

• Investors are hesitant to extend more capital and increase their exposure to the oil patch given the totality of circumstances and views of the global economic prospects.

• Russia invading Ukraine and the subsequent embargo and restrictions on Russian oil.

Q: I hear so much about the Fed raising rates. Why does this matter?
The Fed operates under two primary mandates – promote a healthy labor market and maintain price stability. Said another way, keep unemployment low and don’t let inflation take over. The dilemma is, the Fed has no control over inflation in this circumstance because the Fed cannot do anything about the supply side of the inflation equation. The Fed can only influence demand through balance sheet programs like QE and the reverse of that called quantitative tightening (QT) as well as rate hikes through the one rate they directly set and control called the Fed Funds Rate.

When rates are rising credit is becoming more expensive. Borrowers are forced to pay more to access new credit and depending on the structure of their current debt it becomes more costly to service that debt. This has the knock-on effect of cooling demand. If it sounds like a sledgehammer approach instead of using a scalpel that’s because it is. Think back to the oil conversation above. The Fed can hike their rate 10 more times but it will not get more oil out of the ground – it will not build more houses that were in short supply even before the great Covid migration and subsequent institutional buying frenzy that helped fuel selling and rental price increases. What it will do is stymie demand, if not crush it, which leads to lower prices. The risk is the collateral damage, like job loss, from such an approach.

So, in the end, the Fed is increasing its rate in hopes of slowing demand and thereby inflation. If slower economic growth, recession or job loss is a byproduct, from the Fed’s perspective, so be it. They are a reactive body not a proactive body. Sure, the Fed wants to have a smooth or soft landing where inflation slows without significant impact to the economy but that is an extremely tough needle to thread from the demand-side so the market is pricing in the probability that the Fed can’t do it.

Q: As my investment advisor what should I do:
Navigating volatile markets during an economic downturn is never easy. We do not try to time the market. Our approach remains long-term in that we want to own companies that 3 to 5 years from now we anticipate being more valuable than they are today. Clearly, to make money investing, you have to invest but when you invest there will periodically be times like these that are uncomfortable. Trying to perfectly time and capture each up and down cycle is nearly impossible.

That said, to combat these periods and weather volatility we focus on cash flow needs by generating enough interest and dividends into the portfolio so the lifestyle of a client doesn’t have to change even if the value of the portfolio declines. This allows one the opportunity to go through the business cycle without having to sell assets at a depressed price while maintaining their standard of living. When cash flow needs are not immediate, such as those clients in the accumulation phase, continuing to deposit into their 401-k accounts and other investment accounts can be advantageous because the dollar cost averaging effect at lower prices means buying more shares which can expedite portfolio recovery when a market recovery begins again.

Q: Should I buy more AMZN/GOOGL/TSLA because of the stock split?
Stock splits don’t impact the valuation of the company. In this case all 3 companies are initiating stock splits to lower their per share price to make it easier for smaller investors to buy their shares directly. Near term it’s like anything else, the price could move up or down as the supply and demand for the amount of shares outstanding equalizes but the split in and of itself does not increase or decrease the value of the company. Here’s an example from the perspective of the investor and the company:

• Investor owns 10 shares of Company A and the stock price is $100. The market value is $1,000. Company A decides to implement a 2-for-1 stock split. After the split the investor owns 20 shares of Company A and the stock price is now $50. The market value is still $1,000.

• Company A has 1,000 shares outstanding and a stock price of $100. The market cap of Company A is $100,000. After the 2-for-1 split, Company A has 2,000 shares outstanding and a stock price of $50. The market cap of Company A remains $100,000.

Q: What will cause markets to turn back around?
We are in a race between CPI numbers (inflation) coming down and avoiding a recession. The markets turn around once this debate gains more clarity. Until the Fed is comfortable with CPI numbers, they will continue to raise rates and maneuver their balance sheet towards tighter credit conditions. The Fed’s monetary policy relies on second order drivers, circumstantial at best, to influence consumer demand and economic conditions that meet their dual mandate. They do not prioritize avoiding recession. Therein lies the dilemma of our system – the Fed will do what the Fed will do, as will politicians and global economic players. These dynamics fuel the swings in business cycles and recessions. We are not advocating for one here; we are merely pointing out that history, as a guide, shows recovery and associated opportunities will once again be the ending to this market’s story which would suggest maintaining perspective and not abandoning one’s long-term investment plan to be a prudent course of action.

Q: What market questions or topics would you like us to address?
We’d love to hear from you. Click on the Contact link at the top of our website to ask your questions.