when it comes to monetary policy the fed has painted itself into a corner argues robert phipps director and portfolio manager at per stirling capital management in austin texas “by being overly stimulative and waiting far too long to start withdrawing that stimulus the fed is confronted with a situation where they can no longer just tap on the brakes to dampen inflation” says phipps whose independent ria firm employs 20 financial advisors and manages 15 billion of assets “they will instead likely need to slam on the brakes and that increases the likelihood of recession” in an indepth interview with barron’s advisor the 40year financialservices veteran explains why a recession should it occur could be mild he opines on tactical opportunities and argues that barring a direct natoversusrussia conflict stocks have seen their low for the year where are you from and how did you get into the business while i was born in alexandria va i have lived in central texas for the past 60plus years i found my way into the industry in a rather roundabout way my expectation coming out of washington  lee university was to have a career as an attorney to this end i took a position at a bank to earn the money to pay for law school and started taking businessrelated classes to help me to climb the ladder at the bank as soon as i took my first classes in economics and finance it was an epiphany for me and i knew almost immediately what i wanted to do for the rest of my life with the benefit of hindsight i have always felt extraordinarily fortunate that i did not have the resources to go directly to law school those four decades ago describe your role at the firm while i work directly as an advisor for a select group of individual clients most of my time is spent in capital markets and economic research in formulating the firm’s macroeconomic perspective and in communicating that perspective to the firm’s advisors and clients through written market commentaries and by hosting investment round tables i also manage the firm’s growthfocused separately managed account what’s your perspective on the fed’s recent tightening actions there are four main reasons why we believe that the fed has almost no choice but to act aggressively to combat inflation through both aggressive and frontloaded rate hikes and a fairly rapid shrinking of its 9 trillion balance sheet almost regardless of potential bear markets andor economic contractions the first of those reasons is legislative as congress mandated that the fed pursue maximum employment stable prices and moderate longterm interest rates with a 36 unemployment rate a labor market that chairman powell himself just described as “tight to an unhealthy level” and 5 million unfilled jobs the fed would be justified in tightening monetary policy even if inflation were not so problematic however that is unfortunately not the case and we are confronted with the highest consumer inflation rate in 40 years which means that longterm interest rates are going to be anything but moderate if the fed doesn’t act aggressively to get inflation under control as such we believe that battling inflation is not just a priority but likely the fed’s overwhelming and potentially even singular objective the second reason is political this is a midterm election year and all the polls suggest that the democrats are going to take a political beating if the fed can’t get inflation under control before november when you consider that 10 of the population owns 89 of all equities while 40 of the population doesn’t own their home has less than 1000 in the bank and is being absolutely crushed by higher prices we believe that the fed despite its theoretical independence is much more likely to cater to the 40 who need inflation down rather than the 10 who want equity prices up the third reason is practical prolonged high inflation is much more damaging to the economy than are either deep recessions or bear markets in stocks or bonds furthermore once inflation gains a foothold it is very hard to reverse the last time inflation was at least this high thenfed chairman paul volcker needed to drive shortterm interest rates up to 20 which rocketed mortgage rates to 18 and the prime rate to 215 while causing two deep backtoback recessions in 1980 and 19811982 the deep and prolonged equity bear market that resulted drove the sp 500 pricetoearnings multiples all the way down to eight they are currently almost 26 the fourth reason is one of the fed’s credibility as an inflation fighter a central bank’s credibility is one of its most important inflationfighting tools as it allows it to effectively change monetary policy by just jawboning the markets what’s your confidence level the fed will thread the needle to avoid a recession we tend to agree with former fed vice chairman bill dudley who noted in a march 29th commentary that fed policy decisions have “made a us recession inevitable” from our perspective it is just a matter of when by being overly stimulative and waiting far too long to start withdrawing that stimulus the fed is confronted with a situation where they can no longer just tap on the brakes to dampen inflation they will instead likely need to slam on the brakes and that increases the likelihood of recession there are a number of reasons why a recession over the next few years is likely over the past seven decades 75 of all tightening cycles have produced a recession and this tightening cycle is likely to be much more aggressive than most in addition the majority of times that consumer confidence has collapsed as it has recently a recession has soon followed this makes sense as consumer spending represents approximately 70 of the us economy in addition the price of oil has recently increased by over 50 and while the past is not necessarily prologue it is noteworthy that over the past 50plus years every 50 increase in the price of crude oil has produced or at least been immediately followed by a recession the fed has engineered a “soft landing” three times before in 1965 1984 and 1994 but these were times when the fed was trying to keep inflation from going up as opposed to the current situation where it is trying to push inflation lower which is an entirely different challenge whether or not the us experiences a recession is likely to be of critical importance to equity investors as bear markets accompanied by recessions tend to be about 50 longer and much more severe than bear markets that are not accompanied by a recession indeed over the past 50 years bear markets combined with a recession have been twice as severe and lasted three times as long as nonrecessionary bear markets how bad could a recession be current levels of monetary liquidity are so excessively high that it is likely to take a significant amount of tightening before it has any notable impact on the economy and that may lessen the severity of any recession a positive wild card that could further offset some of the drag from monetary tightening is the positive influence of the reopening of the global economy from the pandemic we are hardpressed to find any historic precedent for the current set of conditions which makes projections difficult that said we would not be surprised if we were to see one or two quarters of 15 to 2 economic contraction the war in ukraine has aggravated inflation what are two or three scenarios for how the impact from this conflict could play out in the markets barring a direct conflict between russia and nato we believe that the biggest impact will likely be on inflation as russia and ukraine are responsible for a significant portion of the world’s natural and agricultural resources and on global supply chains indeed in early march moody’s noted that the russiaukraine war replaced the coronavirus pandemic as the top risk to global supply chains in addition the organization for economic cooperation and development estimates that the war will cut more than 1 from global growth this year while adding 25 to global inflation the oecd further estimates that the war will subtract 14 from euroland gdp and 09 from domestic growth moreover according to a march 22nd report from the dallas federal reserve if the bulk of russian energy exports are off the market for the remainder of 2022 which we consider an increasingly possible outcome “a global economic downturn seems unavoidable” put into historical context how bad current inflation is aside from the hyperinflationary period from the vietnam war to the mid1980s this is the first time since world war ii that we have seen such an outbreak of inflation the current inflation rate is sufficient to double the cost of living every nine years which is a truly extraordinary destroyer of wealth while we do think that depending on the war in europe inflation has a good chance of peaking sometime in the late second or third quarter of this year we do not expect for it to approach the fed’s 2 target anytime soon that means that monetary policy is likely to become increasingly restrictive over the foreseeable future is the market near a bottom while we believe that there is a reasonable possibility that the equity markets will retest their 2022 lows before this bear market runs its course we also think that there is a good likelihood that we have already seen the ultimate lows for the year however that assumes that nato and russia manage to avoid direct armed conflict what should longterm investors be doing now ratehiking cycles are not necessarily bearish for equities at least not initially in the five ratehiking cycles that we have seen since 1990 the major equity indexes were higher one year after the first rate hike 80 of the time that said higher interest rates do tend to compress market multiples with nominal earnings also expected to fall this is a very important consideration for longterm investors we would emphasize highquality stocks with strong balance sheets predictable earnings and strong free cash flow regardless of whether one is investing in growth stocks or value stocks we would also emphasize domestic stocks over foreign stocks and larger stocks over smaller companies as smaller companies tend to be more susceptible to economic slowdowns in regard to fixed income longerterm investors should keep durations short and emphasize securities with variable interest rates what tactical opportunities do you see right now on the tactical front we would also emphasize highquality domestic stocks but would complement them with both inflation beneficiaries and companies that can help to replace the exports that we are losing from russia and ukraine this would include energy exploration and production companies fertilizers and agribusiness metals and mining companies and commodities we also like the outlook for the latin american markets in general and brazil in particular and we think that as a result of the war in europe energy security and natural resource selfsufficiency will be an important longerterm theme that we want to invest in are bonds still welcome in your client portfolios if so why and what kind what to do with fixedincome allocations is the great dilemma for most nontactical investors this could remain an issue for many years to come as when interestrate trends change those trend changes tend to persist for years and even decades to borrow an old saying attributed to former barron’s columnist james grant—ed bonds have transitioned from providing riskfree return to providing returnfree risk in this environment we favor a donoharm approach that features floatingrate and inflationprotected debt some of our advisors are even turning to fixedincome annuities to provide portfolio balance we also prefer some of the bond proxies over bonds these include utility stocks real estate investment trusts and even some preferred stocks and master limited partnerships bonds can still have a diversifying role in portfolios which can justify their continued albeit reduced use however as we see the world they are likely to be a drag on portfolio performance for the foreseeable future