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The Potential Recession, the Personal Impact of Inflation and the Role of Bonds in Your Portfolio

Published on March 31, 2022

Peter Mallouk
President & CEO
Jonathan Clements Headshot

Jonathan Clements
Director of Financial Education

Peter Mallouk and Jonathan Clements discuss whether we are on our way into a recession, those hit hardest by recent inflationary pressure and the role of bonds in your portfolio.

Hosted by Creative Planning Director of Financial Education, Jonathan Clements, and President, Peter Mallouk, this podcast takes a closer look into topics that affect investors. Included are in-depth discussions on financial planning issues, the economy and the markets. Plus, you won’t want to miss each of their monthly tips!

Have questions or topic suggestions? 
Email us @ podcasts@creativeplanning.com


Jonathan Clements: Hi, this is Jonathan Clements, Director of Financial Education for Creative Planning, in Overland Park, Kansas. With me is Peter Mallouk, President of the firm, and we are Down the Middle. It’s been a while. The first three months of 2022, Russia invaded Ukraine, the Federal Reserve finally raised short-term interest rates, stocks lost a little money and bonds lost somewhat more. But Peter, let’s start by talking about perhaps today’s most pressing economic worry, inflation. Consumer prices have climbed almost 8% over the past 12 months, but the pain hasn’t been evenly distributed. Energy prices and cars, notably used cars, are up a lot. Meanwhile, the cost of medical care has only climbed a few percent. Who knew we’d be talking about low increases in medical costs? Wouldn’t that suggest, Peter, that the impact of these price increases isn’t hitting Americans equally?

Peter Mallouk: Well, definitely the impact of price increases isn’t hitting Americans equally. It’s hitting low wage earners, much, much harder. I mean, it’s absolutely killing people that don’t have a lot of assets. If you think about the stock market, the majority of stocks are owned by a minority of Americans. And so if you think about in general, what’s gone up the last few years, it’s things that you own. If you own real estate, if you own a business, if you own stocks, you saw those things go up. And if you don’t own those things, you didn’t really have anything appreciated except your cost of living. Healthcare went up a little bit, but food went up a lot. Cars went up even more. Keeping a roof over your head, whether you were renting or buying, went up a ton, a record amount. And so if you’ve got a fixed wage, I mean, if you’re making $15 an hour, $20 an hour, inflation is absolutely killing you. It’s creating a much larger gap than we had going into the pandemic between the different classes in the United States. Inflation has really deepened that wedge.

Jonathan: And of course, one of the big increases that we’ve seen of late has been the increase in energy costs, cost of heating a home, the cost of putting gas in your car and that’s pretty much an unavoidable cost. Demand is, as economists like to say, inelastic. You’ve got to put the gas in your car. You’ve got to heat your house.

Peter: Yeah. If you’re in that middle to upper class in the United States, well, you probably own a house. You probably have a 401(k) with stocks. So your energy stocks went up over the last two years. Your stocks in general went up over the last two years. The value of your house probably went up a lot over the last two years. So you think things are fantastic, even though you’re paying more at the pump, even though you’re paying more at the grocery store. But if you’re somebody who is renting or you’re in a starter home and you’re just entering the workforce or you’re making a fixed wage that’s low, it’s absolutely crushing you to see your costs over the last couple years having gone up 20% and the compensation hasn’t followed.

Jonathan: So I think for a lot of listeners of this podcast, probably they’re not as aware as they should be of the economic pain that a lot of average Americans are suffering as a result of this increase in inflation. It seems like a relatively modest thing for those people who have lots of assets and lots of income, but for people at the lower end of the spectrum, it’s been a rough time.

Peter: I think it’s really an untold story in the media right now, too. I think we just had a lot of other narratives that are preoccupying us, but I think the after effect of this is going to be a big issue that the economy’s going to have to face. A lot of decisions we’ve made in the last couple years that we’re going to have to deal with later, whether it’s trying to keep Russia’s currency out of the international markets or whether it’s what the impact of inflation has been on low wage earners. There are so many things that are going to have very big macroeconomic effects in the future and social effects that somehow Congress and the future presidents are going to have to sort through.

Jonathan: One of the consequences of climbing inflation has been the rise in interest rates, but rates at the shorter end of the yield curve have been rising much more than those at the longer end. And what are the results of this is there’s been a lot of buzz of late about the yield curve and what it means if it inverts. Today, the yield on the two-year and 10-year treasury notes are almost identical, which isn’t a normal state of affairs. Usually you’d expect the 10-year yield to be significantly more. One of the things that an inverted yield curve is said to portend is an economic slowdown. Do you think the inverted yield curve that we’re on the cusp of having is indeed ending a signal that the economy’s going to slow, Peter?

Peter: It is true that when the yield curve is inverted, meaning the cost of borrowing in the short run is actually higher than the cost of borrowing in the long run, there is a recession in the future. The issue is the recession usually comes eight months to 18 months later and before then, the stock market goes up on average 20% or more. So it’s not just so simple as, hey, the yield curve’s inverted, most of the time that leads to recession. Well, the economy expands and contracts. That’s what it does. It never goes straight up. It’s called an economic cycle for a reason. And so there’s always expansions and contractions. The contractions are called recessions.

And so it’s not it inverts and tomorrow we have a recession. So that that’s a signal that’s actionable, I don’t think is realistic. What it does is it tells us that people that are loaning money for the long run, do not think the economy is going to remain very strong and so that’s why they’re willing to take a low yield over the long run. And so it tends to be a warning signal, but it’s a warning signal that’s not actionable. And if you took action on it today, most of the time you would be a significant net loser.

Jonathan: So just a further warning about the warning signal, Peter, is twofold. One, the last time the yield curve inverted was in mid-2019. Of course, we had an economic slowdown in early 2020. But however powerful the yield curve is as a predictor, it can’t predict pandemics. The reason we had an economic slowdown is because of COVID-19. So who knows? If the pandemic didn’t come along, maybe we wouldn’t have got that economic slowdown. I think the other thing that people should also be aware of is the degree to which the Federal Reserve is intervening in the bond market is much greater now than it was a dozen years ago. So who knows where interest rates would be today, if the Fed hadn’t been so heavily involved in the bond market?

I’m just not sure whether we can trust the inverted yield curve to be a signal that recession is coming down the pike, even though it has historically been so. So Peter, another big development in the first quarter, we saw the broad U.S. bond market drop slightly more than the broad U.S. stock market. Should investors be changing how do they structure their bond portfolios given the recent performance, or should they be changing their expectations to what their going to get from their bond holdings?

Peter: So we’ve always been a firm that’s more owner focused. We want our clients to be owners, not even because of high inflation like we’re experiencing now, but because of moderate, intentional inflation. The Federal Reserve, part of their job is to create inflation. It’s very hard to fight the Federal Reserve. So we’ve always taken the posture that we want our clients to be owners, which is why the majority of clients, they own publicly traded stocks, publicly traded real estate, private equity, things like that and we’ve always been lenders only to make sure that we cover what the client needs over a five to seven year period in case there’s a pandemic or a 9/11 or an ’08,’09 or a war that expands. There are things we can’t control and the stock market will go down significantly through many of those events. So the last five years, we’ve really beat that drum beat really hard.

When rates became really, really low in 2018, we would encourage our clients and our newsletters and our podcasts, “Hey, let’s keep that bond allocation as low as possible.” Today, I’d say this year is the first time I’ve heard clients ask, “Well, why do I own bonds at all?” And all bonds aren’t the same. If I loan money to you for one month, I’m pretty sure you’re going to pay me back and I’m going to get a low rate, because it’s a short period of time. If I loan money to a friend of mine that never pays me back for five years, that’s a pretty bad investment. I’m probably not going to get my money back. I’m going to charge a higher interest rate, because my risk is higher. These aren’t the same, but we call them both bonds. They’re both in the same category.

And I think bonds still serve the purpose of making sure that if the world goes to hell in a hand basket, and that can happen a million ways to Sunday, you need to have a place to go. Well, the stock market is not that place because as much as we think stocks are going to do better than bonds over the long run, as much as we think real estate will do better than bonds over the long run and private equity and all these things, those things get hit very hard in certain types of crises, and we have to have a place to go. That place is the bond side of the portfolio. But I would stay with higher quality, shorter bonds. I don’t want to be loaning money to anybody for 15 years and I don’t want to be taking a lot of high risk loans in this kind of environment.

Jonathan: Yeah. I think one of the things that we’ve talked about in the past and it’s worth reiterating again is that the traditional role of bonds are as viewed by many investors, that they’re going to provide you with a decent amount of income and that story is history. You’re not going to be able to buy a bond portfolio and live off the interest unless you’re enormously wealthy. So what bonds are more than anything else are a shock absorber for a portfolio and a place to turn to get cash when the stock market is deeply underwater. And those should be viewed as the role of bonds in a portfolio and not as a way to generate interest. The interest just isn’t there anymore. So finally, Peter, one last question. In the past year, we’ve seen home prices nationwide increase by almost 20%, but now because of inflation, because of rising interest rates, we’re seeing mortgage rates rising rapidly. If you’re willing to pay a few points, you might be able to get four and half percent, without points the rate on a 30-year fixed rate mortgage is getting close to 5%. Do you think this is going to trigger a slowdown in the real estate market?

Peter: There is a saying when it comes to inflation that the cure for high prices is high prices. When prices get too high, the demand declines a little bit and that’s not always the case, but it’s usually the case. But I think when people buy a home, they don’t say, “I’m going to go buy a $600,000 home or a $1 million home.” They say, “I have this much to spend per month,” and then they go buy as much home as they can. That’s the way the average American works. So right now, 5,000 a month or 10,000 a month is going to buy you less than it would’ve bought you three or four months ago. So yes, as interest rates rise, what someone can afford per month is going to decline. It’s going to move people into lower brackets. There will be less people that can afford $2 million homes, $1 million homes, 800,000 homes and so on. So I do think that rising interest rates are going to slow housing prices, but I don’t think they’re going to tank them and I don’t think they’re going to tank them because the other rule of economics is supply and demand and right now we don’t have enough supply. We do not have enough homes that have been built for the demand, particularly of millennials, looking for homes. There’s all kinds of reasons for this. There’s foreign ownership, a lot of people with two homes now, corporations and institutions buying residential real estate as an investment trying to turn America into rent holders, basically, by buying all these homes, nothing that’s going to be an affordable and everyone starts paying rent to BlackRock or something like that. I think that we have this demand that’s going to stay there, but that we’re going to see prices soften as rates continue to increase.

Jonathan: All right. And finally, Peter, it’s time for our Financial Wellness Tip of the Month. So what have you got for me this month?

Peter: Well, when you look at the bond side of the portfolio, again, all bonds are not created equally, we want you to have bonds to get through a crisis, but just look through your bonds and make sure that you are not invested in a long-term bond fund or a bond that’s taking excessive risk, a high-yield bond fund. The high-yield bond fund is going to behave like a stock in a down market, so it’s not really helpful. And the long term bonds get hit very, very hard in a rising interest rate environment, which is the environment we’re in now. So you want to have bonds to protect yourself—make sure you’ve got the right ones.

Jonathan: And so, Peter, my tip of the month actually came from somebody I know who was concerned about their premium on their homeowners insurance and the premium on their auto insurance and what they were able to do. And not everybody’s going to be able to do this and it’s not going to be applicable in all states, but what he was able to do was call up his insurance company and ask them to reassess his policies based on his current credit score, rather than the credit score when he first took out the policies. And because he had had those policies for a number of years and his credit score had risen during that period, they reassessed the policies. The premiums came down more than 20% on both his homeowners and his auto insurance. Now I’m not saying every listener to this podcast is going to be able to do this and I’m not saying you should do this if your credit score has not risen in recent years, but if you’ve had long term policies and your credit score has improved over that period, it may be worth making that call to insurance company and asking them to reassess your policies based on your current credit score and you could find yourself with significant premium savings.

Peter: Great idea.

Jonathan: All right. So that’s it for this month. This is Jonathan Clements with Creative Planning. We’ve been talking to Peter Mallouk, President of the firm, and we are Down the Middle.

Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.

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