As labor and supply shortages hasten the demise of globalization, there’s a giant sucking sound circulating through the world economy. People in both developed and emerging economies are watching their purchasing power shrink before their very eyes.

To get a read on what’s happening, Financial Advisor checked in with Tom Connelly, the president and chief investment officer of Versant Capital Management.

Financial advisors might think their typical clients, affluent Americans, are largely immune from the decline in global living standards. Connelly disagrees. Having spent nearly nine years chairing the investment committee of the $40 billion Arizona State Retirement System, the Phoenix-based advisor is an expert at matching financial assets and liabilities.

These days, ordinary Americans are forced to make difficult spending choices, so concern about the problems of the 3% or 4% of people with assets in the vicinity of $5 million sounds downright impolitic and irrelevant. Nonetheless, Connelly thinks many well-heeled clients are facing a higher level of lifestyle risk than they or most advisors realize. Clients should be “worried about having enough money even if they have $5 million,” depending, of course, on their lifestyle.

If inflation turns out to be more intractable than conventional wisdom holds, even those retirees living on portfolios with growing dividends plus fixed-income securities (and who don’t need to consume much principal) may “not necessarily” be secure if they lack the flexibility to cut personal spending. The problem is compounded by the fact that once-in-40-years price instability is striking at precisely the same moment that a global wave of baby boomers are turning 65.

Connelly sees his clients reacting in two different ways to the recent bout of inflation.

Those old enough to have lived through the hyperinflation of the 1970s in early adulthood or even as children recognize that their lifestyles may be impaired.

Younger clients, however, are far less likely to see any real threat. Conditioned by the last 15 years, many in this group believe that renewed Federal Reserve magic will ride to the rescue and salvage their portfolios while defenestrating inflation.

Connelly isn’t convinced. He isn’t the only one to perceive a deterioration in living standards unfolding as the world emerges from the pandemic. Allianz senior economic advisor Mohamed El-Erian and former U.S. Treasury Secretary Larry Summers have called it a global challenge.

Rising food and fuel costs will hit other nations much harder, but Americans have enough problems of their own. In Arizona, Connelly has watched housing prices surge at a faster pace than most other markets, increasing home equity for older residents while hurting affordability for younger people.

While the rate of inflation may moderate in the coming months, some price increases are likely to be permanent. Connelly believes that pressures on prices in sectors like housing, labor and food aren’t going away.

There is also a worrisome directional shift in national priorities. In contrast to the period following the Great Recession in 2008 and 2009, when both fiscal and monetary policy in the form of bank bailouts and quantitative easing received sharp criticism, “nobody [in either political party] is championing any kind of budget restraint,” Connelly notes.

This despite pandemic government spending that dwarfed the financial crisis relief more than a decade ago. “We’ll probably have to print money in the next recession. People and politicians aren’t willing to pay the price,” he says.

In 2010, federal debt of $13.6 trillion translated into about 90% of the $15 trillion (GDP) U.S. economy. Today, the debt figure is approaching $30 trillion, or more than 130% of a $22 trillion economy. “Inflation shouldn’t be a surprise,” Connelly says.

And the powerful inflationary undertow is likely worse. In June, Summers, along with IMF economist Marijn Bolhuis and Harvard lecturer Judd Cramer, wrote a paper for the National Bureau of Economic Research arguing “current inflation [rates] are much closer to past inflation peaks than the official [statistical] series would suggest.”

Put another way, if one applies the measurement techniques and weightings from the 1980s to inflation calculations over the last year, we get a number much closer to the 14% rate of the hyperinflation era than the 8.5% recent annual CPI rate. That takes a lot more out of spending power and helps explain the foul national mood.

The notion that markets are in the clear after June could be fanciful. Some believe quantitative tightening, delayed for several months, is already priced into financial markets. Others estimate that removing $5 trillion in liquidity in the next year could take the S&P 500 back to the 3500 area.

If the current path of inflation is any indication, the U.S. could find itself earlier in the Fed tightening cycle than many market participants would like to believe. “When QT kicks in [in September 2022], speculative investments are going to have a big problem,” Connelly says.

Portfolio Concerns
During the first two years of the pandemic, Connelly was hearing a lot of second-guessing from clients whose friends boasted about whopping gains in crypto and hyper-growth stocks owned by the likes of Cathie Wood at Ark ETFs. The fear of missing out was particularly acute among younger clients listening to virtual cocktail party tales of people buying $5 million homes with their crypto profits.

Versant clients typically have portfolios constructed with a value tilt, so many are pleased to be enjoying minimal single-digit losses this year. Connelly favors quality dividend-paying stocks, short-duration bonds (notably municipals), commodities and (to a lesser degree) real estate. Small allocations to reinsurance and private credit have also paid off.

Even in these asset classes, behavior has turned somewhat zany. Gold hasn’t been a great inflation hedge—though gold miners have been minting profits. But it’s far more stable than crypto, which hasn’t been a great hedge either.

Real estate has performed well, most notably the residential sector. Here Connelly isn’t thrilled. He worries about lofty “cap rates,” which are “so high” people are going to need “big increases in wages” to keep paying their rents and mortgages.

When it comes to crypto, Connelly acknowledges a lot of smart people have bought into the concept. Bitcoin has suffered two or three “70% declines and come back stronger every time, so I’m not going to put a nail in it.”

That said, it’s highly risky and appears to be “little more than a bookkeeping innovation.” Clients are no longer chattering and clamoring for it.

At some point, Connelly expects that the speculative parts of the economy will suffer their own deflation. The financial services business could well be ground zero. For example, Wells Fargo, the nation’s largest mortgage lender, recently announced plans to dramatically shrink its presence in that business.

Large pockets of the private equity and private credit markets, which have grown dramatically in the last decade, look particularly vulnerable, he thinks. This doesn’t mean that most private equity or credit investments are in trouble. But the business has enjoyed unbridled growth since the Great Recession and overtaken a huge share of business activity.

Connelly notes what happened the last time the Fed tried QT in 2018’s fourth quarter. The stock market fell 19%, Christmas retail sales collapsed, and junk bond issuance died, prompting the Fed to short-circuit its own tightening plans. So this time it wouldn’t be a shock if “a lot of stuff could grind to a halt,” he says.

Even though growth stocks recovered somewhat in July, the Nasdaq remained down about 17% for 2022 as of mid-August. Some savvy strategists like Richard Bernstein of RBA think the rebound is a “head fake.” Connelly harbors similar suspicions.

ESG, in his view, was the perfect marketing vehicle at the perfect time to keep the aging bull market going right through the pandemic. “I’m not opposed to green investing,” he says. “I just think it is a sales gimmick.”

What he does find troubling is the way the energy and resource crisis is playing out, in his own Southwest backyard, Europe and elsewhere. The water shortage in Lake Mead and Lake Powell has been decades in the making. “It’s shocking how little progress has been made,” he notes.

The global goal of transitioning to a decarbonized energy infrastructure is laudable, but the planning has been atrocious. Ultimately, Europe’s gas crisis, stemming from its reliance on Russia, should be resolved “in two or three years,” but the citizenry didn’t need to suffer the way Europe may this winter or the Southwest will for the next decade. The sad truth is “that’s how we deal with problems today.”

Connelly still considers himself a realist, not a pessimist. “I’m believer that we will innovate and that there will still be growth,” he says. “But inflation makes growth and [investment] duration less attractive and the cost of doing business more difficult.”