A Tale of Molasses and Misfortune

On the morning of January 15, 1919, the residents of Boston could not have imagined the catastrophe that would ensue later that afternoon. The United States Industrial Alcohol Company (USIA), nestled in the North End neighborhood of Boston, was a major producer of alcohol for industrial uses such as the manufacturing of munitions, producing solvents, and fuel for industrial processes. As such, USIA bought and stored colossal amounts of molasses, which served as feedstock in the fermentation process.

On that fateful afternoon, unseasonably warm temperatures, structural flaws, and managerial negligence led to truly catastrophic conditions. Residents suddenly heard a loud rumble echo through the streets. A storage facility containing 2.3 million gallons of molasses failed and unleashed a torrent of viscous molasses that poured through the streets of North End. It is estimated that a gigantic wave of molasses about 26 feet tall, traveling an estimated 35 miles per hour, engulfed everything in its path destroying buildings, knocking cars off elevated train tracks, and tragically resulting in nearly two dozen fatalities.

The flood left a sticky mess in its wake and serves as a poignant reminder of the consequences of myopia, the unintended forces of nature, and professional negligence. But what does this peculiar disaster have to do with monetary policy and the economy? Surprisingly, the two share more in common than one might initially suspect.

A Colossal Wave of Fiscal Stimulus

The COVID-19 pandemic represents one of the most shocking socioeconomic and financial events in history. Unemployment skyrocketed overnight and economic productivity screeched to a halt. The medical and social welfare of citizens around the world instantly became of grave concern. There is little debate that assertive economic stimulus was critical for any hope of economic stability.

However, history showcases the monumental nature of the fiscal stimulus that ensued. The result was an extraordinary wave of monetary and fiscal stimulus, including five stimulus packages and executive actions taken by Presidents Trump and Biden. In comparison to past economic interventions, such as the New Deal or the response to the 2008 financial crisis, the COVID-19 stimulus efforts were titanic. The Federal government injected approximately $5 trillion into the economy, dwarfing previous attempts to stabilize markets during times of crisis.

Inflation is a natural consequence of the events that transpired during the pandemic. Certainly, the swift injection of fiscal stimulus at those levels could inflame inflationary pressures, but supply chain and logistical shocks resulting from widespread shutdowns and diminished industrial capacity perhaps played an even greater role fueling inflation. A logical conclusion is that supply chain issues ignited inflation, yet fiscal stimulus provided the feedstock perfect for accelerating its effects.

In fact, inflation increased rapidly in 2022 and is still well above long-run trend nearing the end of the first quarter 2023. Furthermore, inflation has proven to be quite, pardon the pun, “sticky”. Currently, headline inflation has slowed, but the inflation rate among those goods and services whose prices change less frequently, has been more persistent than desired.

To address this period of high inflation, the Federal Reserve hiked interest rates to help reduce the flow of money in the economy and decrease demand for goods and services, hoping to ultimately bring inflation under control. However, raising interest rates can create challenging condition for banks and other financial institutions, particularly within a system recently tasked with servicing more than $5 trillion in additional assets in less than a 12-month period.

Idiosyncratic Events and Systemic Risk

The issues observed within the banking sector so far this year suggest that it may be more intolerant to interest rate hikes than anticipated. Higher interest rates increase borrowing costs, which can reduce demand for loans and negatively impact banks’ profitability. Banks that do not effectively manage interest rate risk may find themselves in dire straits, as they struggle to maintain stability in a rapidly changing economic landscape. We have also seen that in some relatively rare and bizarre circumstances, some banks have insufficiently hedged interest rate risks resulting from rising interest rates. Silicon Valley Bank (SVB) and Signature Bank (SB) are prime examples of the latter.

The Great Molasses Flood and the inability of SVB and SB to manage its interest rate risk are both idiosyncratic events – extraordinarily unique and unexpected occurrences. Yet, the fear and panic that arise from these events can have serious ramifications and increase concerns about systemic risk, the risk of contagion affecting a broader segment of the sector.

The Wake of Sticky Inflation and You

Historically, when the Federal Reserve employs a series of rapid rate hikes to tighten monetary policy and fight inflation, it most often leads to a recession. Capital markets seem to believe a recession is imminent. Fed Fund futures predict the fed policy rate will decline by about 1.75% over the next 18 months, yet the sticky effects of inflation have resulted in a -2.02% real fed policy rate as of February 2023, adjusting for inflation. That is indicative of substantial uncertainty.

The effects of a recession on credit markets and fixed income investments can be significant. As interest rates rise, borrowing costs increase, leading to a decrease in consumer and business spending. This reduction in spending can lead to a decrease in demand for loans, which can hurt banks’ profitability. Additionally, a recession can cause loan defaults to increase, further hurting banks. Moreover, banks tend to become more cautious about lending ahead of and during recessions, which can decrease the overall supply of credit. This decreased supply can make it harder for consumers and businesses to get loans, further exacerbating the economic downturn.

This is a plausible chain of events for the rest of the year and presents a unique set of risks to client portfolios that we are actively monitoring as part of our fiduciary investment process. Our focus among equity asset classes has already shifted heavily toward thematic quality—managers who invest in companies with strong balance sheets and maintain strong competitive advantages. Our natural posture in the fixed income space is already skewed toward safe and conservative asset classes, however, we are actively monitoring economic conditions and preparing further shifts toward safety and security within fixed income asset classes given the growing concerns of a recession and its potential impact on credit markets and fixed income investments.

There is no better time than during periods of uncertainty to consult with your Fiduciary Investment Advisor. The team is always available to address questions and concerns, clarify and articulate the American Trust investment approach, and to help frame or explain the impact of short-term events on long-term goals.

Please do not hesitate to contact your Fiduciary Investment Advisor if you would like to discuss your investments or financial planning.

Products and services offered by American Trust Company are not insured by the FDIC, are not a deposit or other obligation of, or guaranteed by, American Trust Company, and are subject to investment risks, including possible loss of the principal amount invested.