Focus on the US Dollar
Former U.S. Treasury Secretary James Baker commented some time ago that one of the greatest challenges to the union is that America is seen through our current account deficits and, even more importantly, the debt to GDP ratio. That ratio is at its highest level since the end of World War II. He argued that that is unsustainable. It eventually will significantly erode the standards of living for any country, let alone our own. A country can either significantly cut spending (along with other austerity measures), raise taxes or default on its debt. None of these are in the best interest of the country and none are politically, economically or socially acceptable. The answer, just as it was after WWII, is for the U.S. to inflate its way out of that ratio. In other words, let the dollar continue to inflate. That is not saying, however, that the current levels of inflation are acceptable or the answer.
The Fed’s Two-Tiered Mandates
The Federal Reserve is not shy about communicating its double mandate of a target of low inflation – they state 2 percent and full employment. Most consider full employment to be an unemployment rate of 4 percent. We are currently at approximately 3.5 percent unemployment, with a severe labor shortage and two job openings for every one person looking for a job. Inflation, by way of CPI is at 8.3 percent.
The Fed’s Target Inflation Rate is with PCEPI not CPI
Most of the media report inflation from the US Labor Department’s monthly reading known as the Consumer Price Index or CPI. It is consumer driven, is only from urban areas and gives its largest weighting to housing (or shelter). Investors should take note that the Fed uses the Personal Consumption Expenditures Price Index or PCEPI as its measure of inflation. This is important for investors because PCEPI is 6.1 percent and CPI is 8.3 percent at this writing. The Fed is somewhat closer to its target by way of PCEPI. The PCEPI gives a lower weighting to housing and is from a broader spectrum including producers and non-profits. The Fed feels it is a better indicator of inflation since it was introduced in 2012 (and is from the US Department of Commerce).
What About the Unemployment Rate
Fidelity Investments recently commented that for inflation to come down, unemployment would have to go up as high as 6.5 percent for the Fed to get to its inflation target. That is because this historically low unemployment is driving wages higher at an accelerating rate, thus driving inflation. The question is whether politicians and society would accept that. The answer is probably not. Add to that you see that higher rates of employment (because of fewer dollars in the economy) might release more stimulus with unemployment assistance. The more things change the more they stay the same.
The Impact This Has on Interest Rates and Yields
So, the Fed has tried to reduce inflation by raising short term rates, known as the Federal Funds rate to a new target of 3-3.25 percent. It has also begun to let those Treasury bonds (and Mortgage-Backed Securities) it bought during the pandemic mature (hence reducing the supply of money or liquidity out there). The immediate impact of this will be 1) U.S. banks increase what they earn on overnight deposits with the Fed or other banks and might therefore lend less (an intended outcome) 2) U.S. banks have an increased source of revenue (making the financial sector more valuable in our opinion) 3) Money Market Mutual Fund yields should continue to climb 4) CD yields, mainly shorter term, should continue to climb 5) the domino effect is felt in the Treasury market and ultimately mortgage rates 6) the economy should continue to slow. Risk averse investors can avoid market volatility by moving in to or accumulating assets in the cash equivalent type investments. One caveat: Take caution as to the real rate of return with inflation currently reading as high as it is. More risky assets such as stocks and real estate continue to be (despite their current volatility and price woes) the leaders in outpacing inflation and with the real rate of return.
Is it Different This Time?
We have quoted before the words of the great investor, Sir John Templeton. He suggested that investors take note of the four most expensive words in investing; “This time it’s different.” Reading the news and listening to the commentators, most investors are finding themselves tested and somehow believing that this time it is different. Peter Lynch (another great investor) often called that “background noise.” We don’t think this time is different. We look to history as a greater indicator of where things are and where they are likely to be in the long run. The economy is slowing, earnings are coming down. Stocks follow earnings. There is a winter coming or it has arrived. But spring will come again, and no one knows exactly when that will be, so best to be positioned for recovery vs. trying to time it (which is close to impossible). Some people get frustrated when they constantly hear it best to hold or wait and not give up hope at the worst possible time. We also take note that if you want to build your health you have to be consistent and respect diet and exercise. If you want to build your wealth, you must be consistent with buying and holding and or reallocating when necessary. We remind investors however that not one size fits all: Goals, Risk Tolerance (comfort level) are always the most important.
Our Current Thinking and Suggestions for Investors
The U.S. dollar will start to come down as foreign central banks will begin to sell their holdings of U.S. dollars. Japan has already begun doing this. The U.S. dollar, at this writing is at decades high and is up 16 percent ytd. That hurts other economies and the earnings of many U.S. companies who are multinational (many of America’s largest companies get revenues from overseas and their products and services are much more costly with a higher dollar hence hurting their earnings).
A cheaper dollar could mean stronger returns in emerging markets and with other currencies. Investors can buy mutual funds that invest in both and buy the individual securities. This is more speculative however, so caution is urged.
Inflation will continue to moderate. The Fed will coordinate further rate hikes with respect to PCEPI, not CPI.
Unemployment will rise, which will further reduce upward pressure on interest rates.
There is value with municipal bond yields and rates. The swift move in rates is producing yields, and we think values, not seen in more than 10 years. Investors in higher tax brackets could benefit by locking in these higher tax-free yields. Add to that most states are in strong financial shape and running surpluses.
The demand for housing (40 percent of the CPI and close to 20 percent of the PCEPI) will remain resilient but the opportunity to buy a home will remain muted with higher mortgage rates. Many would-be home buyers are forced to rent since they cannot afford to buy at these rates, keeping rents higher. Fewer new housing units are being built keeping some of that pressure on. Commercial real estate (office space) which is overbuilt could see some relief if landlords see opportunity in converting office space into condos and apartments to meet that demand. Real estate income investments or funds could provide attractive opportunities for suitable investors.
War, cyber warfare, cybersecurity and raised uncertainty with China: The Early Warning Report, in its August edition, continues to highlight the large defense and cybersecurity stocks for the foreseeable future.
Demographic trends: Will huge countries such as China reverse their population growth? Author Peter Zeina in his book “The End of The World is Just the Beginning” ponders this. That could have implications in the next few decades for demand, inflation and interest rates.
Health Care – surprisingly, inflation for health care costs has not been at the rate of PCEPI or CPI. The labor shortage is even more intense in this sector (37,000 fewer nurses than before the pandemic began). We think that economic environments such as this warrant an increased exposure to health care stocks or funds.
Power, or electricity consumption along with shortages, will continue to grow substantially. The world continues to grow its affluence and its standard of living. That means greater demand for power. Data centers (think the cloud), EVs, cleaner water and sanitation for the world, greater indoor climate control et al continue to drive that up. This has implications for continued fossil fuel demand (and hence the energy sector) as well as renewed demand for nuclear energy and companies that operate nuclear facilities. Oil prices will remain at $80-90 per barrel and hence continued strong earnings for oil companies. We think there will be a renewed emphasis on nuclear technology and construction. Expanded demand is also seen for natural gas and even coal for the foreseeable future. Wind and solar will continue to grow but so will the challenges (and opportunities) for the rare earth materials needed to build them.
Artificial intelligence and robotics technology and production will accelerate. This is one innovation that has accelerated due to labor shortages and higher labor costs. Those are the areas that technology companies can grow and expand and increase their earnings. Self-driving EVs and trucks still need to refine their programming but are coming faster than originally thought.
Lastly, the market is doing a lot of the Fed’s work and that is bringing asset prices, earnings, and ultimately inflation down. We are in or entering recession and yields will soon peak and by late 2023 will start to come down. Investors should always be cautious and prudent to not get overly influenced by the media-driven anxiety. Long term, buy and hold and patient investors have typically fared the best.
The First Wealth Management is located at First Florida Bank, a division of The First Bank, 2000 98 Palms Blvd, Destin, FL 32541. Branch offices in Niceville, Mary Esther, Miramar Beach, Freeport and Panama City. Phone 850.654.8122.
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