One lesson I learned during 40 years at a trust company is to always talk to your clients during tense market moments. Now is appropriate. Consistent with past communications, the current conditions will be described followed by commentary about the future.
Monetary Policy
Two actions are operative:
- The Fed has raised the cost of short-term borrowing by 5.25% and in a relatively short period of time (14 months). This was preceded by almost 15 years of low to no cost of short-term borrowing.
- As part of creating the low to no cost of money conditions, the Fed actively purchased $trillions of U.S. Treasuries (a policy called “quantitative easing” or simply “QE”) often offset or exceeded the U.S. government’s budget deficits. Now, that policy is in reverse. The Fed is selling those Treasuries (now called “Quantitative tightening” or “QT”).
Currently, the Fed is in a “watchful waiting” mode, but likely done with raising the cost of money. Their QT policy will continue, possibly into 2025. The intent of their combined policy “tools” is to reduce inflation to the 2% “trend” level.
Monetary policy takes time to have its effect, the notorious “lags”. Notably, it is about economic activity not happening. For instance, a capital expansion that pencils out profitable at low interest rates may not show profits when the cost of capital is at least 5% higher. So, the project doesn’t happen.
Second, project or purchase financing done as recently as two years ago at very low interest rates will face much higher refinancing rates when that debt comes due. The financial capability of borrowers is now the pinch point.
Cumulatively, both policies are having their effect…slowly. What the Fed is looking for is reduced economic activity to ease the upward pressure on prices i.e., inflationary pressure.
Fiscal Policy
The US Government budget is projected to incur a deficit of $1.6 trillion this year, and slightly lower in fiscal 2024. For reference, our economy – called “GDP” - is about $26.5 trillion per year. That deficit is 6% of GDP.
In addition to the deficit spending, three major legislations add to what needs to be financed by the bond markets: The Infrastructure Act of 2021, the Inflation Reduction Act of 2022, and the CHIPs and Science Act of 2022. Together, these add another $2.3 trillion to be financed. They are spread over several years, so combined total averages 9% of our economy. That is huge. Now, add the tab for the Ukraine war and Israel’s defense.
You may have heard the shorthand references “fiscal put” or “Bidenomics”. Running large fiscal deficits described above when the US economy is arguable fully employed is relatively new policy territory*.
Political Influence
The disfunction of the Republican House members is certainly going to be challenged by President Biden’s new funding request (c’mon, it’s only $105 billion!) and in mid-November, the continuing budget resolution.
Geopolitical Influence
Israel – Israel was well along in diplomatic normalization discussions structured by the Abraham Accords. That is now on hold to see how Israel proceeds against Hamas. At issue is the “Arab street”, or the perception of Israel by the masses. If Israel goes “scorched earth” in Gaza, they will lose the Arab street, and hence, the ear of Arab leaders.
Japan is inching closer to ending their massive monetary policy experiment that supported and /or maintained levels in their stock and bond markets. It is simply not sustainable. But the potential bad outcomes are a huge increase in Japan’s government debt financing cost, and the end of their cheap currency. This may well be a 2024 market influence.
Europe is…Europe. Germany’s GDP looks to be dipping negative and the entire region is almost designed to be sluggish. Hopefully contracted fuel supplies will be maintained for the duration of winter.
China –Their likely growth descends to 2-3% pace in the next few years. Indeed, their recent 4.5% GDP growth used 1.5% deflation to “add” to the underlying 3% growth. China has a serious balance sheet problem in their real estate sector (at least). In addition, China has dropped in attraction as a place to do business - stealing intellectual property, security harassment of executives, and capital flow restrictions. Foreign companies have “gotten the memo” so are seeking to invest capital elsewhere. China remains un-investable for the foreseeable future.
Ukraine War – the usual lousy fall weather in the war zone will slow down events, and the stalemate conditions remains the key feature. The motivation for a negotiated end is rising on both sides. Er, both the US and Russia.
Commentary
With all these factors as preamble, what does it look like going forward?
The Middle East is a wild card, so assumptions must be made. Ours is that Israel will use sufficient military “finesse” to accomplish their goals and not lose the Arab street. Net, no wider war, US military involvement, or oil at $150. The payoff from relative peace in the middle east has been envisioned – that is the incentive.
Our economy has been showing growth despite the rapidly tightened monetary policy. Credit the “fiscal put” including the add-on legislations mentioned above. These look to provide support well into 2024. Has the business cycle been repealed? No. Just postponed.
We are seeing economic data indicate a fade, both in terms of consumer and company spending. That is what the Fed is trying to achieve. Added to that is student loans are now back to being repaid monthly, which subtracts from economic activity. Finally, the “fun is over” from the covid related stimmy checks. Estimates for upcoming GDP trends certainly look slower, especially on an inflation adjusted basis.
We also assume that monetary policy will result in higher real rates (inflation adjusted) over a longer span of time. This is a new interest rate “regime”. Equally important, we assume that the Fed specifically does not want to “break something” as that would necessitate new emergency policies. The Fed is trying to get away from QE. Keeping rates high enough to “wear down” the economy and upward inflation pressures is what they are trying to achieve. So, we’ll call 5.25% the top. Forecasts for reductions starting mid 2024 make sense to us.
Areas of serious concern? A large issue is that investments made during the prior low interest rate regime are now priced at a loss. Most owners can simply hold them to “maturity” and chalk them up as lousy investments. For others, they are a meaningful portion of their balance sheets. We got a glimpse of the issue earlier this year with the failure of three banks. Who is at risk? We sense some mid and smaller sized banks due to commercial real estate lending, but we’d also add private equity and private credit to the pool. No one is going to admit the issue and any chance to “kick the can down the road” will be utilized. Does Wall Street have a solution? Of course! There’s some $2.2 trillion waiting in funds to buy those “distressed assets”. They’ll profit, but current asset owners…not so much.
Another large issue is simply the amount of US Government financing the bond market is being asked to do. You see the deficit described above, now add about $1.1 billion of Treasuries the Fed is selling per year. That gets to over 13% of our GDP. Of late, interest rates have been rising despite the war in the middle east – usually you see a “flight to safety” bid in such circumstances. The question is: is the amount to be financed simply too much? The bond market rules. If they say no, that is the answer. And not a pretty one. The Fed can reduce their QT pace on the fly – and that would release a new round of “re-figuring” by market participants.
Assessment
So, what does all this mean for one’s investment portfolio? We are in the middle of company earnings reports, so we’ll get new information on what managements are seeing. In general, companies are coping, but we have seen only a fraction. We continue to point out that the S&P 500 is expensive on a P/E (valuation) basis, but that is skewed to the larger companies that have been driving the index’s performance this year. The equal-weighted version is priced much better. As are midcaps as represented by the S&P 400. International equities? Still not a fan. Overall, maintaining target allocations toward equities.
Fixed income securities finally offer real income returns after many long years in the desert. For a lot of investors, bond returns now meet their investment objectives. And of course, they offer a degree of protection against the potential for “negative shocks” in either the economic or political arenas. Rebuilding your “lifestyle assurance fund” allocation is appropriate, at a minimum.
As you rightly conclude, now is a good time to revisit your investment objectives and how your portfolio is positioned to meet them**. Let me know when you would like to talk.
Pete Kennedy, CFA
Kennedy Investment Counsel
(248) 561 4597
KIC317.com
*Though I’d argue it has its roots way back with the Reagan administration
** I’d also put in a plug for revisiting your estate plan. Substantial changes in taxation occur in 2025 so many will be contacting their estate planning attorneys. Get ahead of the rush!