November 22, 2022
The faceoff between Jerome Powell and the U.S. economy continues. At this point, just maybe the economy is gaining the upper hand. Despite four consecutive 75 basis point increases in the Fed Funds rate this year to almost 4%, the economy remains resilient. Treasury yields beyond five-year maturities have moved down aggressively after the most recent report on inflation, and the yield curve is as inverted as it has ever been in the current rate increase cycle. The economy was still able to swing to positive GDP of 2.6% in the third quarter. The monthly employment report has continued to show positive, albeit slowing, growth even as the unemployment rate ticked up slightly. Fed Chairman Powell has said he will not blink and vows continued aggressive rate hikes until the inflation rate reverses significantly and moves back towards 2%.
So, is it wise to cast your lot with Jerome Powell, and take him at his word regardless of what happens to the economy? That would probably mean investing in an intermediate or longer bond portfolio, with the expectation that he will continue to raise rates until inflation is vanquished, regardless of what happens to the stock market and the economy. Ultimately, a Powell win would manifest itself in lower long-term rates due to lower inflation, a much weaker economy, or some combination of both.
Or do you believe that the economy can weather the Powell rate hurricane and remain resilient until inflation begins to decline due to some combination of Fed tightening and marginal economic slowdown? This is often characterized as the “soft landing” scenario. Keep in mind that concurrent economic indicators are at a level consistent with GDP of 3% to 4% in the fourth quarter.
Over the last few weeks, we have had a rally in both the stock and the bond markets, as the S&P 500 Index has moved up almost 11% since October 12 and the ten-year Treasury yield has fallen over the same period. So far this year, the stock and bond markets have typically fallen at the same time, not risen, so let’s peel the onion.
The big move in both the equity and the fixed income markets took place on November 10th. On that day, the headline CPI report for October came in lower than expected, the S&P 500 increased 5.5%, and Treasury yields fell 25-30 basis points – huge moves for a single day. So far, that market gain has held up over the following trading days. Many said the market rally was unjustified by such a small move downward in a key inflation measure. Shouldn’t the market demand far more proof that the inflation dragon was slayed? It is important to note that this sign of moderating inflation was happening at a time when the economy was still rather robust. The housing market has certainly slowed, and there is news of layoffs in the tech sector, but consumer spending is still strong, and the employment market has shown resiliency. This combination of factors is the key. If inflation can turn down while the economy continues to grow, that is the goldilocks outcome where almost everyone wins.
It is also difficult to have a recession or a market correction when everyone anticipates it. Some large businesses are trimming employees, and many are managing their affairs in a conservative fashion, as if expecting a recession. Such anticipation can help avoid excesses caused by optimism that usually builds up before a recession. If companies are leaner, any unexpected pickup in economic activity should result in revenue that creates bottom line profits.
The Fed does not believe we can have a persistent cooling of inflation without weakness in the economy. The October inflation report hinted that just such a combination may be possible. It will take more subdued inflation readings to convince the Fed. With commodities prices, implied inflation in the TIPs market, and crude oil prices all stable to lower, there is reason to be optimistic. In the meantime, we can be thankful that the rally spurred by lower inflation has had staying power and that the increase in interest rates has given savers the ability to earn about 5% in short government and agency bonds.
Happy Thanksgiving to all.
Random thought: “We have two lives, and the second begins when we realize we only have one.” – Confucius
The Beatings Will Continue Until Morale Improves
September 28, 2022
Ok Jerome Powell and other members of the Federal Open Market Committee, we get it: you are serious about raising rates. Back in July and August, we (the market) suspected that their work might be done by the end of the year. As outlined in our July Viewpoint, many price indices were falling after the 75 basis point rate increase in June, followed by another 75 basis point increase in July. At that time, another 50-75 basis points were expected at the September meeting. The Fed did their best to talk down the market as it rallied, but maybe there were doubters about the resolve of the Fed. Well there is no doubt now, and the pendulum of Fed resolve may now have swung too far in the opposite direction.
We said in July that if the Fed recognized the easing price pressures in widely recognized market indicators, we may have seen the low in stock prices and the highs in longer term bond yields. Since the July Fed meeting, the broad commodities index is down 7%, crude oil down 15%, gold down 6%, and the dollar index up 6%. Commodities down while the value of the dollar is increasing are classical economic signs of deflation, not inflation. Our hope would be that Powell learned something about these relationships as an undergraduate student, but alas, his undergraduate degree is in political science.
Higher rates are certainly creating opportunities in the fixed income market. Treasury yields have moved above 4% across virtually all maturities. Yield spreads have widened on corporate bonds, moving yields close to 5% on intermediate maturity portfolios. Tax adjusted yields on our municipal bond strategy are even higher. We do believe we are getting close to the end of the Fed tightening cycle, and bond prices usually firm up and move higher when the end of the cycle is near.
Based on Jerome Powell’s comments after the latest Fed meeting, the beatings will continue. One economic positive has been the low unemployment rate, and Fed Chairman Powell has now explicitly stated that the low unemployment rate must also be beaten into submission and driven higher. As of 9/27, the S&P 500 Index is down 9% since the July meeting, and most other equity indexes are down more than 10%. Powell has told us this is mostly irrelevant to the Fed; he has said the unemployment rate must go up for the Fed to be satisfied, regardless of what other market and price indicators are foreshadowing. Investors in U.S. inflation-protected securities indicate future expectations for inflation have moved into the mid-2% range or lower across the curve, from two years all the way out to thirty years.
Another portion of the economy that has turned from tailwind to headwind is the residential housing market. The annualized sales rate for existing homes has fallen for seven months in a row, from 5.75 million in January to 4.28 million in August. This is below the roughly 4.7 million sales rate that existed pre-pandemic. New mortgage rates have skyrocketed this year, and the housing market is slowing even though, or due to, home prices being up 60% in the last three years. The housing market provides a key barometer of capital investment and consumer confidence, and it is one more concurrent price signal that the Fed should heed.
It seems Jerome Powell and the Fed have a both a tin ear and a blind spot for market price indicators. They are also receiving warning signs from global economic activity and exchange rates. The dollar has skyrocketed versus many other currencies. Dollar strength adds a strain to foreign economies in multiple ways. It makes imported goods that are produced in the U.S. more expensive, and it makes debts that are denominated in dollars more difficult to repay. These risks are evident in foreign developed and emerging stock markets that have underperformed U.S. markets.
These are some of the many signs of decelerating economic activity and lower prices to come. We have to believe that they will be recognized by the Fed in the near future. If this happens, there will be strong rallies in both bonds and equities. The price earnings ratio for the S&P 500 Index is now below 17 times 2022 earnings. The last instances of a ratio at this level were briefly during the market correction in December of 2018 and at the beginning of the COVID crisis in 2020. When the bounce in stock prices happens, the P/E ratio of the market goes up because it takes time for the earnings recovery to manifest itself. As the P/E goes up in these situations, deniers who claim there is still too much uncertainty and that prices are not justified by earnings miss these major market moves. While 2022 has certainly been challenging for stock and bond investors, we encourage investors to recognize the long-term opportunities lower stock valuations create and the fact that short US Treasury securities now yield over 4% – the highest levels in 15 years.
Random thought: “Life starts all over again when it gets crisp in fall” – F. Scott Fitzgerald, The Great Gatsby
Listening to the Markets
July 19, 2022
Often the markets will send signals about the current, and potential future, state of both the economy and the markets, but investors have to be willing and open to listening. Most often, preconceived notions about what should be happening get in the way. It’s easy to only see factors that support one’s worldview, and this “recency bias” leads investors to expect that whatever is happening currently will continue. We have suspected since the early spring that the July and September FOMC meetings would be key for the economy and the markets. Rate increases of 25 basis points in March, 50 basis points in May, and 75 basis points in June were expected by the markets. The stakes get much higher from here.
Over the last month or two, fears of a recession have begun to approach or surpass fears of inflation. The markets are sending this message. Most stock indexes fell between 15-20% in the second quarter, and the NASDAQ, the home market for many growth and tech companies, dropped by more than 20%. The Fed paid little respect to the stock market as a leading indicator at their June meeting. Stock prices and valuations dropped during the period, as investors feared future actual and estimated reductions in earnings.
But changes are afoot, especially over the last four to six weeks. National Association of Purchasing Managers manufacturing and services indexes fell to yearly lows, and their pricing index declined for the third straight month. New and existing home sales have declined. Small business optimism is at a nine-year low. Indicators of consumer confidence have plunged. One bright spot is employment; the unemployment rate has remained below 4% since the beginning of the year, employers struggle to find employees, and many who are willing to change jobs can gain significant salary increases. At the same time, changes with the employment picture are also creeping in. Weekly unemployment claims have slowly climbed to an eight-month high. These are economic activity indicators that have rolled over, but price indexes are also moving lower.
The commodities index is now down over 10% since early June. Crude oil is also down over 10% over the same five-week period. Market indicators of inflation over the next five and ten years have moved to twelve-month lows. All of these market price indicators have moved lower. The Consumer Price Index (CPI) is a trailing indicator. Waiting to stop rate increases until you see a decline in CPI is truly like driving a car while looking in the rear view mirror. Chairman Powell, are you playing checkers while market participants play chess?
It is entirely possible that we have already seen the high in longer Treasury rates and the low in the stock market. The FOMC raised rates 75 basis points on June 15th. The ten year Treasury yield hit a high of 3.48% on June 14th and is now 50 basis points lower. The S&P 500 Index closed at a low of 3667 on June 16th and is now 7% above that level. Based on what has happened in the economy and the markets over the last month, we would not expect the Fed to follow through on the 2% of rate increases that are anticipated over the next four Fed meetings this year. Those potential increases would bring short-term rates to over 3.5%. That is higher than all longer Treasury yields, which have moved lower over the last month. Keep in mind that all of these lower commodity prices and slowing of economic indicators have happened with the Fed Funds rate at 1.625%.
If the Fed is successful in recognizing a decline in price pressures, and responding with a slower path of rate increases, that could be very good for both the stock and bond markets. Declines in stock and bond markets are painful, especially when they happen concurrently. In most bear markets, defined as 20% declines from peak, market returns are higher one, three, and twelve months out. So far, that is what has happened since early June.
We have remained focused on summer as a key point of reckoning for both the Fed and the economy. Our best case scenario is that price indicators would slow or reverse their rise and the Fed would recognize the change and slow the path of rate increases. The apparent softness in the economy should help get their attention as well. Our concern is that the Fed now wants to see a material slowing in the economy, in addition to lower price indicators and inflation, in order to feel justified that they have vanquished the inflation genie. We believe that the market is sending signs that their work is on-track and closer to complete than recent backward looking inflation indicators may indicate. Jerome Powell, listen to the markets.
Random thought: “In my career, the Fed has a 100 percent error rate in predicting and reacting to important economic turns.” – John Allison IV, retired CEO of BB&T bank
Is it still 2022? Have this year’s market moves aged you? Don’t worry, you are not alone in these feelings, but rest assured that we are considering all of the relevant information and working hard to position portfolios with a longer-term view in mind. The S&P 500 has had its worst start to the year since 1962, with yesterday’s darlings bearing the brunt of this pain. If anything, the recent market losses serve as a reminder that investors should be focused on their long-term goals that rely upon diligent planning, implementation and actionable items in order to reduce the negative impact of making an emotional decision that is based more upon short-term biases instead of actual facts.
Market corrections have always tested even the most experienced investor. They also happen to be a very normal part of fully functioning investment marketplace. The real challenge is that corrections test an investors’ fortitude, conviction, goals and overall approach which quickly leads to even more fear, pessimism, and outright despair. Despite the list of growing negatives that investors are currently facing, there are still a number of positive items that support taking a longer-term view:
How are we positioned and what does it mean to you?
Our investment process revolves around our risk controls. As a reminder, client portfolios remain fully invested, are positioned sector-neutral to respective benchmarks, and currently maintain valuation discounts. These tenets have been accretive year to date, as value stocks (lower price to earnings) have generally held up better than pricey growth stocks (higher price to earnings). Given the severity in divergence of returns across sectors, the fact that we also remain diversified across all eleven market sectors has proven beneficial as well. This fully invested positioning should continue to ensure that when, not if, the market moves higher fully invested client portfolios will stand to benefit from the market’s shift upward.
We have seen a common theme emerge amongst investment managers that believe current market conditions have provided investors with an attractive buying opportunity. This is a sentiment that we also happen to agree with. As a result, Dana has been focusing its efforts to identify those companies that are less economically sensitive and those that can protect their profit margins. Therefore, we are seeking to own companies that exhibit both a resilient business model as well as strong pricing power, both of which are key elements of our investment process. This type of approach supports a longer-term view regardless of short-term noise.
Overall, we remain committed to our relative valuation discipline which provides the potential for downside protection along with the benefits of more positive price movement when the market regains its footing.
Our counsel has always been to stay invested, within the risk tolerance guidelines that you have set with your clients. Your guidance, as an advisor, is always beneficial in times of stress and uncertainty. This is a time to be proactive with your clients – let us know how we can help.
Disclosure: Dana Investment Advisors welcomes any comments to their blog and is more than willing to discuss or explain any aspect of it. This blog is provided for general information only and is not intended to provide specific advice or recommendations for any individual or entity. This is not an offer, solicitation, or recommendation to purchase any security or the services of any organization or individual. The foregoing reflects the opinions of Dana Investment Advisors.
April 25, 2022
The coming actions of the Federal Reserve have now become the key focus and driver of the equity and bond markets. Even though they faced issues during their tenures as Chair of the Federal Reserve, Ben Bernanke and Janet Yellen did not face the issue that Jerome Powell faces now. In March, the S&P 500 dropped almost 13% from its early January high and annualized CPI increased from 7% in December to 8.5% in March.
Over the last quarter century, whenever the markets or the economy encountered a period of stress, the Federal Reserve was able to ride to the rescue by providing liquidity and encouraging investment by cutting rates. During the 2008 recession, the Fed not only cut rates to .125%, but doubled the size of its asset holdings from less than $1 trillion to over $2 trillion. Their asset holdings doubled again to over $4 trillion in 2014, and doubled once more to over $8 trillion by the middle of last year. Annual U.S. GDP is about $23 trillion, and total U.S. debt is over $30 trillion, including intergovernmental holdings. In the last three hiking cycles, Fed Funds peaked at 6.5% in 2000, 5.25% in 2007, and 2.375% in 2019. Whenever the markets have indicated that they cannot tolerate higher rates, the Fed has heeded that warning.
Has there been a downside to an easy Fed? Not in decades. The Fed has been able to cut rates and add additional stimulus to the economy by buying assets. They began by increasing purchases of Treasury securities, then added mortgages, and even supported the corporate bond market through purchases during the COVID-19 crisis. None of these liquidity measures triggered inflationary spikes, providing a seemingly free lunch.
Now the Fed says that it is serious about controlling inflation, and realizes that its actions may cause asset prices to decline and will likely slow economic growth. The market believes the Fed is serious. As of September of 2021, the Fed Funds futures market expected one rate increase by the end of 2022. That increased to three expected increases three months later. By the end of March, the futures markets expected eight quarter-point increases over the next nine months, and now that expectation is closer to ten.
Can the Fed maneuver through 2.5% of rate increases over the next eight months? We doubt it. Real GDP growth is trending back to the 1-3% per year range. Inflation should pull back as the spike in energy due to the war in Ukraine recedes. There are other constituents in the CPI, such as shelter costs, that will prevent inflation from falling back to the levels of the last decade. Treasury yields are in the 2.5-3% range across the middle of the curve, and long-term market indicators of inflation have not moved above 3%. We believe that the market sees sub 3% Treasury yields as a sign that the Fed will not be able to raise rates to 2.5% this year and may not get beyond 1.0-1.5%.
What will the Fed do if the market or economy falters, or before inflation shows signs of receding? This is the reckoning. No Fed has faced this dilemma since Paul Volker vanquished inflation in the early 1980s. We expect a weakening market or economy to slow or stop Fed rate increases before the Fed Funds rate hits 2%. A better outcome would be indications that inflation was retreating prior to the implementation of all of the currently expected rate increases. Nevertheless, it is a dangerous time, and we will be watching closely and taking necessary action in our managed portfolios as the markets react to Fed actions over the next three months.
Counterintuitively, rates at the longer end of the Treasury curve usually peak at or near the beginning of a Fed-rate-hiking cycle, so most of the pain may have already been experienced by bond investors. Going forward, there is more yield to offset further price declines, and this should comfort bond investors. In the equity markets, the correction has lowered valuations. Economic tailwinds exist from a strong housing market, consumers with low leverage, corporations with strong balance sheets and a tight labor market that should maintain a low unemployment rate and strong wage growth. Consumers are also anxious to resume normal life after COVID-19 and this should keep consumer demand and spending robust.
Random thought: “Fasten your seatbelts, it’s going to be a bumpy night” – Bette Davis in All About Eve
April 5, 2022
Dana Investment Advisors is pleased to direct our inaugural donation from the Dana Donor Advised Fund, to ShelterBox USA, Inc., a US-based 501(c)(3) nonprofit and affiliate of ShelterBox Trust, an independently governed charity in the UK. ShelterBox USA is 4-star rated by Charity Navigator and Platinum rated by Guidestar – the highest ratings for non-profit organizations. ShelterBox was nominated for the Nobel Peace Prize in 2018 and 2019.
ShelterBox helps people when disaster strikes by providing them with emergency shelter and essential equipment, which includes helping refugees fleeing Ukraine right now. Our colleague and Fixed Income Portfolio Manager, Noaman Sharief, became a Board member last fall, and brought this organization to our attention. “What impresses me most about ShelterBox,” says Sharief, “is that the individuals associated with the organization are truly committed to serving humanity without delay.”
ShelterBox has three Ukraine-focused projects.
Project 1/Ukraine: Assisting Internally Displaced People (IDPs) who are sheltering in Collective Centers
ShelterBox is sending thousands of mattresses to evacuation collective centers, including schools, churches, and centers in western Ukraine, providing people who have fled their homes with somewhere to sleep and keep warm at night.
Project 2/Ukraine: Repairing Damaged Homes
ShelterBox is preparing to send thousands of ShelterKits, including heavy-duty tarpaulins, tools, and rope. The kits help repair homes that have been damaged so that families can shelter in place. The aid package includes high thermal blankets, hygiene kits, solar lights, buckets, and water carriers to help people survive in conflict-damaged buildings.
Project 3/Refugee Support:
ShelterBox will support refugees in neighboring countries with high priority portable items. As the conflict continues, the needs of people reaching the borders will increase. Resources of some countries are becoming overstretched as more and more people seek safety and refuge. Moldova, for example, has seen more than 380,000 people flee into the country – equivalent to more than 10% of its population.
Mark Mirsberger, Dana’s CEO notes, “Dana employees have always supported charitable efforts with their time, talent, and financial gifts. This new Dana Donor Advised Fund, established in Q4 2021, expands our collective efforts to help others. We plan on growing this Fund so we can provide financial resources to worthy causes like ShelterBox for years to come.”
If you would like to learn more about ShelterBox, please see: https://www.shelterboxusa.org/
A New Kind of World Disorder
March 15, 2022
A brave new world began on February 24, 2022. It is always easy to spot the mistakes that were made in hindsight, but the Western world clearly did not do enough to deter Putin over the last 20 years. He took advantage of U.S. miscues in Syria, and he was clearly testing the West with his incursion into the Crimean and the Donbas regions in 2014. He believed that he could invade and conquer most of the Ukraine, even though Russian puppet leaders have been driven from Ukraine twice in the last 20 years. The failure of the West was a failure to take the threat of invasion seriously and to provide serious deterrents prior to the invasion.
If the Russian invasion is stopped or turned back within the next few weeks, the consequences for the U.S. economy will be minimized. Russian population is less than half that of the United States and declining, and their GDP is 1/12 that of the U.S. The companies in the S&P 500 Index with the greatest sales exposure to Russia still derive less than 10% of their total sales from that country. Historically, bear markets in the U.S. have been driven by economic slowdowns causing recessions – not geopolitical events.
The U.S. economy was in the process of emerging from the COVID-19 pandemic when this equity correction began. While inflation and imminent Federal Reserve rate increases have also been clouds hanging over the market, the economy added 678,000 jobs in February as the impact from the omicron variant wound down. Personal balance sheets are healthy, the housing and auto markets are very strong, and wage growth is robust. Corporate America in aggregate has over $1 trillion in cash on their balance sheets, and they’ll likely continue to use it in ways that benefit shareholders, including boosting dividends, buying back stock, investing in their businesses and doing accretive acquisitions.
Even though cost pressures are intensifying, many companies have been able to overcome both increasing cost pressures and supply chain dislocations over the past seven quarters. Oil prices have spiked during the conflict, but the U.S. economy is far less dependent on oil as an input than it was fifty years ago. U.S. petroleum consumption has been roughly 20 million barrels per day for the last 45 years, even as GDP has more than tripled. The U.S. has also gone from importing 60% of its consumption in 2005, to being a net exporter of petroleum products in 2020.
As most of our clients understand, we are investors and asset allocators, not market timers. The events taking place in Eastern Europe are horrendous, but the state of the U.S. economy is strong. Equity investors should be aware that -10% market corrections are a normal and regular occurring event. While they can be stressful for investors, they typically occur every year even though U.S. equity markets have advanced over 10% annually since 1926. After a rough 2022 start, many equity investors have begun to forget how strong markets were in 2021 with the S&P 500 Index hitting 70 new all-time highs and only briefly experiencing a modest 5% decline. Last year’s 28.7% advance for the S&P 500 Index without significant volatility was exceptional and not typical. Corporate earnings of S&P 500 Index companies are forecasted to grow more than 10% over the next few years, and U.S. productivity and innovation remain strong. Based on this backdrop and on yields of other asset classes, we expect equities to remain the best performing long-term asset class and see no reason why they won’t provide returns similar to their historic average over the next market cycle.
While we caution clients about making emotionally driven allocation changes based on temporary setbacks, there are opportunities to reduce risk and generate consistent investment income with bonds and other asset classes. The Federal Reserve is meeting this week and is expected to begin a tightening cycle by increasing the Fed Funds rate by at least 0.25%. Our adjustable-rate focused Limited Volatility bond strategy will certainly generate higher income as the Fed increases rates. In our equity strategies, we are focused on adjusting our industry exposure within the industrial sector and taking some profits in higher valuation stocks that have been perceived as safe havens over the past few years. We continue to monitor inflation expectations, which we believe will be higher and more persistent.
Clearly these are challenging times for investors, and we are ready to meet these challenges by following our time-tested investment strategies and making adjustments based on our evolving outlook. We will continue to share our insights and welcome your questions.
Random thought: “There are decades where nothing happens; and there are weeks where decades happen” – Vladimir Ilyich Lenin
January 28, 2022
That’s something we haven’t had to talk about in a while. The S&P 500 Index has been on a fairly relentless path upward since the beginning of the COVID-19 shutdown in March of 2020. Through all of the twists and turns of the battle against the virus, through shutdowns and partial reopenings, through the discovery and rollout of vaccines, the market has trudged higher. We have had slight pullbacks in the S&P 500 that have lasted days or weeks, but the market has always resolved higher. Most of the dips are not even worth noticing – declines of a few percent lasting a few days. Until this month, the largest decline for the S&P 500 was slightly over 5% in September and early October 2021. Following that decline, it took exactly twelve trading days for the S&P 500 to reach a new high. By the end of 2021, it is possible that all of the non-believers had been swayed and had now purchased equities. When everyone is ‘in’ the market, there is no dry powder left to provide support when the market dips.
We have had turns in relative favoritism between value and growth companies over the last year. Value outperformed in the first half of 2021, only to see growth companies make up the difference and end the year ahead. Higher valuation growth companies have borne the brunt of the current correction. The S&P 500 is down about 7% this month, but the NASDAQ and small cap indexes have fallen somewhere in the mid teens. Maybe this represents a long-anticipated change in leadership, but it is far too early to tell. When the market climbs steadily, regardless of events, investing appears easy. Anyone can be successful. Buy and hold, buy the dips, etc. Corrections have a tendency to alarm investors and cause them to think short-term which can lead to mistakes and costly long-term decisions.
Future actions by the Federal Reserve seem to be a key concern of investors. The Fed is still buying securities in the open market, pushing dollars into the economy. They suggest that they will stop by March, allowing maturities to run off and their balance sheet to shrink. There are numerous constraints on potential Fed action, on both the stock and bond sides of the ledger. Although this correction seems normal, if it were to snowball into something larger, that would get the Fed’s attention and might cause them to walk back their rhetoric or postpone action. The Treasury market also must “allow” them to take action. The entire Treasury curve provides market feedback on expected Fed action. Ideally, the ten year Treasury yield creeps up methodically, and the two year Treasury increases as well. Normally, the Fed does not begin raising rates until the yield difference between two and ten year Treasuries is 1.5% or more. Right now, the difference in those two yields is less than 1%. The two-year yield is at 1.15%, which would seem to allow for a couple of Fed rate increases, but if the ten-year Treasury yield moves down from 1.8%, it doesn’t leave much room before the yield curve becomes inverted. We believe they will begin raising rates in March as long as the stock market and ten-year yields do not fall further from here.
We continue to believe there is still room for further economic expansion in this cycle. Omicron cases may be peaking, and it has shown to be a more virulent but less deadly strain. Demand in the housing and auto sectors is still strong, which is typically a very positive sign for the economy as a whole. Consumer credit balances have been paid down significantly over the last two years, so there is room for an expansion in spending, even at levels consistently above income levels. Fourth quarter GDP was 6.9%, boosted by a recovery in inventories. Full-year GDP was 5.6%, and the trailing three-year average is 2.9%, a respectable growth rate that includes the COVID-19 trough. Fourth quarter wages grew at over a 5% annualized rate, which should help support consumer confidence and spending. We are also confident that the beginning signs of a market turn from growth to value will provide an expanded range of potential investment opportunities for our portfolios. On the fixed income side, our prudent strategies provided strong relative performance in 2021, and higher interest rates will provide opportunities to earn higher income in the future.
Random thought: “A market downturn doesn’t bother us. For us and our long term investors, it is an opportunity to increase our ownership of great companies with great management at good prices. Only for short term investors and market timers is a correction not an opportunity.” – Warren Buffet
How We Work
November 29, 2021
For those of us who have “desk jobs,” COVID-19 changed the way we work, and we probably will never go back to how and where work was done in 2019. The implications are significant for almost every aspect of our economy. As a nation, we have become more productive, and report that our lives feel more balanced.
More than 18 months after the initial shutdown from COVID-19 in March of last year, only a fraction of white-collar employees have returned to the office in many major cities. Kastle Systems International is the major provider of card swipe systems for office access that have become ubiquitous in most cities. They collect data from 2,600 buildings in over 130 cities around the country. They show that New York City card swipes are down 52% from pre-pandemic levels. In San Francisco, swipes are down 57%. Chicago figures are comparable. New York subway ridership is below 50% of pre pandemic levels, and that is after recovering from levels that were far lower. Kastle Systems’ weekly index of U.S. metro areas currently shows that employees are still going to the office only an average of two days per week. As one would expect, southern states with more liberal reopening policies show a higher in-office presence, but still substantially lower than two years ago. It is fair to say that a significant portion of the workforce has settled into some type of hybrid work routine.
A hybrid environment lets individuals have the best of both worlds – no commute and none of the commensurate costs and hassles. It still allows collaboration through messaging and video apps, and in-person collaboration on in-office days. As many jobs have evolved into an interface between an individual and a terminal or computer, being “together” has become less of a priority.
The implications for both cities and less densely populated areas are significant. Large coastal cities and other major population centers may see a material plateau or decline in values for both commercial and residential real estate. The tax base will decline for sales, real estate, and income taxes. This will be a major funding issue for these areas. Service sector jobs that supported the urban commuter will disappear. Demand for support services in suburban or rural areas will increase, as new services will be needed for those working from home. The $1.9 trillion American Rescue Plan passed earlier this year funneled massive grants to municipalities, but this was a one-time funding. Cities that experience permanent population declines will experience declines in quality-of-life issues.
Many employee surveys have shown that most employees want to continue to work under a hybrid office/remote schedule. We all were forced into it last year, adapted to it, and don’t want to completely give it up. The reason many want a blend is that they see the benefits of both. We shouldn’t push too hard against this change; the experiment will allow us as a group to find the proper equilibrium. It has encouraged a more rapid rate of job change as well; resignations are at record levels, as individuals reassess their priorities and think about how they want to work. Economically, it has been for the better. GDP is at record highs, even with a smaller aggregate workforce. A satisfying and rewarding work life helps us all to live happier and more rewarding lives.
Random thought: “The only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle.” -Steve Jobs
“Look for the job that you would take if you didn’t need a job” -Warren Buffet
Repressed, Not Impressed
September 28, 2021
Why are bond yields so low when inflation is increasing? Why is the cost of food, housing, automobiles, and rent all going up faster than incomes? Welcome to the world of financial repression. The U.S. government is a net debtor. They have borrowed, spent, and now they owe. Inflation reduces future purchasing power. This is bad if you own assets, unless their value increases even faster than the rate of inflation. The total U.S. debt is now over 130% of GDP, while it was under 100% less than ten years ago.
Annual Federal spending from 1953 through 2019 was between 16% and 22% of GDP per year. Generally, it ran below 20% if the economy was growing, and increased to slightly over 20% during recessions. It rose to 24% in 2009 before dropping back down, but spiked to 31% of GDP in 2020, the highest level since the Second World War. Debt and spending typically grows along with the economy, and that generally causes no fiscal issues or stress.
As the debt load has increased, the burden has been lessened by generally low interest rates. Interest expense for the Federal government as a percent of annual GDP was less than 2% until the 1981 recession and interest rate spike. It was between 2% and 3% annually from 1981 through 2000, and then moved back down below 2% per year as interest rates fell and Treasury debt matured and was reissued at lower interest rates.
With current debt levels at record high percentages of GDP, and enormous future spending commitments as the boomer generation retires, higher interest rates would endanger the fiscal position of the U.S. government. The Treasury (Janet Yellen) and the Fed (Jerome Powell) would like to keep interest rates below the level of inflation. While this is not a good deal for bond investors, it certainly helps the Treasury repay the debt as tax collections increase due to inflation but the cost of borrowing stays low. Financial repression is the ability of governments to borrow and pay interest at a rate below inflation. Repression helps them as the seller of Treasuries but hurts investors as the buyer of Treasuries.
So, Powell and Yellen like the current status quo; low bond yields and high asset prices. High asset prices and low borrowing costs keep the economy humming. If we could run with this kind of status quo for a while, maybe the debt to GDP ratio would start to come down.
Unfortunately, Congress wants to get in the game with an enormous spending bill. Both Republicans and Democrats are responsible for the current dire state of fiscal affairs. The Democrats increase spending and claim they favor fiscal responsibility through higher taxes, and the Republicans cut taxes and claim they favor fiscal responsibility through decreased spending. Both parties usually only get half of what they want, and deficit spending grows.
There are some economic and market positives. The employment picture is strong, and wages probably have to go up across many industries. Consumer confidence may continue to support the economy and the recovery from the impact of COVID-19. One big positive is that the employment situation looks positive across the spectrum. Professionals that sit in front of a monitor have seen increased flexibility with work from home and are hesitant to give it up. Many are demanding and getting greater flexibility from their new employers when they change jobs, in addition to increased pay. Skilled industrial production workers are in short supply and will be able to gain pay increases as well. Direct service workers, usually among the lowest on the pay scale, will gain greater pay as it is necessary to get them to return to the workforce.
As the COVID-19 Delta wave recedes, there should be another surge of consumer spending, travel, and confidence. This will serve to support earnings and the market. Our shorter duration fixed income strategies will provide some level of protection against higher rates, especially at the long end of the curve where the Fed has less of an impact. Municipal bonds have also been strong performers in fixed income, with positive returns year to date versus negative returns in most other fixed income sectors. For most economic and fiscal issues, economic growth is the salve that makes things better.
Random thought: “I have not failed. I’ve just found 10,000 ways that won’t work.” -Thomas Edison