Inflation & Interest Rates
Inflation remains THE topic for today and the Fed continues aggressively raising rates to bring it under control. There is current thinking that we are in the 1970s again. While there are similarities, important dissimilarities are worth pointing out. History does not exactly repeat, but it does rhyme.
Commodity prices are a large part of inflation; however, many have already peaked and are falling. Gold is one of the main inflation indicators, but gold has fallen from 2075 to 1650 the last 2½ years which is a 20% drop. Five years ago, it was 1,428 so it is still up 17% after the drop. Other commodities falling from peak levels include: Lumber -62%, Copper -27%, iron ore -59%, DRAM chips -50%, Housing -20%, Steel -48%, and the Baltic Freight Index -78%, and Oil -31%. Oil may get a bounce since the Saudi announcement to cut 2M barrels of daily production. The Fed Chairman has stated that there will be no need for the aggressive rate hike tactics after inflation subsides. Could it be happening already?
The international markets are weak and the dollar is incredibly strong. The dollar is stronger now against the British Pound, than when we were still on the gold standard! And this is after adding $30T to the US debt. The dollar is just about on parity against the Pound and the Euro. The dollar may weaken going forward which creates a tail wind of opportunity for foreign investing that we have not had for several years.
The overly aggressive Federal Reserve may have already accomplished its goal and may have actually over achieved its goal but it does not look like they are stopping yet. The federal fund’s rate is now up from 0.25% to 3.13% and the futures are trading at 4.5% for June of 2023 and then falling off. The effects of interest rate hikes take a while to flow through the economy as projects and new hires are postponed or cancelled. It may be six months to a year from now before the results are more fully reflected by economic statistics.
We are definitely in a recession, as classically defined as 2 quarters of negative GDP Growth. Correspondingly, auto loan delinquencies are back to 2008 levels. However, some indicators are contradictory such as unemployment which remains at a low of 3.5% with a 50-year average of 6.2%. Both private equity managers and distressed debt can benefit long term from the opportunities of lower cost purchases. The traditional 60% stock / 40% bond investment strategy has been a disaster. This is the worst year in 50 years for stocks and the worst year EVER for bonds.
Private equity managers should benefit long term from the opportunities of lower cost purchases but they take years to work out. PE vintage years during recessions tend to do better over the fund life. JP Morgan is saying “alternatives are not optional, but mandatory.” Our hedged investments have hedged and some are positive for the year. Distressed debt is a cyclical strategy whose time has come. By the end of 2023 if rates stop rising, traditional bonds may become attractive for the first time in over a decade. While you wait roll T-Bills and make 3%.
Traditional managers and index funds have a harder time because they tend to remain fully invested. There is not as much tactical risk management in the industry today as in years gone by. The technical swings of human nature are a powerful force affecting investments and may have little to do with the economic fundamentals. We have been working on a solution for this and have partnered with the large research firms of Ned Davis Research and the NASDAQ owned Dorsey Wright for tactical indicators to bring in more risk management. Interestingly, the falling stock market so far been driven more by the technical multiple compression on the Price to Earnings ratio more so than falling earnings. Year to date the PE ratio has dropped by -29.7%, the main driver resulting in the S&P 500 return of -24.8%.
When inflation does subside, and the fed does not have to remain so aggressive, a whole new chapter will open up for the stock and bond markets. The markets usually start moving up BEFORE the recession ends. It is important to be ready and positioned well for this inevitability.
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