Risk is a Four Letter Word

The .75% rate hike by the Federal Reserve and their promise to move “aggressively and expeditiously both to raise interest rates and reduce its balance sheet,” (i.e. reduce purchases of treasuries and mortgage bonds) based upon how the economy and prices react reversed the yield curve ‘contango’ which had made short term rates higher than long term rates. But economists are worried that slowing demand from high energy, food, and borrowing costs will hurt consumers which drive over two-thirds of US Gross National Product. Indeed, less consumer spending lowers growth which causes assets to reprice. Ordinarily substituting bonds for stocks is a good place to wait out stock market declines, but with aggressive interest rate hikes, bond prices are doomed to fall as well.

Inflation, supply chain disruption, and the Russian “special military action” in Ukraine have transformed the global market climate to be broadly negative. China, Russia, Brazil, Bolivia, Venezuela, Saudi Arabia, UAE, India, and it looks now like Mexico as well, have not condemned Putin’s invasion of Ukraine. They have been outspoken protesting that the US and NATO favored war over diplomacy to gain geopolitical & military advantage. They now want to see an end of the “King Dollar” epoch to reduce US economic power.

To advance this outcome, many in this block are buying Russian oil despite sanctions against doing so. They also are circumventing the “Petro Dollar” convention which unless it holds together should/may/will end the US security agreement with “friendly” Arab oil producing countries. Such a change could bring significant consequence because the ‘Petro Dollar’ arrangement (security protection in exchange for dollar denominated oil trade) has underpinned the value of the US Dollar ever since the US went off the gold standard back in 1971. Should this happen the question is what will happen to Dollar demand and in turn yields to sell treasuries? President Biden will need to convince Saudi’s Crown Prince not to merely pump more oil but of the merit of preserving our ‘Petro Dollar’ agreement at a time when Saudi relations with the US are at best “cordial.” Through our international contacts we are closely monitoring this development.

Meanwhile Europe, already in recession, has several national banks at the tipping point of insolvency. The European Central Bank wants to take them over to centralize power and this too further challenges US ADVISORS COMMENTARY CON’T… Page 2 Dollar dominance in Europe. These global dynamics mean the US Treasury must diligently work to sustain the US Dollar’s value keeping it the most attractive treasury for sovereign debt purchasers.

No developed country wants a weak currency because money is mobile and flows to the highest and most secure place. This means US rate hikes are likely to be matched to maintain parity and that Quantitative Easing may very well return as lower gross receipts make servicing high debt tough and printing money is easy.

An attractive currency (money) is both a factual as well as perceived phenomenon. A strong currency with a high yield attracts money but hurts a country’s exports making them more expensive. Raising interest rates slows growth causing assets to reprice because investors’ expectations of future prices are tied to earning's growth rates. Consecutive interest rate hikes intended to slow inflation ultimately leads to Recession when negative consumer sentiment and less spending lowers profits leading to less capital investment and layoffs.

Engineering a soft landing depends on optimizing monetary and fiscal (tax) policies to balance consumption and production. Political divisions cause us to expect more market downside until inflation is under control which is not likely until after the mid-term elections. Because we will only know inflation is contained after the fact, the Fed will likely overshoot causing market mispricings and good opportunities.

Yet knowing what’s ahead is never possible with 100% certainty so our approach is to regularly assess the “health of the economy” and look at what the risk and opportunities are based on that assessment. In the present Bear Market, we hold cash, drug, energy, financial, tech companies and commodities while hedging our technology holdings. We continue to monitor our “Buy List” but don’t believe the market has bottomed yet as downward earnings revisions may not yet be fully priced-in. We are closely monitoring “Dollar Risk” and how the credit and market risks in debt securities, now off-loaded from banks, plays out for private equity, pension plans and leveraged hedge funds. Moreover, we are forever mindful that liquidity is crucial during a market correction and are positioned so we can gain advantage when opportunity becomes overtly obvious.

In summary, it is going to be a hot, volatile summer but one to enjoy. We are on watch and as always truly appreciate your trust and confidence.