Stagflation or Deflation?

Year-to-Date economic data is mixed and centered on the health of the economy. 99% of CEOs now expect an economic downturn though half think it will be mild in the US according to Ernst Young ’23 survey. This outlook is shared by most CFOs at public companies as they expect only a mild recession in 2023, according to Deloitte’s 1st Quarter ’23 CFO Signals survey. CFOs say they expect revenue growth, earnings growth, and capital investment to rise modestly driven by acquisitions, divestitures, and joint ventures in new markets which 99% say they are considering. The top concerns of companies according to the surveys are persistent Inflation which they expect to average 4-6% throughout 2023, supply chain disruptions exacerbated by geopolitical tensions, and talent shortages.

TO policies. We are witnessing deglobalization, rising interest rates, war in Europe, failing banks, a soft real estate market, King Dollar competition, and continued stimulus spending to re-shore strategic manufacturing, decarbonize, and stabilize the banking system. Ordinarily a confluence of so many forces would suggest inflation may be difficult to bring down because these are stagflation drivers. Yet inflation is coming down noticeably except in food and energy. But if banks tighten credit and charge higher borrowing costs due to the Fed’s rate hikes and commercial office loans implode, the economy could easily descend into a deflationary environment.

The consensus of investors clearly believe we’re heading into a stagflationary environment as they believe the Fed will reverse course and lower interest rates both to thwart a deep recession and to assist banks and insurance companies whose balance sheets are in trouble with the mismatch of demand deposits (and income payment guarantees) with their long-term bond holdings. It is the expectation of lower rates that accounts for the relief rallies we’re seeing before the Bear market is over.

Recall the Housing crisis back in 2008-2009 caused the Fed to lower interest rates to zero to stop debt accruals and to fight Deflation (asset prices falling). Remember also we are now at the end of a 40-year debt cycle of interest rates going from peak to trough and back up again quite rapidly. Cheap money creates asset bubbles that are now bursting, and the fix is credit restriction. Less credit and higher debt service charges cause contractions and recessions. With the Fed on record saying “The historical record cautions strongly against prematurely loosening policy. Without price stability, the economy does not work for anyone.” (Fed Meeting August 29, 2022). We think the consensus is right the economy will contract, but wrong that the Fed will cut rates for two reasons. First inflation has squeezed the middle-class putting them in an economy that does work. Higher costs to borrow results in less borrowing and spending. Less of these lowers prices to attract demand. We believe lowering prices is one of the Fed’s ultimate goal. Secondly, the Fed can hardly say publicly they are worried about financing US debt. Knowing the US must re-fi nearly $4 trillion in debt this year and that a consortium of foreign countries is moving away from Dollars, the Fed must keep interest rates attractive to incent sufficient purchasers. And while averaging-up by adding higher yielding bonds with lower yielding ones may make bank and insurance companies balance sheets look less worrisome, it would also continue the distortion of the stock and bond markets. Undoubtedly the Treasury will support the Bond market. They must because they finance the economy by issuing bonds. They don’t issue stock.

The problem is cheap money attracted a lot of takers and too much debt has been issued. The bank failures underscore the problem. As of 12/31/22 the Deposit Insurance Fund reportedly had $128 billion in assets to back the FDIC’s deposit guarantee of $10.1 trillion of insured deposits. Another $7.8 trillion of deposits are uninsured. After the failures of Silicon Valley and Signature banks, Secretary of Treasury Chief, Janet Yellen initially stated the blanket coverage of deposits would extend to all banks. The next day this statement was clarified that all Depositors insured or not at SVB would be covered. Other banks could use the NEW! Bank Term Funding Program to borrow for a one-year term using US Treasuries or other assets and the Fed would lend the face value for these assets no matter their market value. This explanation was immediately followed by a $300 billion liquidity injection into the banking system to meet deposit withdrawals, stabilizing what could have been a panic event. These funds will be provided by issuing new Treasuries and necessarily will be part of the debt ceiling negotiations by Congress over the next several months. The compelling question is will it be $500 billion or a Trillion or more?

So, what are investors to do? Our Answer. Think normal.

Fear of a widespread banking crisis clobbered regional banking stocks and lifted Gold’s price a bit higher. We have not bought into the decline of regional banks expecting bad news on insurance companies next due to their underwater real estate portfolios. We also don’t expect a significant gold and silver rally to usurp “King Dollars” dominance until deglobalization and a re-ordering of the US trade supply chain away from China is complete. Looking objectively at the present situation, we believe maintaining a strong dollar is crucial for the US and holding interest rates in the “normal” range of 5-7% on long maturity bonds supports belief in the FF&C of the US. For this reason, we lean toward taking Fed Chairman Powell at his word. We believe interest rates will go a bit higher, stay higher longer, and bring some pain particularly to the over-leveraged.

We also do not advocate investors buy insurance products like annuities and indexed universal life until the cloud is removed on what backstop insurance companies require. Insurance companies have the same problem as banks and hold similar assets of government bonds and real estate loans.

The fact is for 14 years interest rates were kept abnormally low which caused investors to favor stocks and dividends over fixed income investments that offered comparatively puny returns. We expect to see a long reversal and move towards normalization with high prices for some goods and services and falling prices for others. This fissure will be amplified by the inflationary forces mentioned above colliding with powerful monetary, and eventually fiscal, policies in a Deflationary-Inflationary tug-of-war.

As a Total Return manager working to keep money compounding, we adhere to three financial principles: keep investment costs low, invest in the best opportunities, and combat risks to protect principal. During times of uncertainty risk management combined with a disciplined process to seize value, as Warren Buffett says: “when others are fearful,” is part of our investment process. For now, we are being patient partially hedged and sitting with ample “dry powder” to pounce when favorable prices warrant action. We are not there yet anticipating on-going supply problems, export disadvantage from a rising dollar, and fallout from both geo-political military and economic events on the horizon, but we will be before long.

Thank you for your trust and confidence. Enjoy your summer as we are Watching Your Money!