In today’s blog, we are talking about the current economic environment and how it impacts us.
I know I might be jumping the gun here, but I’ve been feeling very nervous about the state of inflation and how that is going to affect my rental houses, stocks, and expenditures.
While I hope I am wrong, I prefer to err on the side of caution.
Low interest rate and economic boom
First of all, since the 1980s, the world has been turning into a complex global network of businesses.
An additional 2 billion people from India and China joined the global labor force. We all also enjoyed a technological boom that unleashed a multitude of efficiencies and productivity gains for the global labor force (the inventions of the computer, internet, cell phone, iPhone, Airbnb, Amazon, Google, Craigslist, etc.).
Many countries stopped investing in their militaries and instead focused on trade and innovation. All of these contributed to productivity gains, which ultimately aided the Fed in pushing inflation and interest rates lower and lower.
If you look at the chart below, you will see that since 1982, the inflation and interest rates have been on a steady decline.
Of course there are other factors that really pushed the interest rate picture to nearly zero back in 2021, and this is mainly due to the quantitative easing that started in 2008, when the Fed started buying up Treasury bonds to artificially lower interest rates in a bid to ramp up economic recovery from the housing crisis.
The Fed then went into beast mode back in 2020 and expanded the balance sheet to $9 trillion in an effort to suppress interest rates even further and get the U.S. economy through the pandemic.
General concept of how interest rate help push up asset prices
So lower interest rates effectively elevate the value of all assets, from land to businesses to bonds to houses. Lowering the interest rate on government bonds essentially pushes trillions of dollars from the bond market to the stock market because the typical bond investors won’t get any return on bonds.
How would you like to be a fund manager giving your client a big fat zero return on investment while still charging fees? So of course, these folks will be buying riskier investments.
The Fed was also buying mortgage bonds, effectively driving the mortgage interest to nearly zero too. As people can afford more housing, this obviously leads to the rise in housing prices.
This is especially the case since there is currently such a widespread housing shortage in the country; any excess affordability would be sucked up in the rise of home prices.
Is the party over?
The Fed might have overdone it a bit: this process of lower interest rates has pushed the stock market to the highest of the highs. Property prices have shot through the roof, and the sky seems to be the limit. This is true about the bond market as well.
When will inflation go away?
The backdrop of pent-up demand from coming out of the pandemic coupled with the slow restart of the global economic engine after a near-complete shutdown has pushed inflation even higher.
What is worse is the fact that there is also a war raging between two countries that supply a significant amount of the world’s resources (i.e., Ukraine is the breadbasket of Europe, and Russia controls 20% of the world’s oil).
Thanks to these factors, inflation is already hitting highs that have not been seen since the 1980s.
But if you think risk and inflation should be at their peaks, I’ve got a few other things for you to consider.
1. China’s potential contribution to inflation
Right now, thanks to China’s zero-COVID policy, China is in economic peril.
The demand is limited by lockdown. Think about it: People from the most populous country in the world have been locked up or partially locked up for months. Small- and medium-size businesses are being killed. People are not allowed to leave their houses, and delivery trucks cannot make deliveries. All these factors mean there should be minimum demand coming out of China right now.
This is, in fact, good news for the rest of the world, which is suffering from low supply.
But the zero-COVID policy will eventually end, which means millions of Chinese will be coming out of very strict lockdown. I am a big believer that Chinese people are just like everyone else — there will be a significant demand boost coming out of the zero-COVID lockdown. And just like the West, with many of the small- and medium-size businesses destroyed, there will be a supply issue.
When the lockdown is over, I think you will see even more inflation as people will want to travel far from their city apartments just to get away. They will want to eat out more, even if only a few restaurants, if any, still remain.
Sure, you can say Chinese factories will open up and, thus, supply the world with more goods, which will push down inflation. But I am not sure how fast that can be done. I mean, we all saw global supply issues when we came out of lockdown, so why would China be any different?
2. War in Ukraine
At the rate the Ukraine war is going, how much do you want to bet that Russia, specifically Putin, will resort to its only effective alternative bargaining chip, which is a single or a series of tactical nuclear bombs?
Assuming this happens and the world doesn’t end, I would say that Russia would be sanctioned for a long time.
The problem is that, according to the OPEC minister, it would be nearly impossible to replace the oil supply that Russia contributes to the world. This means oil prices would stay elevated for a long time.
Sure, America can turn on its fracking machines, but that is not an instant process and would likely start to take effect in 2023 at the earliest, not to mention that shipping that oil to Europe is not an easy task and has got to be costly.
Yes, Europe is seeking alternatives, but 20% of the world’s oil is a lot of oil. I don’t think Europe is going to find that much additional oil anytime soon.
3. Ukrainian farmers holding off on planting crops
Ukraine is the breadbasket of Europe, and this war has already disrupted the farmers’ ability to plan crops this year.
This will cause a significant disruption in food production and distribution, including corn, wheat, and barley, to the world. If this war continues, it will likely keep going for a long time, and the food supply will by default continue to be disrupted. That also can’t spell great news for those who want to fight inflation.
The Fed versus inflation
The bottom line is, inflation seems to be here to stay for the foreseeable future unless something is done about it, and that is where the Fed is coming in.
Specifically, the Fed has recently turned hawkish, meaning the once best friend of the investor since 2008 has turned into the average investor’s worst nightmare.
The Fed has already started to hike interest rates. So far, rates have increased 0.25% in March and 0.5% in May. Now the Fed has kicked into high gear, and they are talking about multiple 0.50% basis hikes every month until inflation is tamed.
On top of all of this, the Fed just announced they are going to sell $90 billion of Treasury bonds a month (i.e., $1 trillion of bonds per year) that it holds in its $9 trillion balance sheet (i.e., $9 trillion of Treasury bonds and mortgage-backed securities).
The Fed’s goal is to raise interest rates enough to slow demand and get inflation back to 2% per year without causing a recession. That has always been the goal of the Federal Reserve. However, historically speaking, the Fed’s track record for raising interest rates without causing a recession is pretty low.
So my bet is that we will have a recession somewhere down the line, maybe in 2023 or 2024. All of this points to lower asset (i.e., stocks, bonds, housing) prices.
Higher interest rates reduce asset prices
According to the most successful (and probably oldest living) investor of all time, Warren Buffet, interest rates are to asset prices like gravity is to matter. He has repeatedly stated this over the past 15 years.
This basically means that when interest rates move higher, the value of all the future cash that a company expects to generate will be worth less in today’s dollars. Alternatively, when interest rates fall, all the future cash that a company expects to generate is worth more.
What are bad investments during high inflation?
In a high-interest rate environment, companies that produce low earnings now and are expected to grow significantly in the future (i.e., startups, growth stocks, technology stocks) will feel more pain.
2. Companies without leverage to pass costs to customers (think mom and pop shops)
Frankly, from an investment perspective, I’ve been looking at this for quite a while, and the last time there was a supply shock (1972 to 1982), the S&P 500 dropped more than 50% of its value, mainly due to the Fed raising interest rates to fight inflation. In fact, the only sector in the S&P 500 that actually made it out of those years with significant gains were 1) commodities and commodity-related stocks, including gold, farming, and farmland stocks; 2) utilities, including oil and gas stocks; and 3) commercial REITs.
Moreover, the worst thing you can do is buy bonds. As interest rates climb, more and more people sell existing lower interest rate bonds to buy new and higher interest rate bonds, thereby causing existing bondholders to lose money as the prices of existing bonds fall from less demand. However, thanks to new ways of making money, there are also a number of exchange-traded funds, or ETFs — such as the Direxion Daily 20+ Year Treasury Bear 3X Shares, which shorts the Treasury index — that I think could be one way to protect yourself from potential inflation. However, this index is not a long-term hold, and while you can’t lose more money than you put it, it is very volatile.
Bottom line is, the world is a very different place than it was 20 years ago, and while we enjoyed the last 20 years of everyone winning by placing their money in index funds, you might not be enjoying any more double-digit returns for a while.
What are potentially good investments?
For now, I would say commodity, food production, farmland, oil, and materials, as well as keeping borrowed money borrowed (i.e., do not pay off your mortgage that has a low fixed-interest rate), are the probable winners in this directionless market.
And maybe, just maybe, add onto that list commercial banks, such as Bank of America, that are highly leveraged to interest rates and would earn lots of money when interest rates go up.
This is because of something called net interest income (NII). See, commercial banks make money by taking our deposits and lending them to the Treasury and/or giving loans. At this point, Bank of America has about $1.4 trillion in deposits that will be earning higher interest. In fact, as of the latest quarter earnings presentation, Bank of America will be making $5.9 billion of NII for every 100 basis point increase to the Fed funds rate.
And the hikes are about to get real, with 50 basis points in May and potentially more down the line. So fingers crossed on this one.
With all that said, what should your overall investment strategy be? Well, it depends on your particular approach, of course, but if it were me, I would avoid investing in companies that rely on future revenue. Instead, focus your attention on commodities, food production, and banks, at least until inflation is under control.
Would you add anything else to the list of things to pursue or things to avoid as you prepare for a recession? Leave a comment below and share your thoughts.