The one question we never get asked but are asking ourselves is, “Is it possible that interest rates must go even higher to bring inflation under control?”

While we are nearly fully invested in all our strategies (with Global Fixed Income sitting very defensively), we cannot ignore the potential need for higher rates across the yield curve to combat inflation. If and/or when that becomes a reality, we may find ourselves navigating more challenging times because the market is not pricing in a higher-for-longer scenario at all.

This disbelief is evident in the current interest rate yield curve. Since World War II, the yield curve has never been this inverted—meaning that the short-term rates are higher than the long-term rates—for this long. Looking further back, the only other time it was longer was in 1929. (We won’t go there).

Believing that interest rates should return to the lows we saw over the last decade is an emotional belief. It’s also been a contagious one. We say “emotional” because no empirical evidence exists that such a scenario would fit within any historical context. Yet, the global debt markets, especially the U.S. debt markets, are building in a “soft landing” as the base case, unwilling to place any material probability on a bad case.

Why are we at Auour being such downers?

Why can’t we bask in the ever-higher equity prices, the tame fixed-income markets, and leave things be?

Because the federal debt is currently 121% of GDP, with no significant political resistance to the ongoing inflationary deficit spending. As the government offers higher interest rates to support this spending, there’s a risk that private-sector borrowing will be squeezed out. Why take the risk when you can just buy treasuries? The difference in interest rates between government debt (considered virtually risk-free) and private sector debt is at unprecedented lows, reflecting a highly optimistic scenario. Over the next four years, more than $2.5 trillion in low-quality corporate debt will need refinancing. Additionally, we are facing persistent inflation, which might be structural rather than cyclical, potentially leading to a more challenging environment for consumer spending.

Let’s look at some charts to illustrate our concerns.

GDP growth has been surprisingly strong. Even with that, the growth in federal debt continues to outpace it.

The chart below shows the historical interest rate spreads for investment-grade and high-yield debt. The current spreads are the tightest they have been since the late 1980’s suggesting premium pricing (which equals low implied debt costs) and no room for error if rates move higher or economic default scenarios need to be built into expectations.

One may argue the positive side of this situation is that companies have locked themselves in low interest payments. And that is true, up to a point. Unfortunately, much of that debt is nearing maturity and needs refinancing. (Imagine a world where you had locked in a 3% mortgage on your house but needed to refinance it at current rates.) In the case of corporations, the refinancing discussion will be around a higher interest rate and a lower level of appetite for as much debt by investors, pushing management teams into an uncomfortable situation. The charts below show the amount of debt that is in need of refinancing over the next few years.

If rates fall, the situation for corporations depicted above may not be that big of a deal. What would allow rates to drop outside of a collapse in the economy? A tame inflationary environment. But that doesn’t appear to be in the near future, as we are now seeing a re-acceleration in inflation, as shown in the inflation measures below.

With such a high level of emotional contagion, it’s crucial that we respect the empirical evidence and not become complacent in the belief that we are through the storm. As we wrote in the fall of 2023, it is only now that we are entering a period of heightened risk of an economic downturn. Those who expected it in early 2023 did not respect history: it takes time for rising rates to impact economic growth.

Market prices reflect companies’ past growth, current profitability, and future growth expectations. Sometimes, those three can combine to create a feeling of invincibility. We see that now in both the equity and fixed-income markets. Those feelings can change quickly, as we experienced at the start of the pandemic and during the fall of Silicon Valley Bank. In those cases, the U.S. central bank quickly pushed more money into the system as deflation was feared or inflation appeared to be peaking. But now, those two outcomes seem hard to envision.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

We’ve been saying for a while that today’s market landscape is shaping up to be quite different from the past. We said it first in our December 2021 newsletter, “No More Mr. NICE Guy.” We doubled down on the sentiment in June 2022, with “A New Regime.” Predicting shifts in the economy isn’t a walk in the park, especially because such forecasts span years, and it can also take years to verify their accuracy.

Although experts always have room to disagree, it’s reassuring when others with considerable expertise corroborate our outlook on the likely future market conditions. Specifically, we would like to bring your attention to two memos by Oaktree Capital Management’s Howard Marks, who, with more than five decades of investment experience, began arguing in December 2022 that we are likely in front of a materially different investment landscape as we exit the period of easy money across the globe. Although his “Further Thoughts on Sea Change,” from May, offers a comprehensive overview, we recommend also reading last December’s “Sea Change,” for a more nuanced understanding.

Two of Mark’s comments (in bold text throughout this newsletter) stood out to us.

“This memo’s main message is that the changes I described in Sea Change aren’t just usual cyclical fluctuations; rather, taken together, they represent a sweeping alteration of the investment environment, calling for significant capital reallocation.”

“Bottom line: If this really is a sea change—meaning the investment environment has been fundamentally altered—you shouldn’t assume the investment strategies that have served you best since 2009 will do so in the years ahead.”

The chart above shows the total return of various segments of the global market since the market bottom of 2009. For many, this was the start of the easy money environment, when central banks began working to solidify the balance sheets of the global banks. Equities shined over the next 15 years, with the tech blockbusters found in the NASDAQ, leading the charge by a large margin. (It is not surprising that equities outperformed fixed income; equities were very depressed at the end of the financial crisis.) The NASDAQ outperforming is telling. With easier money flowing into the investment world, and with rates falling, investors looked to long-term growth opportunities, not fearing economic uncertainty as it became assumed that central banks would save us from a weakening economy.

Tighter monetary conditions could change the leaderboard, if Marks’ comment is accurate. Whom it changes to is uncertain, but it would be difficult to argue that high-growth companies will command the same valuations going forward.

Let’s move on to another thought Marks emphasizes:

“Everyone who has come into the business since 1980, in other words, the vast majority of today’s investors, has with relatively few exceptions only seen interest rates that were either declining or ultra-low (or both).”

The left chart, above, shows intermediate government yields since 1983—note the ever lower interest rates until 2021—and attempts to decompose the interest rate into the primary factors that drive it. The other observations that stick out to us are the market’s continued belief in a future lower rate environment (expected average real short rates in dark blue), the belief that investors will not demand higher rates for longer-term debt (real term premium in light blue), and the negative expectation for inflation (inflation risk premium in yellow).

The chart on the right shows that the rising inflation expectations (shown in yellow) have not been reflected in a higher inflation risk premium as the dots lie under the historical trend. If we do not see inflation expectations move lower, the tendency would be for long-term rates to build in a more normal premium that could result in another 1% move higher in rates for that component alone. We could see how the charts displayed above lead to the following comments from Marks:

“In Sea Change, I listed several reasons why I don’t think interest rates are going back to that period’s lows on a permanent basis, and I still find these arguments compelling. In particular, I find it hard to believe the Fed doesn’t think it erred by sticking with ultra-low interest rates for so long.”

“Rather than letting economic and market factors determine the rate of interest, the Fed has been unusually active in setting interest rates, greatly influencing the economy and the markets.”

The charts below help demonstrate Marks’ statement about central banks setting interest rates. Since the financial crisis, central banks have been buying government debt in their effort to lower interest rates. That behavior accelerated during the Covid response, significantly distorting global market pricing and likely leading to malinvestment. He says:

“Importantly, this distorts the behavior of economic and market participants. It causes things to be built that otherwise wouldn’t have been built, investments to be made that otherwise wouldn’t have been made, and risks to be borne that otherwise wouldn’t have been accepted.”

If it is true we are moving into a new regime of tighter money—as would be expected from the charts above, which suggest a draining of liquidity through quantitative tightening—it should be expected that the distorted investing and risk-taking will unwind. The issue is that we are not sure how it would happen.

Marks lays out a convincing argument for a change in regime—the sea change—but one should question if his specialty, which is opportunistically purchasing distressed debt instruments, biases his view. He acknowledges this, addressing the ways he could be wrong. One stands out:

“If inflation isn’t brought under control, nominal returns could lose significant value when they’re converted into real returns, which are what some investors care about most.”

And back we come to that dreaded inflation conversation. Historically, current inflation readings would have had us at much higher short-term rates, as depicted in the chart below. Using various forms of inflation (shown in the green columns), historical rates would be between 7% and 9%, versus the current level of 5.75%.

To make matters a bit worse, the deceleration in inflation readings we have experienced since the beginning of the year has lessened. And we could start to see inflation tick back up. The chart below looks at those elements within the inflation calculation that are faster to adjust. Recent readings are signaling a move higher rather than a continuation lower.

This all sounds scary, but it could be looked at more as returning to a period that we experienced in the past, specifically the late 60s and throughout the 70s. Therefore, if Marks is right, we should be learning from the past and trying to avoid the market segments that were more recently benefiting from the easy money. As Charlie Munger said, “All I want to know is where I’m going to die so I never go there.”

Where are those places that potentially require avoidance or at least caution? We will answer with a few comments made by Marks in his May 2023 newsletter:

“Five years ago, an investor went to the bank for a loan, and the banker said, ‘We’ll give you $800 million at 5%.’ Now the loan has to be refinanced, and the banker says, ‘We’ll give you $500 million at 8%.’ That means the investor’s cost of capital is up, his net return on the investment is down (or negative), and he has a $300 million hole to fill.”

We see this as a bigger issue in 2024, when about a third of the high-yield debt market will reach their maturity dates and need to refinance. Many took advantage of the low rates after Covid and will now need to right size their business for a new environment.

“It’s very notable that almost the entire history of levered investment strategies has been written during a period of declining and/or ultra-low interest rates. For example, I would venture that nearly 100% of capital for private equity investing has been put to work since interest rates began their downward move in 1980. Should it come as a surprise that levered investing thrived in such salutary conditions?

The private equity market is estimated to be $4.7 trillion by Preqin, a research group focused on alternative investing, about ten times larger than it was in 2000. As Marks suggests, we doubt many of the current participants in the private equity market have gone through an extended period of rising rates and tight money. Goldman Sachs estimates that over half the experienced return in private equity funds has come from multiple expansion and leverage—two factors that may turn tailwinds into headwinds for the industry. Marks says,

“Whatever the intrinsic merits of asset ownership and levered investment, one would think the benefit will be reduced in the years ahead. And merely riding positive trends by buying and levering may no longer be sufficient to produce success. In the new environment, earning exceptional returns will likely once again require skill in making bargain purchases and, in control strategies, adding value to the assets owned.”

The last 15 years have been a panacea for momentum-leaning investors. And if you could invest while using leverage, your dreams could come true. Now, that may change. What made people rich through high levels of leverage might lead to ruin. Value-based investing has had a tough time through this easy money period. That may change in the new regime.

“Finally, conditions in those halcyon days [of low interest rates] created tough times for bargain hunters. Where do the greatest bargains come from? The answer: the desperation of panicked holders. When times are troubled, asset owners are complacent, and buyers are eager, no one has any urgency to exit, making it very hard to score significant bargains.”

If Marks is right, and we are heading into a period where central banks cannot or will not backstop the investment markets, bargains will start to show themselves. Our mantra has always been what Warren Buffett said best, investors are wise “to be fearful when others are greedy and greedy when others are fearful.”

The reference window for many may span a decade or so. In that case, the overarching assumption that the current high level of interest rates is transitory and will soon revert to their low levels that some investors consider more ‘normal.’ However, interest rate cycles have historically covered 60 – 70 years, making the last 15 years only a phase within the cycle. We concur with Marks that now is the time to expand one’s view to a longer time period and prepare for a different investment landscape.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

The media often plays up the narrative that the U.S. dollar is about to lose its dominance. We can understand investors’ fear but cannot find an argument that warrants the decline in dollar power. We could find reasons to think the dollar may lose some value relative to others but to lose its status as the world’s reserve currency seems hard to justify.

The interesting thing about currencies is that for one to lose, some other one needs to win. So, for all the concerns about the U.S. dollar, one needs to be able to find another currency (or set of currencies) that allay those concerns—no easy feat from our standpoint.

We wanted to have some fun, so we asked ChatGPT to help us write this newsletter. We asked it to write a dialogue between a salesman and a prospective client where the salesman wants the prospect to commit to using the dollar as its reserve currency. The conversation is displayed below. Within it, we will add our thoughts (in blue), either agreeing or disagreeing with ChatGPT.

Note: we have not adjusted ChatGPT’s dialogue at all.

Salesperson: “Greetings! I’m here on behalf of the US Dollar, the primary reserve currency of our world.”

Prospect: “Hello. I’ve been contemplating a shift to the Euro, Yen, or possibly even the Renminbi. Can you persuade me otherwise?”

Salesperson: “I’d be happy to! Let’s begin with stability. The US Dollar is grounded in a resilient economy – one of the most diverse and robust globally. But the strength of the Dollar is not only in the economy but also in the rule of law that governs the United States.”

• Economic resiliency comes in many forms. One way is to measure import/export activity as a percentage of total GDP. The lower the number, the more economically independent the country. The U.S. is resilient in this measure as global trade accounts for approximately a quarter of total GDP. Japan and China are over a third of their economy, and European countries (individually) are in the 50% range.
• Another resiliency measure would be core commodity production to satisfy internal needs. The U.S. is the largest oil producer, with enough to be recognized as a net exporter, and the second largest grain and protein producer, contributing about 20% of the world’s supply.
• And since the salesperson brought up the Rule of Law, the U.S. sits in the same position as European countries and Japan from the governance standpoint. The only way to see this as differentiation is the military power that backs up the U.S. relative to its peers.

Prospect: “That’s a fair point. But what about the Euro? The European Union is quite an economic powerhouse, too.”

Salesperson: “Indeed, the EU is an influential player. However, it comprises multiple countries, each with their unique economic issues. The US Dollar, conversely, is supported by a single, unified economy, fostering predictable and sound monetary policy, all under the umbrella of a strong legal framework.”

• With currencies tied to countries, the perceived value of a currency will be driven in part by the government’s taxing authority backing it. The E.U. has not reached the point where one government has the power to tax. And that each country within the E.U. still has its own central bank adds complexity to currency stability.

Prospect: “The Renminbi’s growth seems promising, though. China is the second-largest economy in the world. And Japan’s Yen has long been a pillar of stability.”

Salesperson: “True, but liquidity and convertibility are crucial considerations for a reserve currency. The US Dollar, being the most widely traded currency, provides unmatched liquidity and ease of conversion worldwide. The Renminbi, while growing, is still heavily regulated, limiting its convertibility. The Yen, despite its stability, lacks the widespread global acceptance that the Dollar enjoys.”

• Much of the dialogue surrounds the power of China. There is no doubt that China has increased its presence around the globe, but we find it hard to see when individuals will want to hold their savings in its currency. The chart below demonstrates the hurdles for China. The Heritage Foundation assembles data on the freedom of different countries. The comparison below is that of the U.S. versus China. The trust in China’s currency is a function of people’s trust in the freedom of operating within the Chinese economy. It appears to have a long way to go.

• We are unsure what ChatGPT references with the lack of the Yen’s lack of global acceptance. What we do know is that Japan is an aging society that has been fighting deflationary trends for over three decades. With few natural resources, a small population, and a considerable level of government debt relative to the size of its economy, it is hard to see the Yen take more on its shoulders.

Prospect: “But the US Dollar’s influence seems to be lessening, doesn’t it?”

Salesperson: “While it’s true that other currencies are growing, the fact remains that international contracts – especially for commodities – are still predominantly denominated in the US Dollar. Its status as the de facto currency for global trade remains unchallenged. Plus, the US military, as the most powerful in the world, provides an extra layer of assurance and stability to the US Dollar’s dominance.”

•  As China increases its presence within its geographical region, they have been able to execute more trade in Renminbi. However, it still reflects a very small percentage of total global trade. The chart below demonstrates the extent of U.S. dominance in global trade. China’s share has grown but only to the extent of trading with neighboring countries.

Prospect: “You make a strong argument. I hadn’t fully considered all these factors.”

Salesperson: “That’s why I’m here! Ultimately, the choice is yours, but consider the proven stability, liquidity, convertibility, and global acceptance of the US Dollar. Plus, it’s backed by a strong rule of law and the world’s most formidable military force. When weighing the strengths of reserve currencies, these factors should be front and center.”

• One item that the AI salesman did not mention is the expected population changes over the next 50 years. The chart below shows the expected changes in population for a set of countries using the year 2000 as the index starting point. The U.S. is expected to grow its population by about 35% over the century, while China could see its population shrink by a third. To put some numbers behind this, China’s working-age population peaked a few years ago at 800 million and is expected to finish the century at 350 million. Economic strength is built on population size, suggesting a headwind for China as we progress through the century.

A currency serves three functions. It must be the unit of measure regarding the value of goods and services, it must be widely used as a medium of exchange, and lastly, it must be a store of value. Many currencies serve at least two of these three. The store of value is the trickier element that filters the list down to just a few.

But to be a reserve currency takes more than just checking those three boxes. It requires trust. Trust that savings can be obtained and converted as demanded by the saver. Trust that the currency’s value will not suffer a significant devaluation on the whim of elected officials. And trust in the political stability of the government backing the currency. Russia has been a recent example of the instability that surrounds authoritative regimes. Though China looks stable, it should not be forgotten that the communist regime has existed for only 100 years and accounts for only 7% of the population. Stability is not a foregone conclusion.

It cannot be guaranteed that the U.S. dollar will maintain its dominance. However, with the information that we see, its demise is highly improbable.

We wish you all a Happy Independence Day.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

White oaks are large, deciduous trees native to eastern North America. The wood from the white oak is highly valued for its strength, durability, and resistance to decay and insect damage. It is also appreciated for its lack of porosity, making it vital to the spirits industry, which ages bourbon in oak barrels for decades. For a spirit to be labeled a bourbon, it must, by law, be aged within a new, charred white oak barrel, creating an ongoing need for a stable supply of new barrels. The cooperage business is highly secretive, so annual barrel production numbers are not disclosed. However, as of 2020, the Kentucky Distillers’ Association estimated that close to 11 million barrels were in use within the state.

Stay with us. A recent episode of Bloomberg’s Odd Lots podcast discusses how the white oak population is expected to decline by 70% over the next four decades unless we address the issue now. It may seem like a problem that can wait, but you must plant and protect the seedlings to have a mature tree in 40 years. The issue is so significant that the bourbon industry has joined forces with forestry services and other stakeholders in forming the White Oak Initiative (WOI). It aims to stem the decline in young trees to sustain a healthy ecosystem.

The WOI produced a report addressing the implications of the long-term loss of white oak trees and provides a plan for combatting the underlying causes of the declining population. One of the more prominent action items: to allow prescribed fires within the forests. In past newsletters, we have mentioned how new forestry strategies in the West involve reversing past practices and starting the use of small, controlled forest fires to reduce the likelihood of large, uncontrollable fires. The small fires remove stored energy in the form of leaves and brush from the forest floor. The white oak plan is based on the same concept. Its powerful root system allows the tree to survive a small fire while the fire removes competing species with weaker root systems.

Are the investment markets so boring that Auour is turning its attention to forestry? No, reader, far from it (although our interest in bourbon as it relates to quality of life is not insubstantial). Listening to this podcast, reading the WOI’s plan, and perusing the web for fun facts about bourbon, the cooperage industry, and trees did have an investment purpose: to find the right analogy for the current investment environment.

The Federal Reserve is walking a tightrope as it works to fight inflation by slowing the economy… but not too much such that it causes significant economic disruption. We appreciate that the Fed’s dual mandate (i.e., protecting the currency’s value and maintaining full employment) has put it in this challenging position. However, its actions to prevent economic turbulence before it starts are no different from past heavy-handed forestry practices of squelching any spark that flies toward a forest. Those good intentions to fight any and all fires resulted in a growing instability in North American forests.

The Purchasing Power of Money

Let’s start with an overarching question: Why do we invest? The answer is to maintain and grow the purchasing power of our savings. We love a Big Mac and want our savings to enable us to afford them in 10, 20, and 30 years in the same manner we can afford them today or better. In other words, we want ten dollars of our savings to purchase the same, if not more, in the future as it can today.

And the biggest hurdle to maintaining purchasing power is inflation.

With the aggressive and determined steps the Federal Reserve has taken since March 2022, we thought the conversation in 2023 would turn to concerns around corporate profits as inflation trended through the year toward the long-term target. The collapse of a few large regional banks initially reinforced our belief that those events would quicken a credit cycle, bringing about an earnings recession and adding confidence that inflationary pressures would subside. This seemed like an unintended, yet effective, prescribed fire, localized to a few regional banks.

But recent inflation readings have not suggested it is quickly moving toward the desired 2% level. And the Federal Reserve governors have been making statements that they may pause to see the impact of past rate rises and the expected restrictive banking behavior.

The government and Federal Reserve’s response to the current banking situation gave many the impression that these institutions blinked. Over the past twelve months, as interest rates have increased, the fixed-income markets consistently expected the high rates would be temporary, and they priced in lower rates starting mid-year 2023. The fixed-income markets did not believe the Fed would keep rates high, even though that was the message from the Fed. Well, words are one thing, and actions are another. And the Fed’s recent indications of a pause in further rate increases favor the fixed-income market being right versus the Fed.

The weekend that Silicon Valley Bank and Signature Bank were taken over, government entities insured all deposits (but said it was a unique situation that wouldn’t be repeated even though this was the third time we have seen them do something similar). In addition, they set up a new credit facility for banks to easily access new funds at the Fed using assets on their balance sheets even though the prices of those assets were suspect. Cutting to the chase, they added liquidity to the system, putting out a fire before it started.

From our seats, the Fed’s credibility is severely jeopardized. It says it wants to reduce liquidity in the system to slow inflation, while its most recent action was to throw more money into the system.

We at Auour are concerned that the Fed is not walking its talk, a similar position the Fed found itself in the early years of the 1970s, where an aggressive Fed (which oversaw an increase in the effective fund’s rate by 8% in less than two years) blinked as banking fears flared. It was followed by one of the worst inflationary periods in the history of the U.S. economy. At that time, the Fed placed its fears of scorched earth above the long-term health of the forest. The chances of a repeat have increased.

Coinciding with the Fed’s noticeable reluctance to fan the flames brought on by the bank failures and maybe a bit less willingness to fight inflation, we are hearing more people suggest that slightly hotter inflation is not something to fear.

Inflation of 2%, 3%, or 4%? What’s the big difference if inflation stays higher for longer? The numbers are small.

The table above helps to show what small differences in inflation rates can do to the purchasing power of a currency. A one or two-percent difference sounds small, but it isn’t. As the table demonstrates, the difference between an average 2% inflation and a 4% inflation rate over ten years can result in a further 20% decline in purchasing power. So the Big Mac got a lot more expensive.

Fed chairman Jerome Powell has stated that he wants to be the Volcker (the Federal Reserve chairman who strongly broke the back of inflation focused on protecting the dollar’s power), not the Burns (the Federal Reserve chairman who blinked in the early 1970s). Powell’s actions started strong, like Burns, but now comes the test of his resolve to protect the currency at the risk of economic softness. Volcker has repeatedly stated that his overall mission was to protect the dollar’s reputation. Powell seems more focused on protecting the reputation of the banking sector—two very different things.

If it isn’t clear yet, we worry that the Fed is losing its resolve to fight inflation. They can’t seem to let prescribed fires burn, potentially increasing the instability within the ecosystem. We do not advocate for a scorched earth policy. Still, we believe that economic turbulence is a necessary evil that exposes the weak companies and strengthens the surviving ones (usually those with a better business model and prudent management), leading to a more stable and durable environment. Like White Oaks.

So, if we are facing a period of a weak Fed and stubborn inflation, how do we look to, at a minimum, protect purchasing power? Equities have shown resilience throughout time, though not for the faint of heart. The graphic below plots the yearly returns of the fixed-income class (using the 10-year Treasury bond as a proxy) versus the equity market annual return (as measured by the S&P 500 Index). With all the caveats that past performance may not translate to future returns, the chart below tells a story. Years in which inflation ran above 5% are depicted in red, while those below 5% are in blue. Focusing only on the red dots, there is only one instance where bonds had a positive real (after inflation) return. For equities, seven out of twenty produced positive real returns. Not great odds. Of those thirteen years producing negative returns, roughly half produced a greater than 10% decline. Obviously, the future can and will be different, but history should be respected.

Here comes the sales pitch. Those periods of inflation had periods of good equity returns and periods that were bad. Suffering that turbulence can make one think they are winning against the fire and then quickly change to fearing they are trapped by it. This, we believe, argues for a dynamic approach to equity investing. We, coincidentally, offer a dynamic approach to investing.

Given the shifting winds, we expect this year to be more dynamic than most. Over the course of this year, we have moved more into equities, first desiring large U.S. exposure and recently moving more into U.S. mid and small-cap and international equities. We continue to carry a more defensive posture in the fixed income investments, seeing no need to wander far from short-duration investments with higher income production.

IMPORTANT DISCLOSURES

This report is for informational purposes only and does not constitute a solicitation or an offer to buy or sell any securities mentioned herein. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. All of the recommendations and assumptions included in this presentation are based upon current market conditions as of the date of this presentation and are subject to change. Past performance is no guarantee of future results. All investments involve risk, including the loss of principal.

All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Information contained in this report has been obtained from sources believed to be reliable, Auour Investments LLC makes no representation as to its accuracy or completeness, except with respect to the Disclosure Section of the report. Any opinions expressed herein reflect our judgment as of the date of the materials and are subject to change without notice. The securities discussed in this report may not be suitable for all investors and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Investors must make their own investment decisions based on their financial situations and investment objectives.

Not a day goes by without an article discussing inflation. And since that is the topic of this article, today will not be the exception.

Good inflation, bad inflation, deflation, stagflation, disinflation, hyperinflation… Did we miss any?

Most examples of very bad inflation, or hyperinflation, have occurred in smaller countries, where outside-their-control factors, such as energy costs and food dependency, caused havoc, and where the country’s politicians controlled the printing presses. (Keep that thought in your back pocket.) Maybe the U.S. with its reserve currency status and relative self-sufficiency, is structurally designed to escape long periods of high inflation? Might the same be true of Europe and Japan, the other major nations with reserve currency status?

Regarding intermediate and long-term inflation trends, it’s not easy to build a logic chain that gets you to a confident outcome one way or the other. Analyzing the short term is easier. Pent-up demand from being sequestered for almost a year, supply chain disruptions that can take months or even quarters to fix, and the availability of easy money is driving up prices in goods, services, and real assets. We see it daily, with current inflation indicators at century highs.

Given the data, it is not a question of if we have inflation (we do in goods and in asset prices), it is a question of if it can and will persist.

There is an argument to be made that persistent inflation is unlikely without a scarcity of core, non-discretionary inputs. (Think back to oil in the 1970’s). For inflation to take hold, households need to experience a steady increase in personal income or else, any rise in prices will need to be met with a reduction in spend in other areas. One only can spend what they can make, what they have saved, and what they can borrow. Keep in mind that inflation is inherently deflationary because it destroys future purchasing power.

When consumers must pay new and higher prices for certain goods, they then consequently will reduce what they spend on other goods—or eat into their savings to pay for them—unless the largest input to the U.S. economy, individuals and their efforts, can collectively push for sustained wage increases (not just one-time bumps). Recent data show considerable demand for labor, with wages moving up, but we would need to see this demand last beyond the post-pandemic re-opening process for it to figure significantly in the inflation measures. Even with a sustained increase in wages, there is a large hole in personal income to fill once the stimulus ends. If it ends. More on this in a bit.

When we think of today’s financial environment, we are reminded of the French economist, Frédéric Bastiat, and his parable of the broken window. The parable describes a child breaking a window, requiring the shopkeeper to spend money for a glazier to fix it. Those witnessing the event see the glazier is employed and therefore he and the economy benefit. Indeed, what would become of glaziers if panes of glass were never broken? But Bastiat argues that beyond the obvious one-time economic benefit the transaction in this example has for the glazier, if you were to extend the idea that destroying panes of glass repeatedly creates an overall good for the economy, he would have to cry foul. For what cannot be seen by witnesses is what could have been. The money the shopkeeper spent to fix the pane of glass can no longer be used in some other fashion, likely in an exchange that would have had a better and more enduring economic result. In other words, fixing the broken window prevented the shopkeeper from “replacing old shoes or adding another book to his library.”

We find this analogy pertinent to our current situation. The pandemic and the harsh economic toll of the shutdowns was like a stone going through a window—actually, like a lot of stones going through a lot of windows, all at the same time (…pause for effect…) and all around the globe. The economy was working well (though it had its issues that we addressed late in 2019) before the pandemic but has since required substantial funds to bring it back to something like the robustness that existed before. The fiscal and monetary response was arguably necessary because the suffering would have been much worse without the stimulus, but at what cost has this relief been to the future?

Let’s put the fiscal stimulus into context: The three stimulus packages to date total a little more than four trillion dollars (we find some humor in using the words ‘little’ and ‘trillion’ in the same sentence, but it seems fitting when we are writing about inflation concerns), which is four times the size of the federal government’s response to the 2008 crisis and more than five times after adjusting for inflation that of the New Deal. The table above shows the magnitude of government support relative to other metrics. Though not similar in all aspects, the federal debt added is comparable in size as it relates to the size of the economy.

Now, let’s jump back to the broken window parable. With lots of windows broken and the government coming in to fix those windows, the demand for glass goes up, and the demand for glaziers goes up, and the demand for puddy goes up. Some folks even decide to use those government funds and put in all new windows, so the demand for casings goes up. And, since we are changing out the windows, should we all consider painting our houses now, as well? A growing concern is that the large influx of funds are all competing for a narrow set of goods/service/assets, pushing up prices temporarily. Is the money spent at those higher prices going to be rewarded with a higher future return? Or will prices adjust back down once the stimulus passes resulting in a near-term loss that hurts future consumption?

The broken windows analogy seems particularly fitting given the current spending environment. Home Depot and Lowes are seeing significant growth. Furniture stores are quoting lead times of 6 to 9 months for deliveries. And try to find a contractor these days… No question those stimulus payments have aided consumers’ actions to better their homes. But is that sustainable?

We have mentioned the size of the stimulus in the context of history but let’s also look at it as a percent of personal income because someday, one supposes, the productive sources of income will need to offset the temporary government benefits.

As the graph above shows, government outlays total about 33% of personal income. Government benefits (think Social Security, Medicare and welfare programs) had been trending up as our population ages, and it was in mid-teens as a percentage of income prior to the pandemic. The stimulus payments have now more than doubled that government spending. It was a needed boost when personal wages abruptly dropped 10% at the start of the pandemic. But is that level of support sustainable?

The strong government response has manifested itself in increased demand within targeted areas of the economy. What investors’ fear (and what the Feds hope, to some extent) is that the scarcity of certain materials and skills will drive an enduring upward move in inflation across a growing portion of the economy. The jury is out if that will happen. And while politicians might want ongoing stimulus—thinking money is free—it will be the bond market and the Federal Reserve that will influence interest rates, if they see price increases becoming permanent. Even a small adjustment up in rates can bring about material ramifications in what is a highly indebted economy. As we were told growing up, in good times, one looks at how much debt they can afford. In bad times, one reflects on how much debt they have.

The number and intensity of inflationary warning signs is ticking up, and we wonder if the economy will allow that to continue. Or will these factors lead, as they have for the past 30 years, to deflationary tendencies?

Attempting to weigh the likelihood of either outcome requires more time. One element that might drive the outcome is the interaction between asset pricing and consumer spending. Why? The Federal Reserve has studied the connection between people feeling wealthy and their spending habits. That research estimated that the dotcom boom in the late 1990’s added 1% to 2% of GDP growth per year. Today, some analysts think the wealth effect is getting stronger because people can more easily access their retirement account balances. Compare this to the relatively recent past, when corporate pension systems, outside the view of the consumer, held most of a person’s investable wealth. Now, more than ever, people have a daily view of their wealth through their retirement savings accounts and online estimates of home value. This feeds into their spending habits, arguably, more quickly.

Keep the following in mind when thinking of consumer spending:

• More than 70% of U.S. economic activity is driven by consumer spending,
• 50% of consumer spending is discretionary, and
• The wealth effect on consumer spending has increased as more consumers rely on self-directed investing versus the old days of defined benefit retirement plans.

Combining the wealth effect with the knowledge that 70% of the economy is services-driven (i.e., quick to be turned on and off) and that 50% of the consumer spend is discretionary (i.e., painful to lessen but do-able), one can argue that consumers flex their spending habits quickly, potentially mitigating the idea of sustained inflation.

When we started drafting this article, it was with the belief that inflation is perking up and with a growing concern that the Federal Reserve was losing control of it. We still see inflation as a concern, but through the writing and research process, we have convinced ourselves that deflationary episodes are also still a concern.

On the opposite side of the spectrum, we see the growing fears of hyperinflation as unlikely. Hyperinflation comes from a lack of trust in the currency, and we do not see, at this time, the Federal Reserve willing to take actions that compromise that trust. They are taking actions that make us concerned (as we have written about previously), but there is a long road from here to extreme inflation. If the printing presses are controlled by the Fed and not the politicians, we see little reason to think the worst.

So where does that leave us?

We are optimists who believe that only the politicians running our government find high inflation beneficial. (Sorry, but we are going there!) They get to write checks to their electorate as a means of maintaining their power, raising taxes (which is deflationary) to eventually cover their obligations. (Refer to the quote at the beginning of this article.)

The Federal Reserve governors are less inclined to allow high inflation than the legislative branch because it could cost them their jobs, and they know it destabilizes the balance sheets of the banks. Also, they have the tools readily available to guard against runaway inflation. However, the dual mandate of price stability and full employment puts the Federal Reserve on an ever thinner high wire, with high rates themselves promoting instability since a highly levered financial system will seek to de-lever and spend less.

And then there is the global investor base…

Uncontrolled inflation is bad for the bond and the equity markets. Deflation is bad for equity markets. And excessive government spending might lead to malinvestment, and a detox process, once it dries up. We also sit at historically high valuation levels in the equity market. All of this explains why at Auour, we are participating in the markets yet positioned to defend if markets change course.