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.

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.

From The Perfect Storm

Our investment objective is to produce above-market, risk-adjusted returns—over an investment cycle—at a lower level of experienced risk while mitigating the declines our clients experience over that investment cycle. Over the course of nine years, we have—to date—achieved it. [Past performance does not guarantee future returns.]

Our method is to detect changing risk environments that, based on historical experience, have led to a higher chance of a market downturn. If we are good at this, we can then reposition the portfolio into a defensive position (likely to include holding high levels of cash, a.k.a. dry powder), limiting the pain and allowing for reinvestment later at better prices. That is our aim, not a promise.

Long-term investing is like setting out to sail across the ocean, heading for a destination on the opposite coast. You plan to catch the Westerlies and traverse the Atlantic from west to east. All you need to do is set the sails, grab the wind and be off! Not quite. Storms present themselves throughout the journey, and each time you must choose the path: through the eye of the storm or detour around it. Most investors are told to weather the storm and hope for the best. At Auour, we choose to go around it. You never know how bad it can get; sometimes storms cause shipwrecks.

We started to move around an expected storm a little over one year ago, beginning in December 2021. During the first half of 2022, we turned a bit more away from the storm by raising cash levels in portfolios. In October 2022, we turned back towards the storm, seeing an opportunity. However, that does not assume that we are past the storm completely. Data suggests we might be in a lingering storm that requires further respect and attention as we thread in and out of the storm’s perimeter. We might need patience as we work our way around it. And, of course, it might not be like past storms. (History doesn’t repeat itself so much as it rhymes.)

The last three decades have trained investors to be impatient as market declines were met with accommodative central banks and enhanced government spending. Starting with the Asian currency crisis of 1997, then the turning of the clock to the new millennium, then the Global Financial Crisis, and ending with the pandemic, global authorities in charge of societies’ collective purses have responded with easy money and fiscal stimulus to dampen the pain felt by consumers and investors alike. A typical economic backdrop to those past calamities was a tame inflationary environment, allowing money printing to produce the desired effect without causing (at least noticeably causing) an overheating of the economy.

A current concern is that today’s environment could play out differently than in the past two decades. Inflation seems uncomfortably high to the U.S. Federal Reserve Bank, the global provider of dollars. And rather than the Fed coming to the aid of an economic problem, they are now causing it because they see excess demand as the inflationary culprit. Stating it differently, central banks came in during past economic slowdowns to spur demand through easy money. Now? They aim to shrink demand by draining money from the system if they think inflation stays uncomfortably high.

We do not want to spend much time revisiting 2022, apart from sharing the above chart that painfully sums up the year in context, showing the annual returns for equities and fixed income indices by calendar year. 2022 was a horrible year with little resemblance to past experiences. It was a perfect storm in which elevated valuations, overconfidence in growth, and cheap money collided.

As we look to the rest of 2023 and beyond, we highlight a few important questions for understanding the path forward and the potential lingering impacts of the current storm.

1. Did the response to the pandemic by central banks mitigate the importance of yield-curve monitoring?
2. Is CEO sentiment an important indicator for labor markets and economic activity?
3. Is the inflation we are experiencing controllable with neutral interest rates?
4. Is there a structural element to inflation that has yet to be discussed or addressed?
5. Can global economies move back to an easy money environment that existed for the past two decades, or do we need to adjust to a more expensive and tighter monetary system?
6. Does history repeat with the next bull market having a new leader? If so, what should we be looking at?
7. Will the conversations decisively turn to corporate earnings from inflation?

Let’s take each one individually.

1. Did the response to the pandemic by central banks mitigate the importance of yield-curve monitoring?

Economic activity benefits from a financial system that borrows in the short term and invests long term. However, economic activity has historically stumbled when short-term rates rise above long-term rates, which is to say, when the yield curve is inverted. The chart below shows that yield curve inversion occurred somewhat reliably before a recession.

The time between when inversion occurs and when a recession (in hindsight) starts has varied considerably throughout history. In some cases, it was as short a period as six months. In other cases, it took multiple years. On average, it has been about 18 months. The yield curve inverted in the summer of 2022, suggesting a recession starting mid to late 2023. Some argue that it could begin sooner, given the aggressive rate increases we have experienced as we came off the zero bound. Others suggest that moving from a zero-rate level neutralizes the importance of inversion, which, from our perspective, is a this-time-is-different argument. Given the historical significance of this signal, we stand closer to believing that no matter why it happened, the fact that the yield curve did invert is an important signal.

2. Is CEO sentiment an important indicator for labor markets and economic activity?

As of this writing, CEOs are not showing confidence. Recent survey results are near the worst experienced. Past periods of lack-of-confidence have led to or coincided with softening labor markets and periods of slow or negative growth. In addition, leading companies within the technology sector have been making headlines with their notable layoffs. It should be mentioned that the confidence of CEOs is volatile and came off extreme exuberance in late 2021. Are the current negative feelings driven by a reflexive move from past exuberance, or is something more amiss? It is important to watch this metric for clues on the severity of any labor market correction.

3. Is the inflation we are experiencing controllable with neutral interest rates?

Discussions fill the airwaves about how much is enough concerning interest rate hikes. Coming from a long period of zero, it is understandable that even 4% seems large and restrictive. And in some cases, it may be (think private equity, commercial real estate, and home prices). However, there is ample reason to believe we are not yet at a point where rates can contain inflation. In December, Fed officials communicated to investors that rates might need to move as high as 5 to 7% under some measures. If true, assets purchased with cheap debt at high prices over the past ten years will likely experience trouble. During past debt work-off periods, we saw owners giving the property’s keys to the banks. We have only seen one example of this so far. We are watching to see additional evidence of this.

4. Is there a structural element to inflation that has yet to be discussed or addressed?

The mania for “faster, better, cheaper” has dominated hype in economic cycles over the last 40 years as technology has embedded itself within our lives. Deflationary trends also helped, as manufacturers took advantage of lower-wage geographies. However, we may be seeing deflationary tailwinds turning into inflationary headwinds.

The global community is changing the “faster, cheaper, better” mantra to “faster, cheaper, better, less harmful.” Concerns that we humans are harming the environment are taking center stage as concerns also grow about the exploitation of slave labor within regions of China. Add to that the growing skepticism around supply dependency on China, and one can see significant investment is being diverted to changing the manufacturing of current output. These significant investments are not expected to bring about lower-cost products or added demand—in many cases, the products cost more.

5. Can global economies move back to an easy money environment that has existed for the past two decades, or do we need to adjust to a more expensive and tighter monetary system?

There is a large discrepancy between the Fed’s view of the future cost of money and what investors think. The chart above highlights the expectations of the Fed on future interest rates (blue) and investors’ expectations (green and orange).

Who is right? If the past is to be respected, neither. Both players have exhibited severe anchor bias—thinking rates will rise back to recent past experiences or fall to recent past experiences depending on the mid-term trajectory. Both have shown little predictive capabilities, as shown in the chart below. The blue line shows the historical Fed Funds rate, while the gray lines depict the future expectations of the rate at that time. There has been a strong bias toward believing that rates go back to where they came from in a relatively short period. And history suggests that bias is nearly always wrong.

We don’t have a strong opinion (we have an opinion, just not a strong one) other than wanting to respect the fight between the two rate makers at present. We see the discrepancy bringing about high levels of uncertainty. Asset prices are very dependent on interest rates. With the current disparity in rate expectations, one should assume asset pricing will be more volatile than average.

6. Does history repeat with the next bull market having a new leader? If so, what should we be looking at?

Historical market recoveries from bear markets have been consistent in that the leader of the past bull market always lags within the new bull market. For example, the technology sector led in the bull market that ended in 2000, and it then lagged as the energy and financial sectors reaped the rewards of the next bull market. The last decade of market gains again showed technology companies being favored, with the sector’s weight within the S&P500 index reaching almost the same magnitude as in 2000.

Is it different this time, where we see the dominant technology companies recover and lead the markets into a new growth phase? Again, the lessons from history take much work to fight. If it is true that heavy investment is needed to move away from China, technology may be the one sector that carries the heaviest of loads.

7. Will the conversations turn decisively to corporate earnings from inflation?

Much of the financial discussion today revolves around inflation, and this newsletter is no different. It begs the question, are we looking in the wrong direction? Not really. Many are focused on if and/or when a recession comes about to help predict the future of corporate profits, which are a material driver of stock prices.

The chart below looks at the declines from peaks for stock prices (as measured by the S&P 500 index) in blue and the decline in corporate earnings from peaks in green. As expected, as earnings decline, asset prices decline. Past economic weakness shows a varying level of earnings decline, with the recession of the early 2000s showing a 13% decline from peaks while the Great Financial Crisis took earnings down 40%. Today, expected earnings are off about 8% from the earnings experienced in 2022, a moderate decline relative to history. To us, it appears analysts and company executives expect a very modest soft-landing scenario.

Inflation is the problem, and the Fed thinks a recession is probably the answer. Investors around the globe are accustomed to central banks dissipating economic softness. This time, the central banks are guiding the eye of the storm directly at the economy as they fight inflation.

Recessions are normal, even if painful. We believe we are in the bottoming process right now. The good news is that health in the labor market is likely to soften the blow, so maybe we will see a reset in growth expectations rather than a reset in operating norms. But even soft landings have a thump.

We want to focus on two economists with different ideas, Thomas Malthus and Joseph Schumpeter—different in areas of focus and outlook. We start with the downer, the quintessential pessimist, Malthus.

Malthus proposed a theory in the late 18^th century that population growth was exponential while food production was linear, leaving no option to avoid catastrophe other than population control. No one can state it as eloquently and depressingly as Malthus, “The power of population is so superior to the power of the earth to produce subsistence for man, that premature death must in some shape or other visit the human race.” Suffice it to say; he wasn’t invited to that many bashes (author speculation, unconfirmed). However, it would have been fun at a party, if he did attend, to holler whenever he sampled the hors d’oeuvres, “Hey Tom, how many peasants do we need to kill for you to have that one?”

Though his theory was specific to population growth and food production, we see it aligned with the “zero-sum” line of thinking. Zero-sum is a term from game theory, and it assumes that in a game played between two participants, if one wins, the other party loses, with no change in the total sum of wealth. In other words, it relies on the belief that the total wealth at play is static, or—and we’re stretching here—in the case of Malthus, the idea that some items are limited and near fixed. We are taking some liberties with this line of thinking by attempting to highlight that what zero-sum thinking and Malthus’s views have in common is the omission in their theories that factors outside their purview may lead to a dramatically different outcome from that presented by their theory. Malthus did not include in his thoughts an adequate view surrounding farming productivity and yield enhancement. Because of that, his theory has been wrong since proposed. Since introducing his theory, the global population has increased tenfold, and current food production is 20% above the need. Malthus and those promoting zero-sum ideas limit their arguments to an incorrect and static view of the variables within the equation, leaving us with only unpleasant options surrounding restriction and sacrifice when human ingenuity has produced better outcomes for an ever-growing world population.

And this is where we turn to the other economist, Joseph Schumpeter. Coming on the scene about a century after Malthus, Schumpeter came to be known for his appreciation of entrepreneurship and innovation and their positive effects on the economy. He criticized the Malthusian ideal—arguing against economic models that froze all but a few of the variables. He reasoned that the arbitrary reduction of economic complexity to a monotonic view of inputs (i.e., if this, then that) would lead to false confidence in a policy decision that was likely to be wrong.

Schumpeter was an optimist (concerning economic growth) and promoted the belief that human ingenuity was the primary driver of economic prosperity. His work attempted to show that waves of innovation spurred economic growth. Innovation was brought on by individuals acting as entrepreneurs, aiming to offer new products or services to fill a need or reduce some economic inefficiency. He promoted the idea of creative destruction whereby new products would displace lesser products and bring about new opportunities and new, more stable economic outcomes.

Why do we bring these two up?

A Malthusian perspective focuses on the eventual—if the population grows exponentially, the world will eventually run out of food. A Schumpeterian view aims to address near-term opportunities—if the soil is enhanced with fertilizer, crop yields will increase this year. Malthus sees resources being depleted eventually with no expectation of adaptation or modification, with the only option for a healthy society being the restriction of consumption. Schumpeter considers the intermediate-term benefits driven by innovation and the increased efficiency that comes from it as a likely means to meet the needs of expanding populations.

Today, we see both theories permeating our lives, with Europe an excellent case study.

The EU energy crisis offers an example of the two theories in action. European governments have been the most active in converting to renewable energy sources. They have taken a Malthusian approach to conventional sources by instituting barriers to fossil fuels to address fears of rising global temperatures. At the same time, enormous efforts have been made by the private sector to explore innovative solutions to produce cleaner energy sources. The situation in Europe highlights the ramifications when those two theories are enacted yet not managed to perfection.

For a decade, countries within the EU have been shutting down energy sources that generate CO2 and nuclear. France and Germany have been leading the transition by outlawing oil fracking and extraction with the hopes that Russian natural gas would act as a bridge to enacting their renewable energy plan. Unfortunately, that plan failed. With the Russian/Ukraine war cutting off a material amount of their energy, they are faced with no easy answers to their winter energy needs. This mismatch in timeframes where the long-term desire to move off fossil fuels has not been matched with innovative solutions ready for large-scale use has seen German energy costs increase tenfold in the last year. Energy price inflation is bleeding into almost all other goods and services as the EU industrial complexes are forced to shut down production. With no quick relief in sight and higher energy prices rippling through the economy, the result appears to be higher-for-longer inflation.

This inflation is from man-made scarcity. And it appears there are only two paths to take: reduce the scarcity by re-opening conventional energy supplies or cut demand to the point of equilibrium. The former is politically unattractive and the latter results in a deep European recession. With the European Central Bank raising rates as an attempt to thwart inflation, it appears they have chosen the second path.

Hangover

What follows is not a segue from the prior conversation but a separate reflection on liquidity. We frequently discuss liquidity within the investment market. Liquidity is the amount of money that flows within the system. Think of it as the oil in the engine—it lubricates the moving parts, allowing them to move with less friction and wear. Our models revolve around identifying market liquidity changes, watching for when it becomes scarce, and risks disrupting the economy. We have been highlighting liquidity issues starting in late 2019. The monetary and fiscal stimuli in response to the pandemic offered some reprieve, but those acts have driven higher inflation and masked underlying weaknesses. With a concerted effort by central banks to contain inflation, this tightening liquidity phase will likely last a bit longer and result in a bit higher than expected interest rates.

If we are entering a period of lower liquidity, it may not be just the investment market negatively impacted. It is hard to assess excess liquidity’s indirect benefit on the economy accurately. Real estate transactions might take longer to complete; credit card limits might be reduced; zero-interest installment payment plans might end; start-up funding might become smaller and harder to obtain. The time to go from idea to production to self-sustaining sales will likely stretch. Companies will likely need more investments at a time when investments become harder to find.

We have not seen a sustained decline in money within the system for more than 40 years. Determining what its impact will be is tough. Very tough.

These concerns inform our current defensive positioning. With pundits arguing the extremes, peddling an all-or-nothing solution to investing, we sit in-between. From our perspective, being entirely out of the market is a very rare situation involving a banking crisis. We are not there, but we are hunkered down for a challenging period during an anticipated global economic reset. We sit with 35%+ cash for our equity-only strategies, and our balanced strategies have less than half the equity of their respective benchmarks. Over our time writing this newsletter, we have described market tops and bottoms as processes, not points in time. We wish we could pinpoint market inflection points but can’t, like all others. The most we can say is that we are in a market-bottoming process now. We know that these are the times that opportunities present themselves and need to be balanced in our views in order to act on them.

“Inflation is the tiger whose tail central banks control,” according to the ex-Chief Economist of the Bank of England (forced to resign in 2021 from the Old Lady as his hawkish view clashed badly with the consensus within the MPC).

Using the same metaphor, one of the key tenets of modern monetary policy is the belief that the art of enchantment (“2% inflation target”) can be relied on to work its self-fulfilling magic in keeping the tiger asleep. “Magic” because to the Fed’s own admission, the theoretical and empirical foundation of how expected inflation influences realized inflation (including its causal relationship) is rather shaky, at least much less proven than the good old-fashioned employment-inflation trade-off.

Inflation was indeed largely well-behaved over the past couple of decades (till 2021, that is). Central bankers across the G20 have taken credit as their own achievement, tacitly ignoring a happy confluence of other socio-economic undercurrents that could have been at play (globalization, the rise of Asian manufacturing supply powers, the spread of competition enhancing information technology, ex-communist countries joining the fray as significant commodity producers, relative fiscal conservatism, the demise of whatever was left of organized labor, etc.). [Auour Comment: We have been referring to this as the NICE period.]

Statistically, the problem could be restated as whether prices/inflation can be assumed to be a stationary process (i.e., stable sample mean, variance, etc.), like (real) GDP growth. If it is, any deviation from the mean (“2% inflation”) is always “transitory” by definition and will mean-revert sooner or later. A more extended history tells us that inflation has been anything but stationary.

It’s becoming increasingly clear that it will take time for the FOMC to readjust its lopsided response function defined by years of focus on “systemic risk” and “zero bound.” The Japanese “lost decades” was a distracting reminder of the clear and present danger. At the same time, Bernanke and Yellen made their academic careers studying the 1930s and the failure of the Fed to intervene back then.

In June, Chair Powell justified the Fed rate hike on risk management grounds. But seen globally, the risk that needs to be managed has come to encompass the institutional independence of central banks. Australia recently launched a review of the RBA after the institution was criticized for delaying interest rate rises even as inflation took hold, prompting its governor to describe its forecasting as “embarrassing.”  In the UK, Liz Truss, the likely next PM, has also promised a review of the Bank of England and its independent decision-making on interest rates. The stakes are high and getting higher…

Nobu

P.S. Back in February 2021, Andy Haldane – then the Chief Economist at the Bank of England – warned against the upcoming spike in inflation in his last speech just before being booted out: “Inflation: A Tiger by the Tail?”:
“Inflation is the tiger whose tail central banks control. This tiger has been stirred by the extraordinary events and policy actions of the past 12 months.”
“…there is a tangible risk inflation proves more difficult to tame, requiring monetary policymakers to act more assertively than is currently priced into financial markets.”
“…the greater risk at present is central bank complacency allowing the inflationary (big) cat out of the bag.”
https://www.bankofengland.co.uk/-/media/boe/files/speech/2021/february/inflation-a-tiger-by-the-tail-speech-by-andy-haldane.pdf?la=en&hash=78C0DB3A631A7B9E2DF6EFBCFE9B3D138D87C449

The last four months have seen investors move from a futurity (new word for us) approach to a more here-and-now approach. The prices of companies focused on future market dominance at the expense of current profitability have been under severe pressure, while more established companies with visible profitability gained newfound respect. The advent of rising interest rates appears to be pushing investors to value money on a current basis rather than on the dreams of the future.

We are believers in the idea that money is a commodity and, much like any other commodity, its value is dependent on the supply of it and the demand for it. In times of easy money (i.e., low interest rates), the holder does not see money as sacred and can afford to invest it in longer-term (i.e., speculative) assets. And, like other commodities, during plentiful times, people use money less judiciously. However, when money is harder to come by and more expensive, investors start putting their precious funds in more near-term vehicles, never wanting it far from them. In such times, investment discipline comes back into favor.

A big change in the interest rate regime—from consistently lower rates with relatively consistent economic expansion (review our newsletter on the NICE period)—to something less nice (e.g., higher rates and uneven economic growth), needs to be respected. And that respect requires exploring the implications of the shift.

In the investing world, we assess an asset’s sensitivity to rising rates using a measure called duration. Duration is predominantly used to discuss fixed income instruments because they have a set lifespan with predefined income streams. However, duration can be used to assess any asset class since any asset has some expectation of productive life, by which we mean the ability to provide income to the asset owner.

A bit more on duration…

Duration measures the sensitivity to changes in interest rates. Take bonds: the longer their duration, the more sensitive their price will be to changes in interest rate. Obviously, a bond with a five-year maturity has a duration of five years. Or a bond with 10 years left to maturity has a duration of 10 years.

Now, if interest rates rise by 1%, the price of an asset with a duration of 5 years will fall by approximately 5%. By extension, an asset with a duration of 10 years will fall by approximately 10%. Why? Because investors want to pay less for income, they expect to receive in the future than for money today. If interest rates rise, it is as though they are being asked to pay even more for that future income. As such, they demand greater compensation through a greater expected return and therefore pay less for it (as lower prices).

The other major component of the duration calculation is the amount of money returned to the investor each year. The higher the amount returned, the lower the duration. Conversely, the less near-term money returned, the higher the duration.

Now that this (brief) economics lesson is done, let’s get back to the reason duration matters.

The longer a bond’s life, the longer its duration. And in the case of equities, which we want or expect to have a very long life (measured in decades or hopefully lifetimes), duration is even longer, so their sensitivity to interest rate movements is much higher.

To demonstrate the sensitivity of various assets, we looked at how they have responded to past interest rate regimes. We do not directly use the chart below in Auour’s risk-regime algorithm, but it does a nice job of showing why we do what we do.

For purposes of this newsletter, we look only at the period from 1990 through March 2022. Although that time encompasses most of the bond bull market, there were short periods within it where inflation showed itself and the Fed fought it with higher rates. Ideally, we would include more data prior to 1990, but doing so would make comparisons with recent times difficult because economic dynamics were different as the dollar went off the last vestiges of the gold standard.

For the 32-year span, then, we defined a rising-rate regime (characterized by Fed tightening) by the acceleration of the consumer price index and the near-term Treasury market rates’ expectation for future rate moves. Within that timeframe, there were five episodes of Fed tightening. That’s not a lot of data points from which to draw strong conclusions, but the results are eye-opening, nevertheless.

We first look at the experienced return and risk of different types of assets during those periods (within the 32-year span) of lower or neutral rates (i.e., an accommodative rate regime, so not when the Fed is tightening). The graphic below depicts what we know as a typical association between assets: assets with higher volatility (and higher assumed duration) produced higher returns. More stable and secure investments, such as short-term bonds from the U.S. Treasury, produced low relative returns, but at a much lower level of volatility and duration. On the opposite side are emerging market equities, where investors were betting on future growth and future profitability.

Source: Auour Investments, Nobuya Nemoto

The next chart presents the same timeframe but during periods of rising rates and with a Fed focused on tightening monetary conditions. This chart shows the same assets but with a noticeable change in their experienced return. Although their duration and volatility are almost aligned with the accommodative regime time periods, the experienced returns are dramatically lower and, in most cases, negative.

Source: Auour Investments, Nobuya Nemoto

In this chart, investors’ desire for more near-term payoffs is reflected by the shunning of assets dependent on the futurity of profits and market dominance.

The above two graphs are likely the best visualization for why we believe in regime-based investing—that there are distinct periods, or regimes, that can bring about very different outcomes. Our ability to determine those regime shifts provides an opportunity to optimize client funds for different market environments. The next two graphs illustrate why we move into higher levels of cash as our primary defensive mechanism and look cockeyed at the traditional belief in static asset allocations.

In building portfolios, the interplay between different assets is critically important. If the assets held happen to react the same in all environments, there is little diversification provided and the entire portfolio may suffer from an adverse event. It is a mainstay in the investment world that we must understand that interplay to protect against correlation in returns when one is hoping for a more diversified positioning.

The graphs below highlight the correlations amongst various types of assets. The darker the shades of blue, the more the two corresponding assets will move in concert. The lighter the color, the more the assets will move independently. One can see, in the graphic on the left, the overall area of blue shading is lighter (i.e., less correlated), and equities and fixed income classes are relatively independent of each other.

Source: Auour Investments, Nobuya Nemoto

However, in the graphic on the right, one can see that when we have experienced higher sustained inflation—and a tightening cycle in interest rates ensues—there is a higher level of correlation between all assets. Another way to say this: in times of increasing interest rates, investors become increasingly risk averse, no matter the asset type, and they look for areas of safety, of which there are few besides cash.

Some parting thoughts.

Immense wealth has been built over the ever-lower interest rate environment of the past four decades, with just short and infrequent episodes of rising inflation and rising rates. This success established a consensus on how wealth is created through leverage and time to amplify the return of rising asset prices. But what if a change in the regime from ever lower rates moves to one with ever higher rates? Our experience is that the victors of past market regimes may become the victims when the winds change direction. For us, we need to take a critical view and be respectful of longer economic history, which spans more than just one half of an interest rate cycle.

The NICE period likely produced an anchor bias over the past 40 years of lower rates, and it has embedded itself into our perceptions of reality. Inflation and rising rates will change what we think is normal. Of course, the problem with calling a change in regimes is that what has occurred for 40 years can always continue for a bit longer.

We cannot predict with precision the changing regimes the investment cycle will experience but we have built in safety features that allow us to buffer portfolios during times of instability and changing risk attitudes. Over the past six months, we have become increasingly conservative with cash balances comfortably above 25% of all strategies. We are waiting for opportunities to reinvest as opportunities present themselves.

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.

– Gary Friedman, Restoration Hardware CEO March Earnings Call

In late 2019, as we were de-risking portfolios ahead of what turned out to be one of the top 10 downturns of our lifetime, we used a musical chairs analogy to describe the situation. We said we were grabbing our coats to go as we saw the number of chairs shrinking, knowing that whenever the music stopped, it would be painful. Now, with inflation running high and war likely to cause permanent changes in how nations cooperate economically, the central banks find themselves in an increasingly undesirable predicament with even fewer chairs at the party. The need for central banks to combat inflation with higher rates in the face of growing uncertainty adds credence to the idea we may be entering a far different period than experienced over the past few decades.

Destruction vs Disruption

Emotions have been running high this first quarter of 2022. The Russian invasion of Ukraine heightened pre-existing economic concerns about growing inflationary pressure and the awareness that interest rates would be rising.

Unsurprisingly, the rising tension has brought on higher levels of volatility. One day people want full risk exposure. The next they want completely out of the market. As we have expressed throughout our history, though, emotional responses to market swings are not the best way to protect and build lasting wealth.

We need to consider separately the (hopefully) short-term impact of war on the global economy and the longer-term potential disruption that the redefining of trade relationships brought on by war and increasing interest rates can cause.

Global markets reacted quickly to Putin’s mind-numbingly destructive invasion of Ukraine, and, as is typically seen with historical events, the markets partially recovered from the lows fairly quickly. We present a table below, produced by Mizuho Securities, showing past market-moving historical events, with their near- and intermediate-term impacts on equity prices (displayed in the chart as percent change from the bottom in various timeframes). In most cases, the markets recovered within months from the initial downward moves. However, in a few situations, the markets continued the downward trend for a year.

Whether the event’s market impact is short- or long-term might come down to whether the market perceives the event as a momentary (though harsh) period of destruction or as an event that will likely cause an ongoing period of disruption.

A destructive event, of course, will carry long-lasting implications for those directly involved. For example, even if the war ended today, Ukrainians face decades of rebuilding and many will carry the scars of war for life. But the regional impact of a destructive event does not always spread to the greater global economy.

On the other hand, we are defining disruptive events as those that interrupt the global economy’s current path with a new factor or phenomenon that permanently changes the direction of growth. The disruptive event acts like a jump ball in basketball, a reset where suddenly both teams must adjust to a new potential direction and tempo of play. We have discussed in past writings some signs the economic backdrop is changing, including a shifting trade environment after China’s takeover of Hong Kong and, recently, rising inflation and the scarcity of non-discretionary goods. With Russia’s aggression, we will need to add a changing energy supply and new East vs. West tensions to the mix.

For us, the trends of the past confirm that in most circumstances we must stay calm and be patient as we weather short-term destruction from war and increasing market volatility. However, in some instances, when the event brought a delineation between one global economic environment and another, past trends and market momentum become harder to trust given the changing landscape. We highlighted in the chart the few instances of this, such as the building of the Berlin Wall that marked the start of the cold war, the oil embargo of the 70’s, and the destruction of the World Trade Center towers on 9/11, as examples that brought about a more enduring and global change to economies. The current situation shares some characteristics of those events, as Russia and China expand their adversarial stance against the West. We maintain our focus on potential longer-term disruptions to the economy that may present new opportunities for profitable investing.

Rising Recession Risk

We are going to let the pictures do the talking to underscore our concern about the risk of recession. Below are four charts that we think highlight that growing risk.

As the Federal Reserve starts raising interest rates, Deutsche Bank’s chart, above, makes the case that tightening cycles provide the backdrop for asset deflation (or busts). With financial leverage being high across the globe, as economic disruptions increase and monetary policies are tightened, the risk of a crisis increases.

Even with aggressive investment in renewable energy, the world today is still highly dependent on fossil fuels, in particular, oil. The chart above shows how previous quick, upward movements in oil prices have coincided with recessions. History isn’t necessarily followed precisely, but we think its patterns deserve respectful consideration.

Consumer expectations are volatile and not a sound predictor of recessions, but with low unemployment and wages growing, it is interesting to see a rising nervousness among the population.

Germany, one of the larger developed economies, is also flashing warning signs. Its economy is slowing from very high levels, and future expectations are negative. The chart above shows the evolution of current and future economic expectations in Germany since 2017. They are moving into a precarious position.

Conclusions

Long-term averages of investment markets show a historically strong return after the impact of inflation, leading most to believe in a static “stay in the market and wait it out” approach. However, within those averages are periods encompassing wars, high inflation, and economic recessions that can test one’s resolve that the future could look anything like the past. In most cases, over the last 40 years of economic growth, the market recovered before market volatility brought one to the breaking point. Those few episodes we identified where the markets did not recover quickly were during periods of rising inflation. And that brings us to the present moment: this chance that we are today in one of the rarer but inevitable market shifts that takes longer to play out calls for, as suggested by our quantitative indicators, cautious positioning in Auour’s portfolios.

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.

“True security lies in the unrestrained embrace of insecurity—in the recognition that we never really stand on solid ground, and never can.”

“Uncertainty is where things happen.”

Over the past two long-drawn-out years, we have discussed the idea that market participants swing between uncertainty and complacency. We have also observed that most investors believe asset prices will be protected by central banks, a phenomenon pundits call the “Fed put.” Investors have had good reason to become complacent and believe in the Fed put because the past two decades have trained them to look to the Fed whenever asset prices drop materially. However, that was during an environment of low inflation, or even deflation, when the Fed had the luxury of acting without igniting an inflationary fire.

The Federal Reserve Bank of the U.S., or the Fed, the dominant central bank in the world, has two mandates: (1) maintain a stable value of the U.S. dollar by fighting off inflationary pressures, and (2) maximum employment. As we have presented over the past few months, the Fed had 40 years of deflationary forces—the Non-Inflationary Consistently Expansionary (NICE) period—that allowed it to dampen economic volatility and reinvigorate a bullish spirit through lower interest rates. And as the next recessionary threat came along, the Fed continued to lower rates because it worked so well the previous time. Investors have been trained like Pavlov’s dogs to gobble up more speculative (riskier) assets when the Fed rings the lower rate bell, and with asset pricing being higher than at almost any time since World War II, the dogs have gotten fat.

The sustained lower rates have reduced investors’ sensitivity to “here and now” cash flows, pushing them into higher risk, more speculative investments. What happens if the next bell to be rung is for higher rates?

We now sit at zero interest rates. Even more importantly, we are experiencing high inflation that could be argued is structural in nature rather than transitory. As uncertainty continues to build with war in Ukraine and an ongoing pandemic, many prognosticators look at the playbook of the last 40 years and assume the Fed will continue down that same path of low rates to protect asset pricing and reinforce speculation, pushing inflation control to a much lower priority.

That assumption seems excessively complacent from our perspective and suggests an anchor bias that could present issues into the future. The anchoring of one’s economic view to only the last 40 years omits the stagflation of the 1970’s and it’s impacts on discretionary spending, economic growth, and the rising uncertainty that plagued the investment markets. We sit with conditions that are far different than those over the past four decades. An underinvestment in energy production along with rising tensions between economic and military parties is a clear deviation from the inclusionary tailwinds experienced since the early 1980’s.

To shake off that anchor bias, we recommend Nassim Taleb’s book Antifragile, written in 2012. Antifragile, very haphazardly summarized, posits that most systems exhibit swings or variations due to system stress, and it argues that such stress, although uncomfortable, can help build long-term resilience and strength into the system. Some will see the “swings” as flaws, or system bugs, and will look to limit the system’s negative feedback. When the Fed moves to dampen economic volatility via lower interest rates, it is doing just that. And we are concerned that such efforts could lead to increased economic instability (which would also surprise many) once rates start trending higher.

Reducing the natural variation that stresses a system prevents adaptation and protects inherent flaws, creating fragility under the appearance of everyday steadiness. The ultimate result is a more chaotic eventual path when larger stresses that can’t be “managed” present themselves. The changing attitude to forest fire prevention presents a wonderful analogy. Today we ignite small, localized fires as a means of controlling undergrowth. The small fires remove latent fuel so that accidental fires have less fuel and are therefore easier to control. Several decades ago, however, the idea was only to prevent all fire, which meant larger, more fierce fires when they did come, which were uncontrollable and devastating to the environment.

In his book, Taleb argues that when large, uncontrollable events occur, there are not only some actors within the system that can withstand the turmoil, there are some that benefit from the periods of increasing fragility. He calls them the antifragile. More on this is a second…

As mentioned above, we contend that the last 20 years of Fed increasing actions to thwart the natural volatility within the economy and the markets have led to a perception of lower uncertainty built into the valuation process of risk assets. It worked because they had the inflation headroom to adjust rates lower. A whole generation of investors have been trained to see lower rates as a solution to market turmoil. We are increasingly concerned that the NICE period is behind us, and the Fed will be forced to focus on inflation fighting.

We are not the only ones discussing this conundrum and what it means for the economy and asset prices. Incremental investors are more and more on the lookout for antifragile assets while distancing themselves from fragile assets. By fragile asset we mean those that have their value arriving in the distant future rather than ones that generate (and protect) value in the here and now. Some recent phenomena suggest a move away from fragility. For one thing, growth stocks have come under increasing pressure. Also, blockchain instruments have been halved since the beginning of the year. And innovation stocks are down 60% to 80% over the past year.

One issue with defining anything as fragile or antifragile is that the definition will be dependent on the system one is looking at and the factors that drive it. What was once antifragile may turn out to be fragile under a different context. During the financial crisis, U.S. long-term sovereign debt was a safe haven. Can that be true in a rising rate environment? The jury is still out.

What we at Auour do know is that cash, the basis for valuing almost all assets, is likely to be antifragile if we see pricing of all assets needing to adjust to an inflation-fighting Fed. Our strategies currently hold roughly 25% cash as we continue to crave antifragility.

Let’s start with the idea that inflation is not fleeting, as hoped, but rather it’s becoming embedded in the economy. In our recent newsletter, we discussed the events leading to scarcity, and, we argued, they appear to be driven more by structural causes than by the money-supply. (Money supply has played a large role, but we think it merely amplified the underlying structural issues.) We sit in an unstable position, then, if you believe history is to be respected.

The chart above highlights this instability. The green line shows the long-term historical relationship between inflation and interest rates. The purple line depicts the same relation only for the period encompassing the pandemic. Even if you believe inflation (shown as “core CPI,” on the x axis) is only temporarily elevated, it still argues for a 200bps adjustment in the 10-year Treasury note—from its current 1.8% interest rate to something around 4%. (As an aside, interest rates on mortgages are traditionally tied to the 10-year Treasury interest rate. Could you imagine a world where mortgages were in the 5% to 6% range?)

The distortion is, as has been well-publicized, driven by the world’s central banks pushing down rates. They do so by purchasing government bonds as a means of propping up prices, which lowers interest rates. Their influence is demonstrated in the declining share of sovereign debt held in the hands of private investors, who traditionally are the natural buyers of fixed income instruments.

Global central banks outside the U.S. have been about the only buyers of sovereign debt for the past decade, blurring the distinction between central banks and political bodies. This suggests one of two paths: that central banks will stop buying sovereign debt, letting the private markets once again control the price of that debt and letting risk-free rates move to market-determined levels; or, that political will wins, central banks lose their independence, currencies risk their value retention and inflation continues to run hot.

Central banks, through their massive buying of debt, have created a blackhole in risk-free rates, drawing all income-producing vehicles into that hole. If central banks need to give up on an easy monetary environment to fight inflation, rates across all income-producing products will increase, leaving little opportunity for fixed-income instruments to appreciate. This has some market strategists arguing that more equity within a portfolio is necessary. However, in our view, that comes with its own set of risks.

The first among such risks is over-valuation.

No matter what metric you choose to measure equity values now, we are seeing historically high valuations. The above chart highlights the CAPE (cyclically adjusted price to earnings) ratio, which is horrible at predicting timing, but good at demonstrating severity when (not if) market participants return their focus to values-based investing. While it is true that the future might be different in unknowable respects from the past, the last 100 years of data should humble us all. The chart below looks at 10-year forward returns versus experienced CAPE. All 10-year forward returns from valuation levels near what we are seeing today have been negative. This is also true for 5-year forward returns. (These last two charts should look familiar because we have presented earlier versions before, and they continue to become even more extreme with updated data.) Extremes typically last longer than many expect, but that doesn’t make them any less extreme.

We are not arguing to avoid equities completely. Instead, we are highlighting the need for caution. The 10-year returns following high CAPE periods of the past come mostly from the dotcom bubble, and a few data points are from the late-1960’s. Many of us are not old enough to remember the 1970’s—the period that returned to valuation sensitivity, but a lot of us remember the 2000’s quite well. We do not see the same disparities in valuations as we did during the dotcom period. The dotcom bubble was localized in technology and communication companies, and during that period one could buy tobacco company stocks with double-digit dividend yields and industrial companies at single-digit earnings multiples (i.e., really, really cheap). Not today. The low interest rate environment and the central bank blackhole have brought almost every asset category to historically high valuations.

We sometimes hear that low interest rates drive a lower risk premium and therefore a higher normalized valuation level. But this has only been true over the past 40 years, in the presence of low inflation when rates were normalizing after the Volker period. If inflation persists and rates move higher, history suggests rather that valuations will drop, even for growth companies, a phenomenon the U.S. experienced in the 1970’s.

If inflation picks up, the graph below does not auger well for valuation levels. A negative relationship between P/E (price to earnings valuation) and inflation has existed for the last 100 years. The higher inflation is, the lower the valuation multiples are that the markets will pay for equities.

The question comes down to the path investors take to get to those lower valuations. In some cases, it is through companies growing their earnings into a more reasonable valuation. In others, it will be a resetting of prices to reflect a more modest growth in earnings. The latter is already showing itself in those companies that benefited from the pandemic as some of the benefactors have seen drops of 50-80% from their highs. No matter which, history suggests that the path taken will not be without volatility.

Conclusion

Though valuations can become anchored, making any normalization to historical averages take time, we suspect we will see periods that resemble the shorter corrections (i.e., one- to three-quarter long corrections, not multi-year ones) we have experienced over the past 10 years. Our suspicion lies in the complacency within the investment markets. This complacency has led to high leverage as many believe that central banks will defend assets prices rather than follow their overarching mandate to protect price stability.

If that is not the case and central banks prioritize price stability above all else, it will put significant pressure on those that have leveraged bets to the contrary with the result being margin calls. Correlations of all assets drive towards one when margin is called, fear takes hold, and people run for the exits.

We sit with a 20% allocation to cash across our strategies, expecting better opportunities to move back into a fully invested position.