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Jeromeggedon and Calamity Janet

Written March 31, 2023April 1, 2023 by Ailie Carlene Elmore , John Heneghan

“Guess what guys, it’s time to embrace the horror! Look, we’ve got front-row tickets to the end of the earth!” This month’s collapse of Silicon Valley Bank (SVB) had many of their well-heeled venture capitalist depositors and customers metaphorically reliving this scene from the 1998 movie, Armageddon. SVB’s downfall had people questioning if we are headed for another epic crisis in the banking system like that experienced in the 2008 Global Financial Crisis punctuated by the failure of Lehman Brothers. On March 8^th, SVB announced a $1.8 billion loss on its investments in long-term treasuries prompted by depositors withdrawing funds. Withdrawals soon snowballed as general partners at venture-capital firms began pulling their money out of Silicon Valley Bank and urged their portfolio companies to do the same. Hours later, Moody’s downgraded SVB Financial triggering its stock price to crash sending shockwaves reverberating throughout the banking system. $52 billion in the market value of JP Morgan Chase, Bank of America, Wells Fargo, and Citigroup was lost as panic spread about the safety of banking deposits, particularly deposits over Federal Deposit Insurance Corporation (FDIC) insurance limits of $250,000. Two days after the initial announcement, the FDIC took control of SVB after depositors attempted to withdraw $42 billion. On March 12^th, the New York Department of Financial Services regulators announced the 3^rd largest bank failure, Signature Bank. Signature Bank was one of the few banks accepting crypto deposits; some believe this made them an easy regulatory target. SVB’s failure prompted Signature Bank customers to move their depository funds to larger systemically important banks, like JP Morgan Chase and Citigroup, as concern rose surrounding its portfolio which was very similar to SVB’s. Systemically important is the code for “too big to fail banks” that the Federal government will likely step in and save in a full-blown crisis.

Panic and concerns surrounding the U.S. banking system sent shockwaves from large banks down to your local community bank known for giving out lollipops for new deposits or transactions. $165 billion in losses of market value were experienced among the 10 biggest bank stocks and $108 billion in losses were incurred among small bank stocks according to the Federal Reserve. Concerns began to arise that we were in for another collapse of the banking system as the closure of SVB marked the 2^nd largest bank collapse ever and the largest since the 2008 Global Financial Crisis. Many experts wondered aloud whether SVB was analogous to a Lehman moment within the technology sector centered around Silicon Valley and San Francisco.

Image Source: Fox Business

The Downfall of Silicon Valley Bank

So where did SVB go wrong? As the name suggests, Silicon Valley Bank was a preferred bank for many tech start-ups and venture capital firms. The bank saw substantial growth during the pandemic as the technology sector was booming and venture capital money was raining down on VC startups, minting hundreds of Unicorns – VC startups valued at $1 billion or more. SVB invested the flood of deposit funds into treasury bonds, mortgage-backed bonds, and other long-dated assets which provided SVB with a larger interest spread over the interest SVB paid to its depositors in the low-interest rate environment during the pandemic. The Federal Reserve monetary and interest rate policy decisions and long-term guidance encouraged this behavior as Fed Chairman Powell labeled incipient inflation “transitory” in 2021. But as inflation continued to rise into 2022, the Federal Reserve was ultimately forced to hike interest rates very aggressively. The yield curve eventually inverted as long-term interest on 10-year treasuries fell below those offered on 2-year treasuries. Consequently, the long-duration securities that SVB purchased to back its deposits fell substantially in value, something on the order of 25%. In accordance with accounting rules and the regulatory framework for banks, SVB had counted on the fact that they would hold their investments until maturity and did not recognize the mark to market impact of higher interest rates in its financial statements. These held-to-maturity securities were carried at cost on their balance sheet until they could no longer be “held.” Sophisticated depositors caught wind of this shadow accounting issue with SVB’s announcement of a $2 billion equity capital raise. Deposits were rapidly withdrawn causing a forced sale of these long-term securities and creating large realized losses.

SVB had also been facing a general slowdown in the venture capital funding cycle and deposit taking. Venture capital investments are far less attractive when the cost of capital rises with interest rates. It’s far easier to finance these ventures that do not cash flow for several years, maybe a decade or more, at zero interest rates, but it’s a completely different ballgame with the Federal Funds Rate at 5.0%. Funding across the venture capital space slowed meaningfully and deposits to the preferred depository institution began to shrink massively. Moreover, these cashflow-burning startup enterprises continued to rapidly withdraw money for payroll and operational expenses. The Federal Reserve’s wild misjudgment on inflation and subsequent unprecedented rapid hiking campaign fomented the destructive conditions for a life-or-death decision between the safety of deposits and SVB’s insolvency, or Jeromeggeden. The Federal Reserve had effectively financially engineered this textbook run on Silicon Valley Bank by its policies. Many sophisticated investors had long ago concluded that the Fed would keep hiking interest rates until they broke something. Technology-sector concentrated SVB proved to be the weak link and the first domino to fall.

The big question is how many other banks will be caught swimming naked on interest rate risk management now that the banking deposit tide is going out. This banking cycle is a foreseeable consequence of Fed monetary policies. Remember under quantitative easing (QE), the Federal Reserve printed dollar reserves and used those reserves to take U.S. treasuries and other government-backed securities out of private hands. These excess reserves generated by QE are now trapped in the U.S. banking system. Depositors are being rational economic actors and withdrawing bank deposits and buying money market funds that hold U.S. treasuries. With money market funds yielding 4.3% today, this deposit withdrawal cycle may be largely irreversible. The Fed should be accelerating its wind-down of its U.S. treasury holdings to soak up the wave of private demand for treasuries.

The Federal Reserve’s Response

The fears around the financial stability of the banking system had investors and consumers alike calling for a slowing of Federal interest rate hikes. Investors and banks alike had already been questioning Chairman Jerome Powell on the timing (too late to start the hiking cycle) and pace (too fast hiking because playing catchup) of their policy decisions. Judgment day came on March 22^nd when the Fed announced another 0.25% rate increase making it clear their priority was combating inflation despite growing fears about the stability of the banking system. The rate hike prompted banks to lose further equity value both domestically and in Europe, causing unease that the Fed’s decision could cause additional damage to the already wounded banking system. Mr. Powell said that “depositors should assume that their deposits are safe” as the government plans to impose further regulations on an already heavily regulated industry. This “watch and see what happens” approach was small comfort and hasn’t given bank depositors in non-systematically important banks that warm and fuzzy feeling about the safety of their deposits. Deposit withdrawals at regional and small community banks continued apace.

Will the Large Banks Keep Getting Larger?

The resulting crisis has depositors and banks alike looking to the FDIC and U.S. Treasury Secretary, Janet Yellen for guidance. Yellen commented at a Capitol Hill hearing that the FDIC will cover the uninsured deposits (excess of $250,000) of both SVB and Signature bank, yet there is great uncertainty if this policy decision would apply to other bank depositors in the future. Yellen publicly said shortly after the SVB collapse that the FDIC could cover depositors whose funds exceed the $250,000 limit. However, when questioned if all banks would receive this treatment at the Congressional hearings, Yellen’s response appeared to suggest that small and midsized banks would be left out. The calamity caused by Yellen’s comments was highly disruptive for many smaller banks as it prompted businesses and individuals to contact their local community banks about transferring their depository funds to larger banks that Yellen said would be protected. This was a surprisingly dismal show of confidence from the U.S. Treasury Secretary who once proclaimed in 2017 as Fed Chairman “I don’t see a financial crisis occurring in our lifetimes.”

From March 8^th to March 15^th, $110 billion flowed out of small banks into larger banks. Small banks account for just 34% of deposits in the U.S. banking system; however, they account for a substantial portion of commercial real estate loans sitting at 74% of total loan activity. Like the iconic Bailey Building and Loan from It’s a Wonderful Life, these small community banks lend out deposit funds to Main Street America borrowers for local commercial real estate projects or businesses. If deposits to small banking institutions continue to contract, then this would reduce capital available for commercial real estate lending. Small banks often work with borrowers whose needs are more specialized or whose funding needs are too small in size for the larger banks in America to consider. For example, according to the American Banking Association, a majority of agricultural lending is done by small and mid-sized banks that have deep roots in their rural communities. Farm loans require specialized analysis and training that not many large banks possess. If depositors pull their money from these small institutions, this could affect the availability of capital for agricultural lending, small business lending, and lending to underserved/underbanked communities.

While concerns surrounding the U.S. banking system have merit, the situation Silicon Valley Bank found itself in was somewhat unique. Nationwide, 45% of all deposits in the United States banks are uninsured; however, at SVB almost 94% of their deposits were uninsured. To stem this evolving bank liquidity crisis, the Fed created a new program to administer additional funding called the “Bank Term Funding Program,” (BTFP). Through this program, banks would be loaned funds if they pledge U.S. Treasury securities, mortgage backed securities, and other collateral. The result would be potentially transferring the risk of bank losses from the bank to the federal government. Through BTFP, the Federal Reserve apparently will provide liquidity to the borrowing bank may give loans based on the par value/cost of the securities rather than its depreciated market value. In other words, they moved the shadow accounting for unrealized losses to the Fed’s balance sheet.

Safety of the US Banking System

Despite ongoing concerns surrounding the stability of the U.S. Banking system and another potential banking crisis similar to 2008, most economists believe that the U.S. Banking system is sound. On a broad scale, U.S. Banks are solvent overall and are not at a high risk of systematic failure or collapse. While rapid interest rate hikes have caused more severe fluctuations in capital flows in higher interest rate sensitive sectors of the economy, like technology and banks concentrated on that sector, we would expect that most large banks have well-risk-managed investment and lending portfolios and show more of diverse depositor base among sectors. Silicon Valley Bank appears to be a unique case of a large bank that did not properly manage the interest rate or duration risk of its investment holdings and Federal regulators were found asleep on the job again. Small community or regional banks may struggle to diversify their portfolio from a geographic standpoint however their focus gives them the ability to lend to a wide array of small businesses such as farms, retail, commercial property, and others. The investment portfolio of these smaller banks is closely watched by bank regulators as they serve such a large percentage of the total loan volume.

Policy actions and statements from the Fed’s Jeromeggedon and Treasury’s Calamity Janet have many Wall Street economists forecasting the U.S. will be in a full-blown recession by the second half of 2023, potentially forcing the Fed to pivot and begin lowering interest rates. Servant Financial client portfolios continue to stay overweight cash and fixed-income securities relative to strategic risk targets. The Federal Open Market Committee’s (FOMC) decision to raise the Fed funds rate by 25 basis points last week shows that the Fed is prioritizing its “stable prices” mandate over financial stability. We believe this policy decision will ultimately lead to increased financial instability while heightening inflation risk. As such, we are maintaining underweights to equity and credit risk and healthy portfolio allocations to precious metals and other real assets.

Based on the FOMC’s subsequent actions, we plan on adjusting risk allocations once financial instability and recession risks have been fully repriced. We expect the Fed will be forced to abandon its inflation fight and lower interest rates materially in the coming quarters. For now, we are advising clients to remain the rational actors that all economists expect us to be. For our portion, that means getting paid to wait by holding excess cash in money market funds with better yields from short-term investment-grade bonds. For example, the Fidelity Government Cash Reserve money market fund (FDRXX) yields 4.3% as compared to just 0.7% more in yield (5.0%) for a high-quality bond fund with a 6-year duration. This short-term positioning greatly reduces the risk of taking a wait-and-see approach to the rapidly evolving macro, policy, and market backdrop.

Keep it simple with money market funds for your liquid savings as well or keep it local if you can. Consider maintaining savings accounts or bank certificates of deposit (CDs) of 6 to 12 months at multiple local banks in support of your community. CDs, like checking or savings deposits, are only FDIC-insured up to $250,000 but are now offering rates from 4% to 5%. Ultimately, it is important to do business with people you trust and places you know will be there when you need them. Have conversations with your local banker to find out how protected your money is. Shop around, this is a saver’s dream after nearly a decade of near-zero interest rates.

Disclaimer: This is not investment advice and should not be used in the context of forming an investment portfolio. See your investment advisor or talk with Servant Financial today about how these factors affect your portfolio.

Russia and Ukraine… One Year Later

Written March 6, 2023 by Ailie Carlene Elmore

By The Numbers

One year ago, the lives of millions of Ukrainians were uprooted, and many more lives around the world were indirectly impacted by the Russian invasion of Ukraine. The human toll alone has been considerable. As it stands today, 8,000 civilians, between 175,000 and 200,000 Russian soldiers, and between 40,000 and 60,000 Ukrainian military members have lost their lives in this crisis. More than 8 million Ukrainians have fled their country. This is equivalent to the population of the Chicago Metropolitan Area being forced to flee their homes. The largest group of refugees are women and children. A further 6,000 Ukrainian children have been taken to refugee camps and facilities in Russia, subject to Russian re-education.

The United States government has provided $68 billion in total economic support with $29.8 billion of that being direct military aid and the rest being humanitarian assistance and economic support. The White House is requesting an additional $37.7 billion in aid in the coming year. The U.S. has given more military aid than any other country; however, the European Union (EU) leads in financial support at $30.3 billion provided to Ukraine within the last year. On the Russian side, communist-led Venezuela, Sudan, Cuba, and Nicaragua have all pledged their allegiance to Russia. While the U.S. has not confirmed China giving direct military aid to Russia, Chinese authorities do not deny their willingness to support their communist ally.

Source: CSIS

In addition to the horrific human toll, the war has also caused a wide swath of economic damage, sending shock waves to financial markets, agricultural markets, energy markets, and world economies. The outcome of the war is still largely unknown as concerns continue to be raised about Russia’s potential use of tactical nuclear capabilities and the uncertain form of Chinese support for Russia. Russia recently suspended its participation in the last remaining nuclear arms deal with the U.S., the 2021 extension of the START treaty (Strategic Arms Reduction Talks). Russia can now begin expanding its nuclear weapons inventories. One year ago, some speculated that Russia would swiftly overtake Ukrainian armed forces, but Volodymyr Zelenskyy and his army have proven their mettle in fighting off close to 320,000 Russian soldiers. While the results of this brutal fight are still hanging in the balance, we will now look back at how this conflict has disrupted global markets.

Agricultural Impact

Agriculture generally flies under the radar for many investors and consumers as a sufficient food supply is generally taken as a given, particularly in the developed West. However, the invasion shed light on the tenuous nature of global food and commodity supply as the stomping of Russian boots on Ukrainian soil was felt from the sunflower fields in Ukraine to the amber waves of grain in the United States. Agricultural commodities such as wheat, sunflowers, corn, and soybeans all depend on the trifecta of fertilizers for plant growth: Nitrogen, Phosphate, and Potash. While the United States is not significantly dependent on Russia for imports of these vital crop nutrients, Brazil and other agricultural-producing countries import a significant portion of their fertilizer needs from Russia and its allies in China and Belarus. The fertilizer pressure globally has sent fertilizer prices skyrocketing with energy, seed, and financing costs for farmers also following suit. Input prices increased 20-30% for U.S. farmers in just one year as Brazil and others scowered the global market for alternative sources of supply. Global fertilizer prices remain firm and/or continuing on an upward trend.

Source: Farmdoc Daily

On the flip side of rising fertilizer prices, agricultural commodity prices have generally offset these rising input costs with corn, soybeans, and wheat prices all hitting 8-year highs in the past year. A relatively favorable growing season for much of the corn belt meant strong net farm incomes across the United States. Prices for agricultural commodities however have begun to fall off recently as the world has begun to adjust grain and input risk premiums to discount expected war outcomes with the war at a seemingly painful stalemate.

Globally, Ukraine supplies the world with 30% of the world’s sunflower and its byproducts (oil and meal). It is also a significant producer of corn, wheat, barley, and rapeseed. The conflict has brought about many uncertainties about whether the fields in Ukraine will be turned into battlefields or if they can produce a crop, will there be open ports for them to take their harvest to for export to global markets. Speculation about the war’s impacts on agriculture production are ongoing; however, if the COVID pandemic and Russia-Ukrainian war have taught us anything, it’s that regardless of what is happening in the world and whether there is war or peace, people still need to eat.

Energy and Financial Markets

Investors have been riding a wave of economic turmoil throughout the last year as the Russian ruble tumbled early on against the US Dollar and then climbed the mountain upward as capital controls and petrodollars came in. The ruble began to sell off once again when US and EU energy sanctions threatened a stranglehold on Russia’s critically important energy and gas business. Crude oil has been volatile as a result of the war with the oil price peaking at $128 last March after the Russian invasion began. Importantly, Russia is Europe’s largest oil exporter and although sanctions have been placed on Russia from the West, Russia has been able to re-direct most of its oil sales to China, India, and Southeast Asia. Natural Gas has been subject to similar turmoil as Europe was one of the main customers of Russian natural gas through the Nord stream gas pipeline system. Europe imports 83% of its natural gas and the war has brought about additional sanctions on Russian gas imports impacting the price European consumers pay for heat and energy. Europe has been forced to find new import partners such as the U.S., Qatar, Nigeria, Norway, and Algeria to keep people’s homes heated and the lights on.

Source: exchangerates.org.uk

A stock market repricing for a looming recession or economic slowdown and the Federal Reserve’s ongoing fight against inflation have eaten up investors’ returns over the last year. However, there are sectors of financial markets that have profited from the Russian-Ukrainian conflict. Aerospace and defense stocks are up 11% in past year according to a subindex of the S&P 500. Commodities and raw materials have also remained strong as both sellers of agricultural products and energy commodities benefitted from higher prices and the uncertainties about a region that produces 14% of the world’s energy (Russia) and is a leader in sunflower oil, corn, and wheat production (Ukraine). Price pressures and volatility will remain in global commodity markets until the conflict is resolved. Amundi, Europe’s largest asset manager, says the probability of a long, drawn out war is up to 30%.

Source: WSJ

Global investors have been adjusting their strategic asset allocations for these geopolitical uncertainties and attempting to benefit from strong commodities and defense stocks. The uncertainty surrounding how the U.S. will respond if Russia deploys tactic nukes has some speculating around domestic defense stocks. Some also believe military spending may be in a secular uptrend as U.S. munitions and defense equipment inventories have been depleted and the White House begins saber rattling against the Chinese. The military industrial complex will likely adopt Rahm Emanuel’s approach by “never letting a serious crisis go to waste” to push their military spending agendas. For those looking to go long a secular defense spending spree the iShares U.S. Aerospace and Defense ETF (ITA) has a low expense ratio of 0.39% with concentrated exposure in defense companies such as Raytheon (21.4%), Lockheed Martin Corp (16.14%), and Boeing Co (7.42%) among others. ITA is not cheap; however, as it trades at 24 times projected 2023 net earnings with a dividend yield of 1.4%. For more a narrow, internationally focused play, BAE systems (BAESY), has experienced strong growth over the past year as Europe’s leading defense contractor. BAESY trades at a more modest 18 times trailing earnings and yields 3.0%. Generally, the stock has benefitted from higher military spending which doesn’t seem like it will be tapering off anytime soon.

How the Russia-Ukrainian war will end is still highly uncertain; however, it is clear that sadly global markets will be actively repricing its extended effects long after the last solider leaves the battlefield.

Where Have All the Good Workers Gone?

Written January 31, 2023January 31, 2023 by Ailie Carlene Elmore , John Heneghan

Reminiscent of the 1984 Bonnie Tyler hit from Footloose, many US employers are crooning for working class heroes. “I need a worker, I’m holding out for a worker ‘til the end of 2023.” The U.S. labor force has been dwindling from food and beverage service to financial analysts since the COVID-19 pandemic began. While some have been quick to blame the shortage on several rounds of government relief money that idled some workers, a combination of factors is influencing this labor change. Millions of people were suddenly unemployed at the start of the pandemic and many industries assumed these people would return to work when normalcy resumed. However, almost 3 years after the start of the pandemic, these “missing” workers may never return to the labor force. This labor shortage could cause a secular shift in American businesses and labor markets.

COVID-19

Government and businesses’ responses to COVID-19 brought about a 50-year high in unemployment, peaking at 14.7% in April 2020. Service workers and business professionals found themselves suddenly without work and wages. The U.S. government came to the rescue, handing out $5 trillion in pandemic stimulus money with a large portion devoted directly to individuals in the form of stimulus checks and extended unemployment benefits. When evidence of a growing labor shortage emerged, many people pointed fingers at the U.S. government for providing so much monetary support and disincentivizing workers to return to the job market. However, the story isn’t that simple. Fears of contracting and spreading COVID and the existential risk of mortality created a widespread shift in lifestyle priorities and an increased desire for a better work-life balance. The result of these factors has been the rise of remote labor and gig workforces. A study done by the U.S. Chamber of Commerce found 91% of survey participants hoped they could continue to work remotely at least part of the time. Businesses have generally adapted to this desire and been accommodative. However, remote labor isn’t really a possibility for customer-facing service roles or manufacturing jobs for which labor activities are concentrated in a single location.

The U.S. Labor Department reported 10.5 million job openings in November 2022 with the labor participation rate at 62.3%, down from 63.3% in February 2020. Not only do service industries have their “Help Wanted” signs out but so do financial services and professional and business services. While workers are demanding more remote work, these professional industries are demanding people come back to work in their office buildings to collaborate with their colleagues. Workers have been less receptive to this return to the office mandate causing worker turnover rates to reach 57.3% in 2021, up from 45% just two years earlier. Businesses that have been able to accommodate their workforce’s desires for at least partial remote work are generally experiencing lower turnover and avoiding severe labor shortages.

No More Baby Boomers

Economists argue that this labor shortage was always on the demographic table. The labor participation rate has been on a downward trend since 2000 and some argue it is as simple as the laws of supply and demand. One of the largest generations in U.S. history, the Baby Boomer generation, is clocking out with no plans to punch back in. The median age of the Baby Boomer generation (born 1946-1964) turned 66 last year meaning many boomers are taking a refrain from Johnny Paycheck’s 1977 hit song, “Take This Job and Shove It” and checking into retirement. The next generation behind the boomers, Generation X, is about 5 million people short to fill the employment hole the boomers are leaving. The next generation able to take the Boomer’s place is the Millennials; however, it is still going to be several years before they enter the labor force. COVID-19 only intensified Boomers leaving the workforce as older generations were more susceptible to adverse outcomes from the virus. Boomers were also less likely to adapt to changes toward more remote work. This trend may have something to do with the adage of old dogs and new tricks.

Source: Statista

These trends in labor demographics are not likely to be resolved any time soon as the World Bank projects the number of people between the working ages of 15 and 65 is set to decline by 3% over the next decade. “Without sustained immigration or a focus on attracting workers on the sidelines of the labor force, these countries simply won’t have enough workers to fill long-term demand for years to come,” said the chief economist at Indeed. Historically, immigration and globalization have helped bridge the labor gap; however, during the pandemic we saw a reversal of both trends. Policy reform towards immigration will need to happen if the U.S. wants a sufficiently dynamic labor force in the years to come.

Is the End in Sight?

The question begs, how long will this domestic labor shortage last? While a body of evidence suggests this is a systematic change, other economists argue a potential shift into a recession could help lower demand for labor and bring the labor situation towards equilibrium. The shifting landscape of the U.S. economy toward a recession would likely reduce hiring levels as companies are forced to cut back on growth plans. While we may see an uptick in unemployment levels, it is doubtful it will reach the near 10% unemployment levels the Great Recession of 2008 brought. The looming recession and persistent inflation point to a normalization of the labor market in 2023; however, some companies are still going to need to make adjustments to their business models to compensate for the loss in workers.

Companies are beginning to readjust their hiring strategies and their job expectations to accommodate the current labor market conditions. Inflation has made it difficult for companies to keep pay scales in line with the cost-of-living increases. It is going to be increasingly important for companies to be proactive with their employment strategies and stay ahead of the trends in worker lifestyle demands if they want to retain good talent. Companies such as IBM (Ticker: IBM) predicted this shortage long ago and began outsourcing their talent to countries with growing populations such as India. They have been able to capitalize on lower market-based wages in these developing countries and cheaper input supplies.

Meanwhile, the technology sector is busily working on solutions to these labor shortages, like artificial intelligence and machine learning. The most recent market hero in this space is ChatGPT from the venture firm OpenAI. ChatGPT optimizes language models for dialogue. The ChatGPT model has been trained to interact with users in a conversational way. This format makes it possible for ChatGPT to answer follow-up questions, admit its mistakes, challenge incorrect premises, and reject inappropriate requests. Several in the Twittersphere claim that ChatGPT has passed portions of the Bar Exam, medical license exam, and MBA operations exam. Further, experts interviewed by UK’s Daily Mail believe ‘AI will take 20% of all jobs within five YEARS’ and explain how bots like ChatGPT will dominate the labor market. According to the article, Microsoft invested $10 billion in ChatGPT and said that the technology will change how people interact with computers.

From our standpoint, the best way for investors to express a purposeful view on the future emergence of artificial intelligence and machine learning is through the leading technology heros, like Microsoft and Apple, who have massive distribution capabilities through their existing software and hardware product suites and business relationships across sectors. We like iShares U.S. Technology ETF (IYW). This ETF provides exposure to the leading U.S. electronics, computer software and hardware, and IT companies. IYW’s boasts assets under management totalling $7.8 billion and a reasonable expense ratio of 0.39%. IYW has traded down 35% in 2022 and trades at an estimated 2023 price to earnings ratio of 23 times. The following summarizes IYW’s top holdings:

We recommend buying IYW on future weakness and sitting on the sidelines holding out for a hero ‘til the morning light. In other words, wait until the next recession and buy these tech heroes who are strong, fast, and fresh from the fight.

Twelve Themes of Christmas

Written December 22, 2022December 22, 2022 by Ailie Carlene Elmore

Contributions made by: John Heneghan & Michael Zhao

‘Twas the week before Christmas, when all through the financial house, not an investor was resting, not even a DC louse. 2022 brought investors increased market volatility and a wide array of risks and uncertainties remain, yet some opportunities may lie hidden under the Christmas tree. From inflation worries to geopolitical risks, we have been on a wild sleigh ride this past year. But whether you landed on the naughty or nice list this year depended on your ability to navigate the economic whiteouts caused by the likes of the Federal Reserve, Vladimir Putin, and Sam Bankman-Fried.

Tis’ the Season for Interest Rate Hikes

On the first day of Christmas, Federal Reserve Chairman stuffed my stocking with 7 rapid interest rate hikes. The Fed has been hiking the benchmark Federal Funds Rate at an unprecedented pace to combat high inflation which is causing concern among investors and consumers alike. As the cost of borrowing increases, whether it’s for a mortgage, car loan, or credit card, it impacts the affordability of goods and services for many households. People tend to hunker down on spending and are less likely to take on new debt, which impacts aggregate consumer spending and business investment. Recently, the Federal Reserve raised its benchmark interest rate from 4.25% to 4.5% in its final policy meeting of the year. This marks the seventh consecutive increase in just nine months to the highest benchmark interest rate in 15 years.

The Federal Reserve has signaled its desire to keep interest rates higher through 2023 with the potential of rate easing, not until 2024. As a result of the Fed interest rate hikes, mortgage rates have reached 20-year highs, interest rates for home equity lines of credit are at 14-year highs, and car loan rates are at 11-year highs. Savers, on the other hand, are seeing the best bank deposit and bond yields since 2008. The 10-year U.S. Treasury yield hit a 12-year high in September at 3.93% causing foreign investment to flock to U.S. treasuries and spurring strength in the U.S. Dollar. After several years of low-yielding bond investments, investors are busily re-balancing their investment portfolios so they can much more safely jingle their way to their investment objectives.

Source: Statista

Dashing through Inflation

Santa’s pocketbook may be feeling a bit squeezed this gift-giving season as inflation continues to rage at the North Pole, particularly for the basic foodstuffs like milk and cookies. The Bureau of Labor Statistics reported earlier this month that the U.S. Consumer Price Index (CPI) saw a 7.1% increase year over year during the month of November, down from annual CPI of 7.7% in October and lower than the 7.3% increase forecast by economists. Importantly, the November monthly increase slowed to 0.1% and was driven into positive territory primarily by rising food (0.5%) and housing costs (0.6%). The PCE Prices Index due this Friday is the last consequential data release for the year. Other data this week mostly focuses on the housing market where home sales have slowed down, but actual prices continue to rise. Still rising housing costs are a problem for the Federal Reserve as “shelter” expenses account for the largest share of CPI. Housing cost increases have been slowing down and many economists believe gauges for both home prices and rents will start to show declines in the coming months. The Fed’s owner’s equivalent rent measurement is a notorious lagging factor and when this statistic rolls over it may take a substantial bite out of headline inflation. Supply chain backlogs, rising costs, government spending, labor shortages, and increasing demand have all played a part in elevating inflation to its current levels. As a result, these inflation trends have been the principal driver of the Federal Reserve’s aggressive hiking policy which has economists, investors, and consumers appropriately worried that a Fed-induced recessionary winter storm might be brewing as the Fed overshoots on the hawkish side.

Baby, it’s Looking like a Recession

Current economic pressure really can’t stay, baby, it’s looking like a recession. Recession fears are rising as investors lose confidence in U.S. economic performance in the face of an unprecedentedly rapid and yet unfinished Fed hiking cycle. Despite relatively strong economic growth in the third quarter of 2022 and a still low unemployment rate of 3.7%, the Federal Reserve has lowered its forecast for next year’s U.S. economic growth in light of its rate hikes and expects the unemployment rate to rise by the end of 2023 as well. Some believe that the current widespread concerns about a recession may help us avoid one, as caution leads to less risk-taking and borrowing, potentially cooling the economy enough to reduce inflation and the need for further interest rate hikes. Lagging inflation statistics remain elevated and central banks globally are continuing to raise interest rates to destroy demand and slow economic growth in the coming year. More real-time inflation measures, like the Cleveland Fed’s “Inflation Nowcasting” measure, show inflation moderating. Inflation Nowcasting’s fourth quarter run-rate CPI is at 3.5% and Core CPI (excluding food and energy) is at 4.7% suggesting the Fed is “fighting the last war” rather than anticipating what will happen next.

The U.S. Dollar All the Way

Santa’s reindeer are taking a new launch angle this year along with the U.S. dollar by soaring to new heights in 2022. The US Dollar Index, a measure of the dollar against a basket of other major global currencies, had been on the rise throughout 2022 but started to taper off in late November and December. Other central banks have joined the competitive rate-hiking game and compressed interest rate differentials. The strong dollar is beneficial for American consumers who purchase foreign goods, as it makes them cheaper in U.S. dollar terms. However, it can be an earnings headwind for American businesses that export goods or have multinational business operations such as McDonald’s and Apple. McDonald’s reported that its global revenue fell 3% this past summer due to the strong dollar as the rising costs of Big Macs have foreign consumers turning to other options. The strong dollar is also a reflection of the relative strength of the U.S. economy compared to other advanced economies, such as those in Europe (Euro) and Japan (Yen). Foreign investors flocking to higher and arguably lower-risk U.S. treasury yields only bolsters the dollar further.

U.S. Dollar Index; Source: Google Finance

Eat, Drink, & Spend like Consumers

U.S. consumers found themselves on the nice list in this year of profligate government spending. The US government gave consumers several nice stimulus checks due to the COVID-19 pandemic. While some consumers used these relief funds to pay for day-to-day necessities, others have been able to enjoy new furniture, electronics, and vacations that have them saying “Mele Kalikimaka”. Economists predict this holiday season may be the last fling of spending toward luxury brands and exotic travel. The current level of consumer spending is projected to dwindle towards the end of next year as recessionary fears manifest and unemployment levels grow as the Fed’s aggressive hiking policy takes hold.

It’s Beginning to Look a lot like a Labor Shortage

Santa may be having a bit of trouble finding enough elves to manufacture toys in his workshop this year. The COVID-19 pandemic brought about many changes to people’s lifestyles, and many re-evaluated their lifestyles as they were challenged with their mortality. Across the nation businesses in every sector are feeling the pressure to find enough skilled labor to meet the growing consumer demand for goods and services. In 2021, 47 million workers quit their jobs in what is referred to as the “Great Resignation.” The industries hurting the most are food services, manufacturing, & hospitality. Workers have signaled a desire for better company culture, work-life balance, and compensation. Some believe the labor shortage will work itself out if a recession were to occur. However, others argue that this is just the beginning of secular labor shortages as declining birth rates in the U.S. and other developed nations have economists worried that we are not restocking the world’s workforce fast enough. Maybe Santa will be nice enough to supply us with some of his highly productive elves to bridge this gap until intelligent robotics develop further.

Source: US Chamber of Commerce

How Vladimir Putin Stole Ukraine

At the top of most of the world’s Christmas wish list is for the Russian-Ukrainian conflict to be resolved. Not only did the invasion of Ukraine in February bring about economic disruption but it has brought devastation to the Ukrainian and Russian people. It is estimated that close to 7,000 civilians in Ukraine have lost their lives in the conflict. The power-hungry, Russian Grinch Putin, is committed to overtaking Ukraine for strategic access to important trade routes and resources. Currently, Russia is occupying several major port areas along the Black Sea. The Ukrainian defense has been putting up a strong fight with the help of $32 billion and growing of financial support from U.S. taxpayers. Several trade restrictions and sanctions have been put into place to hurt Russia financially. However, since Russia is the global largest energy supplier of natural gas and oil, these sanctions are only putting more extreme pressure on energy prices worldwide. Ukraine is also a large exporter of agricultural products, and the conflict has caused several production and logistics issues for Ukrainian farmers. Commodity prices have climbed as a result, particularly for wheat. While the conflict today looks unresolvable, maybe Grinch Putin’s heart will grow three sizes and he’ll decide to shower Who-ville with presents instead of artillery. “Fahoo fores dahoo dores!”

Photo Source: Behance

Source: Wikipedia

Making Energy Bills Bright

As the war between Russia and Ukraine rages on, energy bills for people around the world continue to climb. Oil and natural gas prices have soared in 2022 with Europe being hit hardest by the jump given its deep dependence on Russian natural gas. In August, gas futures hit a record high of 350 euros creating immense pressure for European nations to set price limits on natural gas. Household electricity prices from natural gas-fired plants have increased in Europe by 67% in just one year, stopping some Europeans from lighting their Christmas trees this year. The European energy ministers imposed an electricity price cap this week to help lessen the burden on consumers. The United States has also felt the brunt of high energy prices as power prices rose almost 16%, the highest increase in 41 years. Consumers also felt the pressure at the gas pump as the average price of a gallon of gas rose to $4.96. Maybe in 2023, we can be like Santa and his reindeer-powered business model by running more of our economy on renewable energy.

Cryptocurrencies Roasting on an Open Fire

Cryptocurrencies roasting on an open fire, Sam Bankman-Fried nipping at your confidence. One of the largest cryptocurrency exchanges and hedge funds, FTX, filed for bankruptcy this November after information was released about its risky holdings and clandestine relationship with its affiliated hedge fund Alameda Research spooked many of its exchange customers. Several exchange customers sought to withdraw their crypto holdings from the FTX exchange, prompting the bankruptcy filing of the company. It turns out FTX was another Ponzi scheme or con game with apparently none of FTX’s well-healed venture capital investors doing any due diligence or demanding a role in corporate governance. The price of Bitcoin has fallen 65% in the past year with investors losing confidence in an asset class imputatively regulated by the SEC and Commodities Futures Trading Commission (CFTC). The CFTC has defined bitcoin as a commodity, but a turf war has continued with SEC creating regulatory uncertainty and ample opportunities for miscreants. FTX was a Bermuda-based firm regulated by the Securities Commission of the Bahamas. The SEC could have required crypto exchange registration and reporting and U.S. domestic incorporation. Former FTX CEO, Sam Bankman-Fried, has agreed to extradition and will now be answering to the Justice Department and SEC for violations of wire fraud, money laundering, securities fraud, commodities fraud, and conspiracy to violate campaign finance laws. The once shiny wrapped package that was FTX Digital Markets now looks like a lump of coal. Expect the naming rights for FTX Arena, home of the Miami Heat, to become available soon and most of FTX’s liberal political contributions to be returned to the bankruptcy court. Bernie Madoff will look like a petty thief compared to SBF.

Dreaming of Student Loan Forgiveness

About 43 million Americans received a nice Christmas present from President Biden this year, with forgiveness for part of their $1.6 trillion student loan debt. President Biden announced the plan earlier this year sparking both joy for recipients and scrutiny from every other U.S. citizen. The plan would eliminate $10,000 in federal loans for individual borrowers making less than $125,000 per year or couples earning less than $250,000 annually. Pell Grant recipients, which account for 60% of current student debt holders, could receive upwards of $20,000 in forgiveness. However, this largesse begs the question of where the money for this forgiveness will come from as the US government already is $31 trillion in debt. Biden’s Executive Order faces many legal challenges in Congress and the Supreme Court to overcome and move this profligate effort forward.

All I Want for Christmas is Farmland

The bright star on top of the investment tree this year is an asset class that has been at the top of many institutional investors’ Christmas wish lists all year, U.S. farmland. Farmland hasn’t always been seen as an accessible investment option. However, farmland funds such as Promised Land Opportunity Zone Fund and others have been formed to allow investors access to in this durable, inflation-beneficiary asset class. Iowa State University recently reported farmland values in Iowa were up 17% in 2022 which comes on top of a 29% increase in 2021. Similar stories have been reported throughout the Midwest as strong commodity prices fuel farm incomes and transacted land values. The COVID-19 pandemic had people re-evaluating what is important to our world with basic human needs, like food, at the top of the list. While consumer preferences and social trends may change, people will still need to eat, making farmland one of the most durable asset classes through time. This has many investors saying “All I Want for Christmas is Farmland.”

We Wish You a Diversified Portfolio

At Servant Financial, our goal is to help you navigate these turbulent times and help you make the best decisions for your investment portfolio. We understand increased market volatility may be causing investor unease, but it is times like these that the basic investment principle of portfolio diversification proves its mettle. With inflation still a concern and US treasuries on the rise, we are paying close attention to iShares 0–5-year TIPS Bond ETF, STIP. With low management fees (.03%) and a 30-day SEC yield of 5.84%, its 2.5-year duration could be an ideal addition to a blended debt and equity portfolio. The principal value of TIPS (upon which the stated interest is paid) is adjusted semiannually as inflation rises, as measured by CPI. STIP holds a variety of U.S. treasuries with maturities of less than 5 years protecting you against rising interest rates and inflation. STIP is a core holding of Servant’s risk-based client portfolios.

Happy Holiday’s from your friends at Servant Financial and we wish you a globally diversified portfolio.

Instead of holiday cards or gifts, Servant Financial will be making an annual contribution on behalf of clients and friends to Mercy Home for Boys & Girls.

May this holiday season be a time of rich blessings for you and your family.

Source: Pinterest

Wild Turkey Inflation Run

Written December 1, 2022December 1, 2022 by John Heneghan

Equity and bond market investors have a very busy week ahead of them after giving thanks with friends and family this past week. The Federal Reserve also has its work cut out for them on the inflation front. Unfortunately, a lackadaisical Fed Reserve has let inflation go on a wild turkey run. The latest Consumer Price Index (CPI) reading for October 2022 came in at a roasting annual increase of 7.7%. As usual whenever inflation is an issue, it’s typically driven largely by the necessities of human existence. Energy prices increased most of the CPI measurements at 17.6% followed by food increases of 10.9%.

According to the University of Illinois, 46 million turkeys are eaten each Thanksgiving. The American Farm Bureau Federation estimated that the average cost of this year’s Thanksgiving holiday meal for ten people increased 20% to $64.05 from the 2021 average of $53.31. America’s collective Thanksgiving spending increased more than $225 million for just the turkey and not counting side dishes (46 million times $4.97 AFB price increase for turkey). U.S. Secretary of Agriculture Tom Vilsack had previously warned all Americans of a large turkey shortage. Free-market Austrian economists chortled that Secretary Vilsack had neglected to count the docile turkeys at the Federal Reserve and in leadership in the executive and legislative branches of the Federal government.

All kidding continued, let’s talk turkey about inflation. The greatest economic uncertainty and focus for investors seems to be whether the Federal Reserve gaggle is succeeding in reining in inflation or not. Stock market bulls are feeling a little more confident that the Federal Reserve is moving closer to ending its tightening program after “minutes” from the November policy meeting showed “most” of the Fed herd favored slowing the pace of interest rate hikes “soon.” According to the Fed minutes, some turkeys even warned that continued rapid monetary policy tightening increased the risk of instability or dislocations in the financial system.

Most Wall Street experts predict the central bank clucks will raise the benchmark rate by 50-basis points at its upcoming December 13-14 meeting following four consecutive 75-basis point hikes. The most important inflation updates this coming week will be the PCI Prices Index on Thursday and the November Employment Situation on Friday. Investors are also anxious to hear Top Cockster Jerome Powell discuss the US economic outlook during an appearance at the Brookings Institute on Wednesday afternoon. Powell recently crowed that the Fed could shift to smaller rate hikes next month, but, like all two-handed economists, also squawked that rates may need to go higher than policymakers thought would be needed by next year. Stock market bears maintain that the more important issue is how high rates will ultimately need to go and how long the Fed will hold them there. All of which is of course dependent on how fast inflation comes down. This is the key question being debated among economists, business leaders, investment advisors, and investors.

For their part, the Fed members generally see inflation coming home to roost rather quickly. The range of Fed member projections from their last dot plot exercise in September, 2022 are as follows – 2022 (5.0% to 6.2%), 2023 (2.4% to 4.1%), and 2024 (2.0% to 3.0%). This Federal Reserve has lost an incredible amount of market credibility by being stubbornly beholden to its “inflation is transitory” mantra in 2021. It’s prudent for all economic actors, particularly low- and middle-income consumers and workers who arguably suffer the greatest hardships during inflationary periods, to at least consider that the turkeys at the Fed are once again being too optimistic on inflationary trends. If the moral sense of the global working-class population is that inflation is a secular trend, it may likely become a secular trend. Look for striking workers and protesting citizenry in the U.S. and globally.

I believe it was Founding Father Patrick Henry of “Give me liberty or give me death!” fame that also counseled, “I have but one lamp by which my feet are guided, and that is the lamp of experience. I know no way of judging the future but by the past.” Thankfully, the investment professionals at Research Affiliates (RA) have examined inflationary eras of the past in their recent article, “History Lessons: How “Transitory” Is Inflation?” RA examined a meta-analysis of 67 published studies on global inflation and monetary policies. Their key conclusions from their study were as follows:

The US Federal Reserve Bank’s expectation for the speed of reverting to 2% inflation levels remains dangerously optimistic.
An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.
Reverting to 3% inflation, which we view as the upper bound for benign inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with the median of over 10 years.
Those who expect inflation to fall rapidly in the coming year may well be correct. But history suggests that’s a “best quintile” outcome. Few acknowledge the “worst quintile” possibility in which inflation remains elevated for a decade. Our work suggests that both tails are equally likely, at about 20% odds for each.

As Fed Chair Jerome Powell remembers well because he lived it, the last secular inflationary episode in the United States was in the 1970s and 1980s. If Shakespeare is right that “What’s past is prologue,” here is a summary of the return performance of various major asset classes in the 20-year inflationary period from 1970 (CPI breached 6% in 1969) to 1986 (CPI declines to 1%) to illuminate the darkness of an unknown investment future.

Source: Data complementary of the TIAA Center for Farmland Research

The best risk-adjusted return profiles from this secular inflationary period were high quality fixed income instruments of varying maturities and farmland. Note that farmland and bonds were negatively correlated over this period so may complement each other rather nicely in a portfolio positioned for secular inflation. REITs and gold provided similar annual returns but at much higher levels of volatility/standard deviation.

In bowling, three strikes in a row is called a turkey. In economic parlance, that’s the triptophanic effect of the sleepy leadership at the Federal Reserve and in the executive and legislative branches of the Federal government.

Commodities Refresh

Written October 30, 2022 by John Heneghan

Investors are shaking out the dustbin of their investment strategies to take a fresh look at commodities that haven’t seen a strong portfolio allocation since the 1970s/80s. With inflation rampant and the U.S. consumer price index hitting a 40-year high in September of 8.2% annual rate, it may be time to reconsider commodities as an investment option. With this inflationary backdrop, it’s the first time in a generation that investors are losing sleep over inflation eating away at their purchasing power and devaluing their hard-earned life savings.

Conventional wisdom holds that commodity investments can provide beneficial portfolio diversification and hedging benefits against inflation. The commodity asset class is generally considered a tactical insurance policy rather than a strategic asset allocation. The returns from commodities are more episodic driven primarily by inflationary surprises leading to commodities’ primary use as a tactical or trading instrument. Historically, commodities have not been a stable source of returns. On a forward-looking basis, investment firm Research Affiliates projects measly expected annual returns of 0.2% over the next ten years with an expected volatility of 15.5% for commodities (Asset Allocation Interactive research platform). That said, commodities’ asymmetric return profile can provide valuable inflation protection similar to recoveries under an insurance policy from catastrophes.

Accordingly, we think of the commodity asset class as a tactical/trading tool to deploy before a wave of unexpected inflation or a long period of sustained inflation. In hindsight, an opportune time to allocate to commodities was earlier in 2021 while the Federal Reserve’s mantra was “inflation is transitory” and well before the Fed’s December 15, 2021 inflation capitulation. For instance, an allocation to the iShares S&P Goldman Sachs Commodity Index (GSCI) Commodity-Indexed Trust (GSG) returned 39.0% for calendar 2021 and has gained a further 26.0% through October 26, 2022. Although we were appropriately concerned about inflation trends and adjusted Servant Financial client portfolios accordingly, we did not add any direct exposure to commodities to client portfolios. We opted instead to tilt model portfolios, subject to client risk tolerances, to real assets and inflation hedges with more stable risk-adjusted return profiles – gold/precious metals (CEF, GDX, SLV), bitcoin (GBTC, HUT), farmland (FPI), and Horizon Kinetics Inflation Beneficiaries ETF (INFL).

With spectacular commodity price responses to the unexpected spike in inflation now largely behind us, we are hard-pressed to add commodity exposure to client portfolios at this juncture unless we were highly confident that a long period of sustained inflation or what is called a Commodity Super Cycle (Super Cycle) has begun. Super Cycles are extended periods of time of around a decade where commodities as a whole trade at prices that are greater than their long-term moving averages. A Super Cycle will usually occur when there is a large industrial and commercial change in demand within a country or globally that requires more resources or supplies of commodities with large demand-supply imbalances.

There have been four super cycles over the last 120 years. The first started in late 1890 and was accelerated with widespread industrialization of the United States and industrial build-up associated with World War I. This cycle peaked in 1917. A new Super Cycle started in the late 1930s with the advent of World War II and peaked in 1951 after Europe and Asia’s heavy rebuilding from the war was complete.

The next Super Cycle started in the 1970s at the beginning of a long phase of global industrialization. World economies industrialized and populations moved to urban centers, requiring more raw materials and energy to sustain this more intensive growth. The Vietnam War and Nixon’s closing of the gold window (halting foreign nations’ convertibility of U.S. dollars to gold and the dollar plunged by 1/3^rd in the 1970s) were also significant factors in this cycle.

Note that the Vietnam War was one of the first Cold War-era proxy wars with eerily similar characteristics to the current Ukraine-Russian conflict. The Vietnam war took place in Vietnam, Laos, and Cambodia from November 1955 to the fall of Saigon in April 1975. It was “officially” fought between North Vietnam and South Vietnam. However, North Vietnam was supported by the Soviet Union, China, and other communist allies. While South Vietnam was supported by the United States and its democratic allies. Ominously, the Vietnam war lasted almost 20 years. The 1970 Super Cycle came to an end as the Vietnam War ended and foreign investments fled as extractive industries became nationalized.

The most recent Super Cycle began in 2000 as China and its population of 1.3 billion, or 20% of the world’s population, joined the World Trade Organization. With 1.3 billion Chinese jumping on the globalization and industrialization bandwagon, demand for energy and raw materials needed to build new megacities surged. The Great Recession hit in 2009 and ended this last Super Cycle.

The current spike in inflation and commodity prices could well mark the beginning of a fifth Super Cycle. The Ukraine-Russia conflict, destruction and/or destabilization of global supply chains from the COVID-19 pandemic, breakdown in global trading partnerships, dangerously loose global central bank monetary policies, and a shortage of new investment in energy and raw materials exploration and development point to the makings of a fifth Super Cycle potentiality.

Ole Hansen Head of Commodity Strategy at Saxo Bank believes this lack of investments in materials and energy sectors, as depicted below, together with the forces of decarbonization, electrification and urbanization will keep supply tight and inflation high.

At a minimum, investors should consider the possibility of a new Commodity Super Cycle. The key matter of debate is whether investors believe the Federal Reserve will ultimately be successful in taming the inflation beast. The Fed is playing catchup after letting the beast run wild for some time before taking credible action. For a more in-depth discussion on the Fed’s chances of policy success, readers are encouraged to watch investment research firm Real Vision’s video where perspectives on both sides of the economic debate – deflation/disinflation/recession and inflation/stagflation – are discussed.

We’ll be watching for signs that the Federal Reserve’s interest rate hikes and quantitative tightening cycle are having the desired economic impact – the destruction of demand for goods and labor. One factor we’re highly focused on is the labor market and whether unemployment levels will trend higher and if inflationary wage pressures lessen. Secondly, we’re watching for signs of a possible Federal Reserve policy mistake, like a premature policy pivot before the back of inflation is broken.

Our preferred investment vehicle for a tactical allocation to commodities is the Invesco Optimum Yield Commodity Strategy No K-1 ETF (PDBC). PDBC is an actively managed exchange-traded fund (ETF) that seeks broad-based commodity exposure through financial instruments (commodity futures and swaps and U.S. Treasury Bills) that are economically linked to the world’s most heavily traded commodities. The Fund’s commodity allocation is production weighted and therefore structurally overweights the energy complex relative to other commodity indexes. The following summarizes commodity allocations (current % and strategic rebalance target %):

Sector	Current % Allocation	Strategic Rebalance Target %	Commodity Allocation
Energy	63%	55%	WTI Crude, Brent Crude, Natural Gas, Gasoline
Precious Metals	8%	10%	Gold & Silver
Industrial Metals	9%	13%	Aluminum, Copper, & Zinc
Agriculture	20%	23%	Corn, Soybeans, Sugar, Wheat

PDBC outperformed GSG in 2021 returning 41.9%, but the Fund is lagging that GSG year-to-date at 20.7% in gains through October 26, 2022. Importantly, the Fund does not generate a K-1 tax reporting obligation.

Clear signs of an impending Fed policy mistake would lead us to aggressively consider a tactical allocation to commodities through PDBC. One low-probability scenario would be a significant dislocation or lack of market liquidity in the U.S. Treasury market that forces the Fed to purchase treasuries. The Fed would effectively be adopting yield curve controls, much like the recent Bank of England’s actions in the gilts market to stem an uncontrolled blow-out of gilt yields. One expected casualty in this outlier fact set would be foreigners’ loss of faith in the U.S. Dollar with an ensuing currency devaluation like in the 1970s when Nixon ended dollar convertibility to gold.