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Inflation Conundrum: How to Protect Your Portfolio

Stock Market and Inflation Trends

Stock indexes have continued their bull run in July ahead of the much-anticipated June Consumer Price Index (CPI) report. On July 10th, the S&P 500 and the Nasdaq Composite both closed at record highs, marking their seventh consecutive session of gains in July. The Dow Jones Industrial Average ended just shy of its own record close. Through July 10th, the S&P 500 was up 3% for the month, while the tech-heavy Nasdaq surged 4.9%, and the Dow added 1.4%

The continuation of risk-on attitudes were encouraged by Fed Chairman Powell’s July 9th comments in Congressional testimony before the Senate Banking Committee.  Powell expressed caution about cutting interest rates, stating that the data does not yet support full confidence in the inflation path needed for a rate cut. He emphasized the need for more positive economic indicators to boost his confidence on the future path of inflation. Powell also warned that maintaining high interest rates for too long could negatively impact economic growth.  On the other hand, he commented that prematurely easing monetary policy or easing too much could harm the Fed’s progress in taming inflation.

The Federal Reserve remains focused on achieving its 2% inflation target and is closely monitoring labor market conditions, which have shown recent signs of cooling but remain relatively robust.  If you recall, May CPI came in much cooler than expected, which went a long way in restoring Wall Street’s faith that expected Federal Reserve rate cuts would happen in 2024.

The June Consumer Price Index (CPI) was reported on the morning of July 11th, and it did not disappoint. CPI for all items decreased by (0.1%) in June 2024, which was below expectations of a 0.1% increase. This is the first negative month-over-month inflation print since May 2020. Year-over-year headline inflation for June of 3.0% now sits at a 12-month low.  Core CPI, which removes more volatile energy and food prices, increased 3.3% from a year ago.

In response to the June CPI print, bond traders have increased the odds of a Fed rate cut by September 2024 to 83% from 67% odds before the deflationary June CPI inflation print.  Exactly one year ago, the Fed stopped raising interest rates.  Despite market and Fed expectations for at least one interest rate cut this year, U.S. inflation remains 100 basis points above the Fed’s 2% inflation mandate.

The next inflation update is the June PCE Prices Index on July 26, which is Fed’s favored inflation indicator. Additionally, there are two more CPI prints and one more PCE Price read due out before the Fed’s next meeting in September.

Bull vs. Bear

Bullish and bearish investors immediately began battling it out after the June CPI print as to whether inflation has been tamed by the Federal Reserve or not.  Mastering of inflation is generally considered bullish for both bond and stock markets.  Alternatively, the starting of a Fed easing cycle without putting a lid on inflation is considered bearish to both markets.  The worst-case economic scenario is stagflation where we experience slowing economic growth, but inflationary pressures remain.

Risk capital began making its bets on July 11th right away as capital made meaningful rotations by asset classes, equity market capitalization and sector, and geography.

Here is a heat map for the trading day for popular, domestic Exchange Traded Funds (ETFs):

Bond ETFs (AGG, +0.5%, LQD +0.5%, JNK +0.4%) as expected all responded positively to the deflationary CPI print. While the top-performing major equity benchmark was interest rate-sensitive small caps (IWM, +3.7%) on the day. Capital-hungry small caps have substantially lagged the S&P 500 (SPY, -0.9%) on a year-to-date basis by over 10%.    The technology-heavy NASDAQ (QQQ, -2.2%) was the worst performer on the day along with the S&P 500 Technology sector (XLK, -2.5%) as investors booked profits and/or took some chips off the Magnificent 7 table.  Interest rate-sensitive sectors within the S&P 500 had meaningful bounces with Real Estate (XLRE, +2.7%) and Utilities (XLU, +1.8%) the top performers.

It’s also worth noting that traditional inflation hedges like precious and industrial metals also did well with gold (GLD, +1.7%) and S&P Materials sector (XLB, +1.4%).  The U.S. Dollar Index (DX-Y.NYB, -0.6%) traded lower against a basket of the other global fiat currencies.   Fidelity Wise Origin Bitcoin Fund (FBTC, +0.1%) was flat, but China (FXI, 2.2%) was the top-performing international market on the day as the dollar weakness acts as a for sale sign on Chinese goods on international markets.

Relative to the S&P 500 decline on the day, noteworthy contributors to Servant Financial client models were Farmland Partners (FPI, +3.2%), gold miners (GDX, +2.8%), Sprott Physical Gold and Silver Trust (CEF, +2.0%), silver (SLV, 1.9%), high quality value-oriented large caps (DSTL +1.6%, BRK.B +1.2%, MOAT +1.1%) and uranium (URNM, 1.3%).

Protecting Your Portfolio

Inflation has remained stubbornly above 3% and well above the Federal Reserve’s official 2% policy target for more than three years.  Over this period, the traditional 60%/40% (equities/fixed income) portfolio has struggled and may no longer be an appropriate default investment approach going forward.

The risks of continued persistent inflation above the Fed’s target inflation of 2% are considerable.  The Federal Reserve is expected to begin an easing cycle at a time when the fiscal situation remains nothing short of precarious.  As witnessed in the recent Presidential debate and in the discourse that followed, there is a complete lack of fiscal restraint being expressed by political leaders on either side of the aisle.  The Congressional Budget Office recently estimated that the fiscal budget deficit was estimated at $1.9 trillion, or 7% of U.S. GDP, for the year ended June 30, 2024.  The last time the deficit was this high as a percentage of GDP was during World War II.

Just to cite one conundrum reflecting Washington’s inability to responsibly govern, the Federation for American Immigration Reform testified before the House Budget Committee that American taxpayers pay $151 billion annually due to illegal immigration.   The CBO estimated 2024 deficit of $1.9 trillion apparently does not fully account for the cost of illegal immigration at the state and local level or include discretionary costs and long-term entitlement costs associated with illegal immigration.

The prospects for a traditional 60/40 portfolio in a future resplendent with high and sustained inflation are worrying, particularly if inflation is like that experienced in the 1970s and early ‘80s stagflationary period. Servant Financial believes broadly diversified portfolios require a healthy allocation to inflation-protected assets like gold and precious metals, bitcoin (“digital gold”), real estate, high-quality large-cap equities, energy, and raw materials to weather any potential economic disturbances ahead.  Specifically, Servant Core portfolio allocations to Real Assets, Infrastructure (energy), and Digital Assets range from approximately 9% for the most conservative client risk profiles to 25% for the most aggressive risk profiles. We also run a bespoke “best ideas” portfolio that has substantially all its assets invested in Real Assets, Infrastructure, and Digital Assets.

We close this article with a wise quote from another period of war, irresponsible governance, and economic injustice for the working class and poor in our nation.

“In this unfolding conundrum of life and history, there is such a thing as being too late. Procrastination is still the thief of time. Life often leaves us standing bare, naked, and dejected with a lost opportunity.  The tide in the affairs of men does not remain at flood — it ebbs. We may cry out desperately for time to pause in her passage, but time is adamant to every plea and rushes on. Over the bleached bones and jumbled residues of numerous civilizations are written the pathetic words, “Too late.””

~ Martin Luther King, Jr., Beyond Vietnam — A Time to Break Silence

Delivered 4 April 1967, Riverside Church, New York City

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