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The Next Big Thing

As humans, we are constantly looking towards “the next big thing.” Children look forward to Christmas Day when they find presents under the tree. College students look forward to the end of the semester and being one step closer to closing the door on homework and exams. Adults constantly think about the next big life event such as buying homes, marriage, starting a family, retirement, or just trying to make it to the weekend after a long workweek. The human nature of “the next big thing” has created the yearly phenomenon of the New Year’s resolution.

Have you ever wondered where this tradition started? Why did we become so caught up with big or important goals or accomplishments of “next year I am finally going to get in shape” or “this is the year will be the year I finally start my own business”? The tradition is said to have begun 4,000 years ago with the ancient Babylonians. People would hold massive celebrations to honor the new year which began in March when crops were planted, and new life would begin to grow. Oftentimes this would be the time that the Babylonians would crown a new king which is an interesting analogy as we head into election year 2024 in the United States. Likewise, Ancient Romans believed in a similar practice and that their god Janus (how January got its name) would look backward to the previous year and make predictions about “big things” in the coming year.

Thousands of years later, we follow a similar practice of looking at our biggest accomplishments of the past year and setting new bigger, or higher goals for the coming year. In last month’s article, we evaluated the ups and downs of the U.S. economy by addressing interest rates, recession concerns, consumer spending, geopolitical issues, and bitcoin adoption among others. Looking at 2024, we see some New Year’s resolutions on the brink for the U.S. but not your typical “I want to lose 10 pounds” or “I want to finally get out of debt,” even though the U.S. government should definitely work on that second one. We expect some New Year’s resolutions within the U.S. regarding economic stability during election year madness and the public likely has some resolutions about the growing credit card burden in light of rising inflation and interest rates post-COVID-19 pandemic. We also expect a few big companies to have an IPO on their New Year resolution list and investors will be keeping a watchful high to see if they can hit these goals.

We Need to Keep the Economy Calm During the Election Year Madness

High on the New Year’s wish list for 2024 for many in the United States is to maintain a relatively stable economy during what is sure to be a volatile election year with more ballot histrionics and chicanery. Regardless of political beliefs, it is easy to see that polarization between political parties is paramount, which may only breed volatility in the economy and financial markets. People typically keep a watchful eye on the factors driving the economy during elections as sometimes changes in power or just the thought of a change in power can create uncertainty or confidence that shifts the trajectory of the economy one way other the other.

U.S. Bank recently published an analysis examining how elections have historically affected the U.S. stock market. Their analysis showed that while election years can bring added volatility to the market, there was no evidence suggesting a meaningful long-term impact on the market. U.S. Bank showed in the figure below how political party control has historically impacted the value of the S&P500 specifically during the first 3 months following an election.

However, individual sectors can swing more widely than overall markets depending on the key campaign issues during an election year such as energy, infrastructure, defense, health care, and trade or tax policy. Key issues going into the 2024 race are likely to be inflation, climate change, foreign policy, student loan forgiveness, and reproductive rights. U.S. Bank also concluded that the individual drivers such as economic growth, interest rates, and inflation are still the most critical factors for investors to consider. Each political candidate is likely considering these market-moving factors as they position their “big things” for their 2024 election runs.

This Year I Want to Get Out of Credit Card Debt

Those plastic shiny cards in Americans’ pockets may be seeing a little less action in the coming year. Credit card debt levels reached an all-time high of over $1 trillion in 2023 as consumers resort to spending on credit to maintain their standard of living in the face of the rising costs of almost everything. Interestingly, Statista reported in a recent survey that people’s #1 priority going into 2024 was saving more which means swiping less. The average unpaid debt among consumers is around $7,000 and the double-digit interest rate accruals on those debt levels do not bode well for consumer saving or spending.

Source: Statista

While the Federal Reserve is celebrating inflation heading towards its 2% target, some people forget that the inflation number is a year-over-year metric. This fact means while year-over-year inflation numbers have come down, they are being compared to high single-digit inflation numbers from the previous year. Let’s look at the specific costs of a few items. A loaf of bread in March 2020 just before the pandemic began was around $1.37 and a gallon of milk was $3.25 according to the U.S. Bureau of Labor Statistics. Currently, the price of bread is $2.00 per loaf and the price of a gallon of milk is $4.00 meaning there have been “big time” increases of  46% and 23%, respectively, in the price of these staples in just 3 years. On the other hand, the median household income in the United States has only grown around 9% since 2020 suggesting that wage increases have not kept up with consumer price inflation. That’s a “big deal” and this mounting credit card debt and higher interest rates will make it very difficult for most consumers to dig out the debt hole that has been created. Applying the first “big rule” of getting out of the hole is to stop digging, many consumers will cut up their credit cards and pursue more frugal lifestyles.

This is the Year We Go Public

In 2023, there were the fewest number of IPOs in recent history with only 153 companies going public compared to 181 in 2022 and 1,035 in 2021. Some of the biggest IPOs for 2023 were AI chipmaker Arm Holdings PLC [NASDAQ: ARM], which IPO’d on September 14 at a $54.5 billion valuation. The next biggest was Kenvue [NYSE: KVUE], Johnson & Johnson’s spinoff of its consumer healthcare division (Band-Aid, Tylenol, etc.) which IPO’d on May 4, at a valuation of $41 billion. In third place was the popular shoe brand, Birkenstock [NYSE: BIRK], IPO’d on October 11, at a valuation of $7.5 billion.

Looking ahead, 2024 is shaping up to be a “big year” for the IPO market.  Topping the list of “next big thing” is Stripe, an Irish e-commerce company valued at $50 billion as the most valuable privately held “technology” concern in the world. Batting second is AI company, Databricks, planning to go public with at a $43 billion valuation. Next in line is the popular social media service, Reddit, planning to go public with at a $15 billion monetization of its more than 50 million daily users.

Buzz due to a recent report from Bloomberg has also ensued around a possible public offering for Elon Musk’s Starlink which provides satellite internet to users around the world. The service has brought high-speed internet to people in even the most remote areas of the country to connect electronically with the rest of the world. Musk released a statement in November saying that Starlink had achieved break-even cash flow but denied reports that the company would be spun out separately from Space X and go public in 2024. Space X, including the Starlink satellite business, is truly the “next big thing.”  Space X’s 2023 market share of global satellite launches is estimated at 80% and it has an estimated valuation of $150 billion. While Musk seems to have already “hit the moon” with SpaceX, some are wondering what he will do next and if a Starlink IPO will be the next chain in his legacy.

Bitcoin Spot ETF Approval

Speaking of “big launches”, Reuters reported that up to seven applicants for a spot Bitcoin exchange-traded fund (ETF) only have a few days to finalize their filings to meet a looming deadline set by the United States Securities and Exchange Commission (SEC).  The SEC has set a deadline for spot Bitcoin ETF applicants to file final S-1 amendments by Dec. 29, 2023. The SEC reportedly told applicants in meetings that it will only approve “cash only” redemptions of ETF shares and will disallow in-kind redemption of ETF shares.  Further, the SEC also reportedly wants Bitcoin ETF filers to name the authorized participants (AP) in their filings.  APs are effectively market makers and risk takers in the creation and redemption of ETF shares.  APs acquire the underlying bitcoin that backs the ETF shares created and, likewise, sell the underlying bitcoin for ETF share redemptions. Any issuer that doesn’t meet the Dec. 29 deadline will not be part of a first wave of potential spot Bitcoin ETF approvals in early January.

The SEC approval of one or more bitcoin spot ETFs is expected to markedly increase institutional and retail investor demand for bitcoin as well as accelerate the bitcoin adoption curve. Bitcoin experts predict this will result in much higher prices for Bitcoin over time.

Bitcoin is currently trading at $42k and has been by far the leading asset class for 2023 with a 154% year-to-date return.

Our New Year’s Resolution

As we sing Auld Lang Syne into the New Year, we at Servant Financial remain committed to maintaining broadly diversified global investment portfolios tailored for each client’s risk tolerance and station in life. Further, we will make it our New Year’s Resolution to stay on top of the “next big thing” that could either adversely or positively impact the achievement of your long-term investment goals and objectives.  That “big thing” could be inflation or deflationary concerns that suggest positioning towards greater real asset exposures or lightening up. Alternatively, it could be sensible, yet unconventional portfolio allocations to more volatile asset classes, like bitcoin and gold miners, as anti-fragility plays on the bankrupt fiat money system. Hopefully, the end of 2023 will bring you great joy and satisfaction in some of your biggest life accomplishments for the year and the turn of the year brings you thoughts of resolutions that have you aiming higher or asking yourself what’s “ the next big thing” in your life.  May prosperity, good health, and well-being be your constant companion in the New Year.

Speeding Towards the E.R. – Economic Recession

Somebody Call 911, the U.S. Economy is Sick.

Ambulance sirens blare, doctors prepare, and the patient is on their way to the E.R. with little time to spare. The patient is the U.S. economy which is on its way into the E.R. – Economic Recession that is! Anxiously waiting for the wellness diagnosis are U.S. consumers, Wall Street investors, and analysts around the globe. A recession is defined as a “significant, extensive, and lingering period of economic downturn.” Some may argue that since COVID-19 we have been experiencing these symptoms as inflation persists and equity markets tumble. But who diagnoses a recession or determines economic well-being? The r-word has been tossed around over the past few years by Wall Street experts, media pundits, and struggling consumers but the entity that gets the final say is the National Bureau for Economic Research (NBER). Unlike the relatively timely results from your personal physician, NBER’s diagnosis can be painstakingly slow. It took 366 days for NBER to announce its recession conclusion after the 2008 financial crisis. That’s like sitting in your doctor’s office knowing you are seriously ill with common flu symptoms, yet the doctor will not accept the obvious diagnosis and prescribe anything until they rule out every other ailment first.

So, what’s the hold-up? Why does it take so long for NBER to call a recession? Much like doctors, several tests and conclusions must be drawn by NBER before a formal recession decision is made. NBER states “It waits until sufficient data are available to avoid the need for major revisions to the business cycle chronology.” Their goal is to not sound an alarm that could cause consumers and investors to make premature decisions before all the data is analyzed. In other words, NBER does not want to be the proximate cause of a recession.  The effects of a recession diagnosis can radiate through the economy and impact government policy decisions.   Accordingly, NBER takes its time to confirm a recession has occurred well after that conclusion has been universally accepted. Not only do they take their time calling a recession, but they also wait to confirm the economy has healed and an economic recovery has taken hold. It can also take more than a year for NBER to make the call of a recovery. See below.

Source: Newsweek

The symptoms of a recession can vary and are unique in each case. Many define a recession as two consecutive quarters of falling real Gross Domestic Product (“GDP”); however, NBER evaluates a variety of metrics before making the call. NBER analyzes data about labor markets, consumer spending, business spending, industrial production, and overall income. They take a more holistic approach to analyzing the economic situation rather than using a practical rule of thumb or threshold to trigger a recession diagnosis. So, let us look at the current vital signs of the U.S. economy.

Vital Sign #1: Gross Domestic Product

The U.S. economy’s GDP is a key benchmark of economic performance. GDP measures the value of the final goods and services produced in the U.S.  As an economic vital sign, typically a recession diagnosis is given when the economy’s GDP experiences two consecutive quarters of negative GDP growth. The economy experienced this already during the first half of 2022.  There was considerable debate in many circles about a recessionary call at that time given the one-time distortive impacts of COVID-19 preventive measures.  Consensus GDP projections for 2023  were for growth of around 2.5% in the first quarter. The Commerce Department announced on April 27th that GDP growth slowed to a 1.1% annual rate as consumers retrenched due to high inflation and rising interest rates.  Reported first quarter 2023 GDP marked a slowdown from inflation- and seasonally adjusted 2.6% growth in the fourth quarter of 2022 and 2.2% average annual growth in the 10 years before the pandemic. This rapid slowing in the U.S. economic pulse sets the stage for a potential recession in the second half of 2023 if this vital sign continues to deteriorate.

Vital Signs #2, #3, and #4: Inflation, Federal Reserve’s Monetary Policy, and Bank Instability

While persistent inflation is not necessarily a sign of recession it can be the first domino to fall in a series of economic drivers. Inflation has been causing the United States economic discomfort for the past year and its peak of over 9% was like a sharp pain in the gut of the U.S. economy. Chronic inflation caused the surgeons at the Federal Reserve and U.S Treasury to grab their scalpel and open up the patient to take a closer look. In last month’s article entitled Jeromeggedon and Calamity Janet, we highlighted the banking and economic trauma caused by the sheer force of the Fed’s aggressive rate hiking campaign and the potential damage to the banking system, a lifeblood to the U.S. economy. This aggressive monetary policy has caused the yield curve to invert which is a telltale sign that the patient isn’t well, and it is a reliable signal of an oncoming recession. Typically, banks profit on the spread between longer-term assets and the interest paid on short-term liabilities such as bank deposits.  However, if the yield curve is inverted, bank profitability is problematic. As a result, banks may have to lessen their lending activities which can reduce economic growth. Moreover, today banks can deposit their excess reserves at the Federal Reserve and safely earn 5% on the Federal Funds Rate. This further depresses bank lending.

The inverted yield has already caused a few banks to collapse that anticipated inflation to be “transitory” after comments made by Fed Chairman, Jerome Powell in 2021. However, inflation persisted causing the Federal Reserve to aggressively hike interest rates.   This caused long-duration securities to fall in value, taking Silicon Valley Bank down with it. Concerns surrounding bank stability have arisen and depositors have already started to reduce their bank deposits below the FDIC’s $250,000 insurance limit. The fallout from the banking crisis has economists and the Federal Reserve cautioning that a recession is probable later this year. Not everyone agrees about the potential unhealthy condition of the banking system as the Vice Chair for Supervision, Michael Barr, said the banking sector “is sound and resilient.” While there are multiple opinions about the diagnosis and prognosis of the US economy, the banking sector should at least be considered an acute care patient and continue to be closely monitored.

Vital Signs #5 and #6: Consumer Spending and Unemployment Levels

“It’s a recession when your neighbor loses his job; it’s a depression when you lose your own.” – Harry Truman. But what would President Truman have to say about an economy that is experiencing some of the lowest unemployment levels ever, but the central bank is signaling a recession beginning later this year? Consumer spending has not appeared to be slowing much even as recession fears among economists persist. Retail spending jumped 3% from December 2022 to January 2023.  Yet the consumer appears to be leveraging future income to meet consumption as consumer debt levels have reached historic peaks.  And while its growth has tapered a bit in recent months, household debt is projected to reach the highest value in history with the personal savings rate also declining after hitting its pandemic high at almost 35%. Credit card debt is at an all-time high with U.S. household credit card debt reaching $986 billion in 2022, a 15% increase from 2021. While some see this metric as a strength of consumer sentiment, others believe that Americans are having to put more and more on credit cards to keep up with rising prices and wages that have stagnated.

 

Source: SP Global

Some people may look at consumer spending and wonder when consumers will start to crumble and begin reducing their consumption and spending. However, the continued strong economic outlook for the job market has some wondering if a change in consumer behavior will even happen. Historically, recessions are characterized by weak job markets and subsequently reduced consumer spending. However, this is not the type of labor environment we are experiencing right now. With an unemployment level hovering just above 3% and consumer sentiment scores still strong, American workers remain confident in their job security and ability to maintain income and spending levels. Consumers who are confident about their job prospects and income level will likely continue to spend and finance purchases on credit cards.

The strong job market has been an important vital sign for consumers however it has been to the detriment of many employers. “Help Wanted” signs continue to be posted in a variety of businesses from retail to finance and technology. Companies are having a hard time filling open positions and coupled with continued supply chain lags, their production has slowed. This fact has many economists intently focused on government and private market reporting on employment statistics, watching closely for early symptoms of illness in the job market.

The Prognosis and Prescription

So, what’s the overall prognosis for the U.S. economy? Will the old adage “an apple a day keeps the recession away” hold true in the upcoming year? Both the Federal Reserve and economists have signaled the economy is likely to enter a recession within the next 12 months.  Many economists, like physicians often do, put a little sugarcoating on their messaging using terms like “mild” or “treatable”  The most up-to-date leading economic indicators from The Conference Board point to a 99% likelihood of a recession over the next year with the root causes stemming from the Federal Reserve’s interest rate hikes and tightening of financial conditions within the banking sector. The Federal Reserve has predicted a mild recession to begin later this year with a recovery happening over the next two years.

Investors have been watching recession vitals closely and some argue that recessionary fears are already priced into the market. We believe this market is at historically high relative valuation levels and is priced for an economic soft-landing or shallow recession rather than the median historical recession.  The S&P 500 for example has continued an upward trend since January even as recessionary fears grew.  This U.S. large cap valuation index has moved higher mostly on the back of a handful of large technology names.  Further, while earnings expectations for 2023 have come in, they are only showing a mild earning contraction over 2022 which would be a highly favorable outcome for the typical recessionary period.

Given this prognosis, we lowered risk elements across Servant client portfolios by lightening up allocations to a) equities and b) inflation hedges earlier in April.  Proceeds were deployed into short-term treasuries and high-quality corporate bonds.  Note we were conservatively positioned across investor risk profiles prior to these tactical moves.  These trades further increased our equity underweight.

We trimmed allocations to Distillate U.S. Fundamental Stability & Value ETF (DSTL) by a third and deployed proceeds into iShares iBonds December 2024 Term Treasury ETF (IBTE).  We also swapped allocations to iShares 0-5 Year TIPS Bond ETF (STIP) for Invesco BulletShares 2026 Corporate Bond ETF (BSCQ).  The STIP inflation hedge has played its important portfolio buffering role well as inflation moved from “transitory” to “chronic” in Dr. Powell’s medical charts.

The motivation for the equity trimming is purely a function of stock market valuations rising into a deteriorating economic backdrop, creating an even more unfavorable risk/return set up.   We continue to believe that crucial pillars to the economy and markets are trending in the wrong direction and opportunities for a smooth transition out of elevated inflation are running out of time. Issues in the banking system may also cause further economic disruptions at the same time the elongated negative real wage growth cycle for consumers will ultimately force real spending to slow.

In short, the stock market is priced for mild or “transitory” case of economic recession in line with Fed speak while we are discounting the downside case that the economy is speeding towards the E.R. with potentially more acute or “chronic” conditions.

Jeromeggedon and Calamity Janet

“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 8th, 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 12th, the New York Department of Financial Services regulators announced the 3rd 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 2nd 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 22nd 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 8th to March 15th, $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.

 

 

Twelve Themes of Christmas

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

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.

Almighty Dollar

Current Status of US Dollar

What do George Washington, Abraham Lincoln, and Benjamin Franklin have in common? These three American icons found on the $1, $5, and $100 bills have been getting much stronger the past several months. The U.S. dollar is undergoing one of the longest periods of almost steady appreciation in several decades impacting domestic and foreign economies alike. The ICE U.S. Dollar Index, the most widely adopted currency index, measures the international value of the US dollar against other major fiat currencies with a weighting of Euro (58%), Japanese Yen (14%), British Pound (12%), Canadian Dollar (9%), Swedish Krona (4%), and Swiss Franc (4%). The buck’s value is currently up 22% since the start of 2022 with little end in sight.

Source: Wall Street Journal

The rise in the dollar’s value is unsurprising as record inflation in the United States has prompted the Federal Reserve to aggressively raise interest rates over the past several months. Just last week, the U.S. central bank decided on another .75 percentage point increase, the third consecutive rate hike. This pushed the implied Fed funds curve higher, with terminal Fed funds now expected to peak at 4.6% and remain above 4.0% through the end of next year. The yield curve inverted further with the 2-year versus 10-year treasury spread at 50 basis points (0.5%).  These changes in the risk-free U.S. treasury rates are driving the cost of capital higher for all risk assets and significantly impacting equity and currency markets. While the stock market has experienced significant losses, the dollar has been benefiting from increased capital flows due to rising treasury yields. The U.S. 10-year treasury note is at a multi-year high, yielding over 3.5%. Rising U.S. interest rates have foreign investors flocking to higher-yielding U.S. treasuries and pulling capital out of lower yielding, perhaps riskier currencies, bond and equity investments in other countries. This trend is particularly visible in energy dependent jurisdictions like the European Union, China and Japan.

Impact of the US Dollar on the Global Economy

Efforts to combat inflation through interest rate hikes have been counteracted by the strengthening dollar, fueling cheaper imports for the American people. However, the rest of the world has felt the brunt of this change. The economies being hit hardest by the punch of the U.S. dollar, are some of the U.S. largest trading partners: China, Japan, and Europe.

On September 26th, the British pound hit its lowest value ever against the U.S. dollar, sending U.K. bond yields soaring. Emerging economies have also declined in value relative to the dollar with currencies in Egypt, Hungary, and South Africa falling by 18%, 20%, and 9% respectively.

Not only are rising U.S. interest rates impacting these economies, but geopolitical concerns between Ukraine and Russia have Europe in an economic war of its own with Russia. Combined with surging inflation and the aftershocks of the COVID-19 pandemic, the war between Russia and Ukraine has Europe in an energy crisis, only furthering their currencies’ devaluation. Energy prices have skyrocketed while supply dwindles as Europe, particularly Germany, was very heavily dependent on natural gas imports from Russia for its global manufacturing base and winter heating. As European countries are forced to look to the U.S. and other markets for alternative oil and gas imports, the devalued Euro currency is only deepening the economic damage as most imports are traded in U.S. dollars.

Domestic companies with international operations are also being squeezed by the strong dollar. McDonald’s reported global revenue fell 3% this past summer while Microsoft stated that the changes in foreign currency values cut their revenues by close to 1% in the last quarter. According to a report by CBS news , companies comprising the S&P 500 receive 40% of their revenues from foreign countries. This has only added fuel to the downward spiral of the stock market as earnings expectations are lowered due to foreign currency translation losses and inevitable demand destruction. Domestic and foreign companies alike are pointing at the U.S. monetary policy as the root cause of the dramatic economic slowdown globally.

Investment Opportunities

In every market scenario there are winners and losers, and the current strength of the U.S. dollar is no different. While the U.S. stock market has entered a bear market with 20% declines across most major stock indices, treasuries and corporate bond yields have been on the rise in recent months as outstanding bond prices have declined in response to Fed interest rate hikes. Moody’s reports Aaa corporate bonds are currently yielding 4.65% which is up from 2.60% just a year ago while Baa bonds are currently yielding 5.78% on average, up from 3.26% a year ago.

Source: Bloomberg

The looming energy crisis in Europe has some adventuresome investors looking to clean energy options to capitalize on potential long-term secular growth. Even though the energy crisis is worse in Europe, the U.S. has still experienced stubbornly high oil, gas, and electricity prices over the past few years, contributing to the high inflation rate. Last month, we told you about the iShares Global Clean Energy ETF (ticker: ICLN) and the First Trust NASDAQ Clean Edge Green Energy Index Fund (ticker: QCLN) with assets under management of $5.5 billion and $2.4 billion, respectively. Each ETF has demonstrated strong 10 year returns and the government has deepened its commitment to clean energy through the Inflation Reduction Act, meaning this strong performance is likely to persist in the future.

One way to make a contrarian play on the strength of the U.S. dollar waning, or mean reverting over time, would be to invest in a basket of emerging market currencies which for the most part are energy and resource rich.  We explored these alternatives on Research Affiliates Asset Allocation Interactive website seeking a fixed income alternative that is expected to pay a real yield (nominal yield less expected U.S. inflation of 4.0%) and an attractive Sharpe ratio (return per unit of risk).  Perhaps the best alternative was Emerging Market Cash asset class.  As of August 31, 2022, Research Affiliates expects EM Cash to generate a real return of 2.4% (real return in excess of U.S. dollar cash of 4.6%, ie. real loss of (2.2%) holding U.S. dollar) with volatility of 7.2%. This compares to a real return of (0.4%) with volatility of 3.8% for U.S. Treasury intermediate bonds.  Of note, Research Affiliates’ risk and return metrics for the EM Cash asset class were derived using a variety of information, including using the J.P. Morgan ELMI+ index as a representative example.  Servant Financial portfolio models generally include an allocation to the J.P. Morgan EM Local Currency Bond ETF (EMLC).  EMLC yields over 7% and is comprised of mostly investment grade (72%) sovereign debt obligations in local currencies.  The top 4 currencies represent 38% of its holdings – Indonesian Rupiah (10%), Chinese Renminbi (10%), Brazilian Real (9%), and Mexican Peso (9%).

As you might expect, the price of EMLC has been declining in line with the U.S. dollar strength this year.  We rebalanced the model portfolio last week and at much earlier juncture in 2022 where EMLC was among the list of buys both times.  Rebalancing is a prudent investment practice whereby investors buy more of their losing positions and sell winners to get back to overall targeted asset class allocations. Research Affiliates recommends modest allocations to EM Cash of 2% to 4% in conservative to aggressive risk models.

Conclusion

2022 is turning out to be one for the financial record books as inflation, geopolitical pressures, and the bear market has George Washington, Abraham Lincoln, and Benjamin Franklin being stretched in every direction in our wallets. Global recession concerns are rising as the Federal Reserve’s high conviction battle with inflation is affecting consumers and markets all over the world. As participants in a global economy, we need to remember the words of the man found on the $5 bill. “The money power preys on the nation in times of peace and conspires against it in times of adversity. It is more despotic than monarchy, more insolent than autocracy, more selfish than bureaucracy. It denounces, as public enemies, all who question its methods or throw light upon its crimes.” -Abraham Lincoln.

The ubiquitous strength of the almighty dollar and resultant market mayhem suggest the Jerome Powell led Federal Reserve is currently playing the role of Lincoln’s “money power.”  The Fed is wielding economist Adam Smith’s “invisible hand” with brass knuckles as it tries to break the back of inflation.  The potential collateral damage of the Fed’s heavy-handed approach include the domestic and global economies, the credibility of the Fed, and the almighty dollar’s dominance as the sole global reserve currency.

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