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Tag: inflation

Little Ditty About Gold

Written by John Heneghan

In the investment world, it is often said, “It is better to fail conventionally than to succeed unconventionally.” Investors’ attitudes have been shaped over the last four decades to believe that the best portfolio strategy is to simply invest in a traditional benchmark 60/40 stock-bond portfolio.  The Wall Street mantra to buy “stocks for the long run,” balanced with an allocation to government and corporate bonds for their stability and safety of income reigns in investment advisory circles.  As we noted in last October’s “Got Gold?”, modern investment portfolios have generally been constructed with gold absent from the asset allocation, despite gold’s long history of portfolio diversification benefits and as a hedge against inflation and geopolitical risks. For example, around 71% of U.S. advisors have less than 1% exposure to gold.  And only 2% of U.S. advisors had between 5% and 10% of gold exposure in portfolios, with none having an exposure exceeding 10%, according to Bank of America Global Research.

Luminary investor Peter Lynch, portfolio manager of the highly successful Fidelity Magellan Fund and writer of “One Up On Wall Street: How To Use What You Already Know To Make Money In The Market” takes a decidedly balanced approach to investing.  He often condensed his commonsense approach to “Never invest in anything you can’t illustrate with a crayon.”  He further advised that if you cannot summarize your investment thesis in a concise two-minute elevator speech (or convey your thesis through a short song or ditty), then you should simply move on.

Crayon Illustration

Our fanciful, fictional “crayon illustration” this month begins by time traveling back to the 1980s to a tune about “Two American kids growin’ up in the heartland.”  A rural upbringing with its Tastee-Freez pop culture instilled in our young lovers a great appreciation for scarce assets like gold, farmland, and true love.  In fact, the singer-songwriter in our tale was a co-founder of the Farm Aid concert fundraiser in Champaign, Illinois in 1985 along with Willie Nelson.  Of course, we’re talking about John Cougar Mellencamp and his little ditty about Jack and Diane.  Let’s imagine that our young Jack and Diane developed an unconventional investment plan back in 1982 after their “little ditty” got some AM/FM radio airtime.

These “two American kids growing up the heartland” just “doin’ the best they can” did some napkin illustrations while eating their $1.50 chili dogs.  Today, a gourmet chili dog costs $5.19 at Portillo’s, or 3.5 times the price of a chili dog in 1982.  Jack and Diane took a portion of the royalties from their certified gold single (1 million in unit sales) and decided to invest it in a scarce asset with stable, enduring value across time and cultures.

“Jackie sits back, collects his thoughts for the moment.  Scratches his head and does his best {Peter Lynch}.    “Well then, there Diane, we oughta {just buy some gold.} “Diane says, Baby, you ain’t missin’ a thing.”

Jack has been thinking about his awesome good fortune of a number one single and so they buy a single gold bar at the average price of gold in 1982 of $447 an ounce for a total investment of $179,000.  Our hopelessly romantic young lovers bury that gold bar behind their favorite “shady tree” on the generational family farm for safekeeping.

Today, that gold bar birthed from true love and a solid gold single about rural life in America is now worth a cool One Million Dollars! Gold’s spot price just surpassed $2,500 per troy ounce on August 16th, an all-time high. With gold bars typically weighing in at about 400 ounces, that makes Jack and Diane’s gold bar worth around $1 million, or 5.6 times its cost.

Source: Trading Economics

Got Gold Reflections

In our October 2023 gold report, we cited commentary from former Credit Suisse economist Zoltan Pozsar that appears to be quite prescient with the benefit of 10 months of hindsight:

Commenting further on the commodities allocation Pozsar echoed the words of Ray Dalio on “gold, inflation and growth”:

“Within that commodities basket, I think gold is going to have a very special meaning, simply because gold is coming back on the margin as a reserve asset and as a settlement medium for interstate capital flows. I think cash and commodities is a very good mix. I think you can also put, very prominently, some commodity-based equities into that portfolio and also some defensive stocks. Both of these will be value stocks, which are going to benefit from this environment. This is because growth stocks have owned the last decade and value stocks are going to own this decade. I think that’s a pretty healthy mix, but I would be very careful about broad equity exposure, and I would be very careful of growth stocks.”

Year-to-date through the week ended August 16th, gold has indeed been shining with total returns of 19.4%, leading all major asset classes except Bitcoin. It’s been a safe haven’s dream, outperforming many traditional stock indices.  VanEck Gold Miners ETF (GDX) and iShares Silver Trust (SLV) have also been showing some luster while playing some catch-up to gold over recent years with total returns of 27.7% and 23.8%, respectively, over the same period.

Bitcoin (digital gold) continues to be this decade’s top hit with total returns of 40.7% year-to-date. If gold is the old reliable of the 1980s, Bitcoin’s been the wild, unpredictable teenager of this era.

The midstream energy asset class nosed out U.S. large caps (S&P 500) with a total return of 17.6% compared to 17.5% for the S&P 500 over this period.  The Magnificent Seven technology stocks, particularly Nvidia, have been responsible for a substantial majority of the S&P 500 year-to-date gains, with Nvidia alone skyrocketing by 162.2%.

With the Federal Reserve expected to embark on a rate-cutting cycle at its next meeting in September, ongoing wars in Ukraine and the Middle East, and Presidential candidates floating inflationary policy trial balloons like price controls (“inflation’s absolute best friend for life”), hiking and lowering of corporate income tax rates, tariffs on imports, taxing of unrealized capital gains, forgiveness of student loan debt, and free healthcare for all, Pozsar’s statement on inflation from that Got Gold? The article is also looking like a 24-karat prediction:

“Two percent inflation and going back to the old world, I don’t think it stands a snowball’s chance in hell. Low inflation is over and we’re not going back.”

Forward Positioning

With continued U.S. dollar purchasing power erosion due to inflation, gold continues to serve as a store of value, outperforming bonds over the past five decades as illustrated by our protagonists Jack and Diane. Gold has returned 7.9% annualized over the past 50 years, outperforming U.S. intermediate-term bond returns of 7.0%.  Gold has also been one of the top-performing assets since the peak of the Tech Bubble in March 2000 with an annualized return of 9.2%, outperforming U.S. large-cap stocks’ total return of 7.8%.

Exhibiting low correlations with major asset classes and a positive correlation with inflation, gold can serve as a strategic portfolio diversifier. Demand from U.S. investors is starting to increase, while strong demand from central banks and geopolitical and financial risks have helped drive gold to all-time highs in 2024. While there are risks, current fiscal policies, geopolitical tensions, central bank dynamics, and expected easing in monetary policy could bode well for gold returns in the coming years.

Potential risks to gold include higher real interest rates and the emergence of Bitcoin as a potential mainstream alternative. Since 2016, Bitcoin has outperformed gold, although gold has outperformed very recently.  The growing interest in Bitcoin among investors, particularly younger generations, may be cannibalizing gold demand. Servant Financial advocates a blended approach that includes physical gold, Bitcoin/digital assets, and gold miners as we seek to hedge portfolios for the inevitable erosion of purchasing power resulting from inflationary monetary policy.

Record gold prices and signs of cost stabilization have led to notable margin improvements for gold miners. Gold miner production has reaccelerated, with large miners seeing improvements in cash flow as capex has leveled out since the start of the year. Stock performance of the miners has also been improving, with gold stocks outperforming U.S. large-cap stocks in 2024. Given record gold prices, we see the potential for further production improvements at attractive margins. Servant Financial plans to maintain existing client portfolio exposures to gold miners but intends to trim positions if the current balanced sentiment on gold miners moves toward excessive bullishness.

Let’s close this golden ditty about Jack and Diane with a karaoke sing-along, “Oh, let it rock, let it roll.  Hold some gold to save your souls. Holding on to sixteen as long as you can. Changes come around real soon, make us women and men.”

Inflation Conundrum: How to Protect Your Portfolio

Written by John Heneghan

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

The Next Big Thing

Written by Ailie Carlene Elmore , John Heneghan

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.

Got Questions?

Written by Michael Zhao , John Heneghan

In the December 2022 newsletter, we featured “12 Investment Themes of Christmas” where we presented important forward-looking finance considerations for the approaching new year. We discussed economic themes surrounding interest rate trends, inflation, recession predictions, consumer spending, cryptocurrencies, and farmland among other topics. We thought a review of 2023 in the form of queries would be a good springboard for our themes for 2024 – a few questions before the quest for answers if you will.

 1. Are Fed Hikes Finished?

In a bold move to address decades-high inflation, the Federal Reserve added 1% to its benchmark federal funds rate by way of four 0.25% hikes, bringing its target rate to a new range of 5.25% to 5.5%.  However, the Fed has held its target rate steady since its last hike in July. These four increases follow a series of seven interest rate hikes in 2022 with the target rate ending 2022 at 4.25% to 4.5% up from 0.0% to 0.25% in March 2022.

The Fed appears to be done and will await the lagged effect of its aggressive hiking campaign.  It is commonly believed that monetary policy works with “long and variable lags” (Milton Friedman dictum) of up to 18 months after a rate increase.  Fed Chair Powell has made it clear that the Fed will retain rates at current high levels for an indeterminate period. Powell also left open the possibility of more rate hikes after the Fed’s mid-November meeting. The Fed will render its next interest rate decision in mid-December with the bond market expecting the Fed to remain on hold at this meeting.

The Fed’s commitment to addressing the challenges posed by inflation has been digested by the bond market with the market consensus of a first-rate cut pushed out until June 2024.  This is consistent with the Fed Reserve Board’s most recent dot plot for a median Fed Funds Rate of 5.1% for 2024.  But can we be certain that Fed hikes are finished?

2. Has Inflation Been Tamed?

The Fed’s aggressive interest rate hikes appear to be having a positive impact. Recent data reveals a notable drop in the inflation rate with the October 2023 headline Consumer Price Index (CPI) showing a 3.3% drop year over year. The headline CPI for 2023 currently sits at 3.2% with core CPI (less volatile food and energy) at 4.0%. This marks a significant improvement compared to the 6.5% headline inflation rate in 2022 but remains well above the Fed’s 2% inflation target. The slowing inflationary trend is great news for consumers and businesses. Lower inflation rates mean that the prices of goods and services are increasing at a slower pace, allowing consumers to make their hard-earned money go further.

While there are still challenges in the housing market with rising costs and slowing sales, the overall outlook suggests an optimistic shift toward lower inflation and eventually more affordable housing costs.  If the Fed has achieved its goal of a soft economic landing with CPI heading towards its 2% inflation target, then homebuyers can expect lower mortgage payments as the Fed interest rate cuts begin.  The Fed Reserve Board’s most recent dot plot for median headline PCE inflation (Personal Consumption Expenditures Price Index, the Fed’s preferred inflation measure) was forecasted at 2.5% and Core PCE of 2.6% for 2024.  But can we reasonably expect that inflation has been tamed by the Fed absent some sort of economic fallout?

3. Is A Recession Inevitable? 

Despite earlier concerns about a possible 2023 recession, the economic landscape has shown incredible signs of resilience and improvement despite the Fed’s rapid hiking campaign. Economic indicators such as unemployment rates and GDP growth are fundamental measures of a country’s economic health. The unemployment rate, which stood at 3.7% in 2022, has increased only slightly to 3.9% in 2023. This trend of modest softening of employment is consistent with the Fed Reserve board’s most recent dot plot for a median unemployment rate of 4.1% for 2024.  Fortunately, the GDP growth rate on the other hand has surged from 2.1% annual run rate to 4.9% in the third quarter of 2023. This strong GDP growth suggests an economy more resilient than Fed expectations with increased job opportunities and improved consumer spending.

The Fed Reserve Board’s most recent dot plot calls for median 2023 GDP growth of 2.1% and GDP growth slowing to 1.5% for 2024.

Amazingly, the Fed dot plots for interest rate policy, inflation, employment, and GDP growth are all telling a synchronous tale of a Goldilocks economy – warm enough with steady economic growth to prevent a recession; however, growth is not so hot as to cause inflationary pressures and force additional Fed rate hikes.  Is it possible the Fed porridge gets too cold, and a recession is inevitable or too hot and the Fed has to institute further rate hikes to cool its stew?

4. Is the U.S. Dollar Set To Rise?

The US Dollar Index has held relatively steady since the end of 2022 and currently sits at 104.20. Despite a small dip to 100 in July, the dollar continues to reflect the strength, resilience, and reliability of the U.S. economy. The U.S. economy’s resilient performance, coupled with the US Dollar Index holding its ground, underscores the Dollar’s status as a safe-haven asset. This is particularly notable in the global context where other major economies like China, Japan, UK and Europe are grappling with more pressing economic challenges such as recessionary conditions (China, Europe) and persistent inflation (Japan, UK).  When a formerly synchronous global economy moves into economic and geopolitical disharmony, does the world’s reserve currency rise in value.

Source: MarketWatch

5. Will Consumers Keep Spending?

According to the latest data, consumer spending growth has risen 4.9% in 2023 following a 9% increase in 2022. This is likely attributed to rising wages and the largesse of COVID-era government spending programs. As these government programs are phased out, particularly the moratorium on student loan debt repayments, more and more people are taking on unnecessary debts and overspending, especially with very high interest rate credit cards. People are making luxury purchases, spending money on traveling, purchasing new cars and clothes, etc. In September of 2023, the total amount of U.S. credit card debt broke $1 trillion for the first time in history. This immense growth in consumer debt raises alarms about financial stability on both individual and systemic levels. More and more consumers will potentially face immense financial strain if the employment picture softens considerably or if illness impacts a household breadwinner. With Black Friday and Cyber Monday here, we’re about to see firsthand whether consumers will keep spending.

6. Perpetual Labor Shortages?

The labor shortage challenges identified last year persist into the current economic landscape. Industries across the board are struggling to find enough skilled workers to meet their business demands. This mismatch between demand and supply can stall economic growth, decrease productivity, and delay production and services. The worker shortage persists in all industries except for goods manufacturing, retail, construction, and transportation. There are currently 9.6 million job openings in the U.S. with only 6.1 million unemployed persons. Even if every unemployed person were to become employed, there would still be an insufficient workforce to meet the demands of employers. This is especially true for the financial services industry where only 42% of the existing job vacancies would be filled if all experienced and qualified professionals (in finance) joined the workforce. The shortage remains a critical problem for many industries and finding an effective solution is proving to be extremely challenging. Have we entered an era of perpetual labor shortages? If so, what does the mean for the inflation picture?

7. Is the Russian-Ukrainian War Really Ending?

The two-year old conflict between Russia and Ukraine, currently deemed a stalemate, has prompted the U.S. and its allies to signal the necessity of negotiating a peace deal. The prolonged nature of the conflict has decimated Ukraine’s national resources, particularly its military personnel, with reports indicating a disastrous shortage of soldiers. The U.S. Department of Defense’s (DOD) recent announcement on November 3, 2023, reveals an increased commitment to supporting Ukraine with equipment, but who will operate them? The DOD is supplying Ukraine with additional military vehicles and gear, $125 million for immediate battlefield needs, and $300 million through the Ukraine Security Assistance Initiative (USAI) to enhance Ukraine’s air defenses. This brings the total U.S. financial support for Ukraine to a staggering $44.8 billion which highlights a sustained and costly effort to support Ukraine’s defense against Russian aggression.

Sadly, new evidence is emerging that a peace deal was achievable at the beginning of the war. At a recent meeting with the African delegation, Putin showed the draft of an outline of a preliminary agreement signed by the Ukrainian delegation at Istanbul in April 2022. The peace deal provided for Russia to pull back to pre-war lines if Ukraine would agree not to join NATO (but Ukraine could receive security guarantees from the West).

Recently, there have been notable shifts in the pricing of key natural resources, such as softening in oil, gas, and agricultural commodities. This signals a potential easing of tensions and the removal of the market risk premium as the end of the war may be in sight.  But if the same foolhardy political leadership prevails that rejected the potential peace deal in the early stages of Russia’s “police action” in Ukraine, how can we be fully confident the Russia-Ukraine war is really ending?

8. Will Energy Disinflation Continue?

Surprisingly, natural gas prices for home utilities have decreased by 20.8% since 2022. Gasoline prices at the pump have also declined with the average price per gallon dropping to $3.41 from $3.95 in December 2022. Gas prices are primarily dropping due to lower demand from drivers (less overall driving) and cheaper blends of gas (lower production costs mean lower costs at the pump).  In the context of the U.S. economy, declining gas prices may signal a period of lower economic activity or a slowdown. Gas prices are expected to drop even more throughout the winter and into 2024 ahead of the summer driving season. This disinflationary pulse in consumer energy prices signifies ongoing adjustments in the supply-demand equilibrium and could have broader implications for consumers’ standards of living.  A key question for consumers in 2024 is will this energy disinflationary trend continue and offset inflation pressures on household budgets elsewhere.

9. Are Bitcoin and Other Blockchain-based Businesses Institutionally Investable?

On November 2, 2023, FTX founder Sam Bankman-Fried, once a billionaire and a prominent figure in the worlds of crypto and politics, was convicted of one of the largest financial frauds in history. A Manhattan federal court jury found him guilty on all seven counts affirming that he had stolen $8 billion from users of his now-bankrupt cryptocurrency exchange. This verdict comes almost a year after FTX filed for bankruptcy which wiped out Bankman-Fried’s $26 billion net worth. This conviction is a substantial win for the U.S. Justice Department with Bankman-Fried facing a potential maximum sentence of 110 years.

With the start of the FTX case, the price of all cryptocurrencies experienced a significant downturn due to shaken confidence in the crypto market and its many charismatic, entrepreneurial founders. However, proven, transparent blockchain-based business models are starting to rebound with Bitcoin emerging as a top-performing asset class for 2023.   Year-to-date through November 17, 2023, bitcoin had gained 67% compared to gains of 26% for midstream energy (Alerian MLP Index), the second-best asset class, and 19% for the S&P 500, third-best asset class.

U.S. regulators at the Securities and Exchange Commission (SEC) have awoken from their slumber and are now taking a more proactive regulatory stance.  After seemingly being asleep at the wheel, the SEC has been taking highly visible actions against bad actors like Sam Bankman-Fried and the CEO and founder of Binance, Changpeng Zhao. Zhao has recently stepped down from Binance after pleading guilty to violating U.S. anti-money-laundering legislation. He faces a $50 million fine and a potential prison term. In addition, Binance has agreed to pay a $4.3 billion settlement. Bankman-Fried and Zhao’s cases are part of a broader crackdown on crypto-related financial crimes and display the increased regulatory enforcement actions in the digital asset industry.

Proactive regulation and legislative clarity are welcomed by many of the leading crypto players like Coinbase, the largest U.S. cryptocurrency exchange platform, and Grayscale Investments, the world’s largest crypto asset manage based on assets under management and the sponsor of Grayscale Bitcoin Trust (GBTC).  The expectation of increased legislative and regulatory clarity from Congress, the SEC, and the Commodities Futures Trading Commission (CFTC) in the near future has encouraged several brand-name, highly credible institutions, like BlackRock and Fidelity, to step into the digital asset space.  The CFTC has determined that bitcoin is a commodity and the SEC and IRS have not publicly challenged that determination. We believe that legislative and regulatory actions in 2024 may emphatically answer the question, “Are bitcoin and other blockchain-base businesses institutionally investable?”

10. Will Student Loans Be Forgiven?

After the U.S. Supreme Court in June struck down his unilateral attempt to “forgive” at least $400 billion in student loans, President Biden has diligently sought  a work-around to this reprimand from the highest court in the land. In October 2023, roughly 3.6 million Americans received a nice Christmas present from President Biden with potentially $127 billion of their student loan debt being forgiven. President Biden announced the plan earlier this year which brought joy and relief for some students and criticism and scrutiny from many other students and taxpayers(some of whom had already paid off their student loan debts). By alleviating a substantial portion of student debt, the plan aims to ease the financial burden on millions of Americans, providing them with increased financial flexibility and potentially curry their favor in the 2024 Presidential election. Based on annual income, students may qualify for student loan relief of up to $20,000.

 

The move has sparked considerable debate, drawing attention to questions of fiscal responsibility and the long-term impact on the country’s financial health and inflation rates. This also begs the question of where the money for this forgiveness will come from as the US government already faces $33.7 trillion of debt. The current iteration of student loan forgiveness rests on the Biden Education Department’s claims it has the authority to expand income-driven repayment under the Higher Education Act.  This directive is subject to Congressional legislative oversight and/or Supreme Court challenge and begs the question, “Will Students Loans Be Forgiven?”

11. Will Farmland Continue To Be the Star Of the Show?

Farmland stole the mic the last few years as an emerging institutional asset class. Its low volatility and historical negative correlation with traditional assets and positive correlation with inflation had investors lining up to find their slice of farmland heaven. As a result of the increased interest, strong commodity prices, and global food demand, the value of farmland rose throughout the United States 15-25% in just a two-year period from 2020 to 2022. However, that growth had some wondering if it would continue through 2023. In August 2023 the USDA reported farmland valued appreciated 8.1% from 2022 to 2023 but we are starting to see some signs that transactions may slow in the new year. Growing input prices made planting commodities more expensive while commodity prices have declined from peaks in 2021 and 2022. While net farm income is projected to back off from a peak in 2022, it is still projected to remain modestly above the 20-year averages for net farm income and net cash farm income. Even if U.S. farmland leaves the podium as one of the top performing asset classes in 2024, it will always have a seat at the table because of U.S. agriculture’s vital role in making sure the 8.1 billion mouths across the world are fed.

12. How Should a Diversified Portfolio Change?

At Servant Financial, our role is to help you plot the course in these uncertain times. We understand that recent inflationary trends, costly patterns of increased geopolitical conflict, and increased economic and market volatility may cause investor unease.   The basic investment principle of portfolio diversification has more often than not proven its character in the past and we expect it will continue to do so in the future.  That’s why we are asking the questions now on behalf of our clients so we can continuously assess the risk-reward opportunity set now available.  Last month’s featured article, “Got Gold?” established our foundational thinking that the traditional 60/40 (equities and bonds) portfolio allocation will struggle in an era characterized by economic uncertainties, inflation, and geopolitical unrest.  Our task in the ensuing weeks and months is to live these foregoing twelve questions towards some range of likely outcomes and a capstone result that answers the question, “how should a diversified portfolio change?”

 

 

 

 

Got Gold?

Written by John Heneghan

Hedge fund investor and billionaire Ray Dalio of Bridgewater Associates once retorted “If you don’t own gold, you know neither history nor economics.” Gold interest began spiking again during the COVID-19 pandemic as investors flocked to real assets to hold their money in while equities were flopping. As the S&P 500, NASDAQ, and Dow Jones have started on a downward trend once again, gold has again been experiencing gains in value. Hopefully, most readers can answer yes when asked “Got Gold?”  Servant Financial clients can assuredly answer affirmatively as outlined at the close of this article.

Despite Dalio’s admonition, gold holders, or gold bugs as they are affectionally called, are in the minority of U.S. investors. The Gold IRA Guide conducted a survey in 2020 to reveal the opinions of Americans surrounding gold and silver ownership. 1,500 Americans were surveyed between the ages of 18 and 65+. The survey revealed that 89% answered “no” when asked “Got Gold?”  Only 10.8% of respondents owned either just gold (4.3%) or both gold and silver (6.5%). Some respondents just owned silver (5.1%), suggesting a combined 84% of Americans owned neither gold nor silver at that time.

An updated survey by Gold IRA Guide in May 2022 of 2,500 American households found that almost 4 out of 5 reported having done nothing with their investment portfolio or retirement accounts to hedge against generationally high inflation.  Consumer Price Inflation (CPI) was reported above 8% for all items in both March and April of 2022.  Frankly, I think this is a sad commentary on institutional money management because it is very likely that many of these survey respondents were working with trusted investment advisors.  Unfortunately, a large majority of money management firms have apparently not “studied history or economics.”  Lemming-like, many institutional money managers are beholden to the traditional 60/40 stock and bond regime that has worked so well for the last 3 decades since the start of the 1990s.

Ray Dalio has also stated that “There are two main drivers of asset class returns – inflation and growth.”  We know from history that growth has been the dominant driver since the 1990s aided by a secular decline in inflation and interest rates.  Unfortunately, over the next 30-plus years, our elected geniuses in Washington and their co-conspirators at the Federal Reserve mistook that secular trend for permanence and repeatedly doubled down on the mantra “deficits don’t matter.” While most American households cannot feasibly operate under a budget deficit, the U.S. government seems to think they can. Washington elites ignored “history and economics” by spending and printing without limitation.  It’s as if they were seeing the world through Morgan Wallen Whiskey Glasses:

Line ’em up, line ’em up, line ’em up, line ’em up

Knock ’em back, knock ’em back, knock ’em back, knock ’em back

Fill ’em up, fill ’em up, fill ’em up, fill ’em up

‘Cause (INFLATION) ain’t ever coming back.

However, it is now increasingly apparent that we are entering a secular period in history where inflation trumps growth as the primary driver of asset class returns.  Safe passage through this new secular inflationary period requires polishing up on the history of gold cycles.  The chart below from Octavio Costa at Crescat Capital provides a nice overview of gold’s price history since the 1970s.  It’s important to note on this timeline that in August 1971 President Nixon closed the “gold window” which prevented foreign governments from redeeming their dollars for gold.  Up until this point, gold had served as an important governor on U.S. spending and printing.

History shows that when gold was the primary monetary unit before the adoption of gold-backed fiat currencies, gold also served as a governor of war.  Would-be aggressors were limited in financing war against their neighbors by the amount of gold stored in their treasuries and the amount of gold booty or other resources they could recover from their conquests. The same goes for pirates and naval conquests.

For those readers interested in digging a little deeper into gold, we’ve found that the most comprehensive analysis of gold markets available is entitled “In Gold We Trust”, prepared annually by Incrementum.  Incrementum published their 417-page, 17th edition earlier in 2023 entitled Showdown | In Gold We Trust report 2023 (hyperlinked to YouTube summary presentation of the report).

Incrementum presciently entitled their May 2023 edition “Showdown.”  The report summarizes the four important Showdowns that they expected to play out over the next year or more:

  1. West Versus East Geopolitics
  2. Competing Currencies (BRIC+ Currency Bloc)
  3. Failing Monetary Policies
  4. Price of Gold (gold price advances have been tame relative to Incrementum’s cycle view)

Obviously, Incrementum was aware of the Russia-Ukraine “showdown” at the time of publication but likely could not have anticipated another violent “showdown” in the Middle East.  Sadly, the inhumanity of humanity intervened again in recorded history with another Middle Eastern war on the 50th anniversary of the Yom Kippur War of 1973 (also known as the Fourth Arab–Israeli War).  That war began on 6 October 1973, when an Arab coalition led by Egypt and Syria jointly launched a surprise attack against Israel on the Jewish holy day of Yom Kippur. Following the outbreak of hostilities, both the United States and the Soviet Union initiated massive resupply efforts for their allies (Israel and the Arab states respectively) during the war which led to a confrontation between the two nuclear-armed superpowers.

Source: Bloomberg, SpringTide

Incrementum included a thoughtful, far-reaching interview with former Credit Suisse economist Zoltan Pozsar.  Pozsar is a Hungarian-American economist known for his analysis of the global shadow banking system.  He published a widely read December 2022 analysis while at Credit Suisse entitled “War and Commodity Encumbrance”.

Pozsar has since started his own macroeconomic advisory firm specializing in funding and interest rate markets called Ex Uno Plures.  The firm’s name (“out of one, many” in Latin) is the antonym of E Pluribus Unum (“out of many, one”), the motto on the Great Seal of the United States and dollar bill.  The firm’s raison d’être and the main thesis of the War and Commodity Encumbrance whitepaper is that “for generations, investors have been operating in a unipolar macroeconomic environment, where the U.S. dollar reigned supreme globally and where E Pluribus Unum was the perfect motto to describe what became known as the global dollar cycle. However, the conflict between the U.S. and China is set to reshape the global monetary order centered around the U.S. dollar. De-dollarization, the re-monetization of gold, the invoicing of a growing number of commodities and goods in renminbi, and the proliferation of CBDCs (Central Bank Digital Currencies) will challenge the US dollar’s hegemony (“out of one, many”).”

Incrementum’s headline quote from the Pozsar interview reads, “Two percent inflation and going back to the old world, I don’t think it stands a snowball’s chance in hell. Low inflation is over and we’re not going back.”

Here are some of Pozsar’s specific recommendations from the interview for adapting to the New World Order as he sees it (emphasis added):

  • We are moving into a multipolar reserve-currency world where the dollar will be challenged by the renminbi and the euro for reserve currency status.
  • These currencies, especially the renminbi, would not necessarily be used as a reserve currency, but rather to settle trade. Gold could play an increased role here. (Pozsar notes that since 2016-17, the renminbi has been convertible to gold on the Shanghai and Hong Kong Gold Exchanges.)
  • The Chinese are using swap lines to settle international trade accounts. This is a fundamentally different approach from the dollar reserve framework and would mean that trade can occur in renminbi without nations needing to hold vast reserves of the currency.
  • The various crises that today’s financial market participants have witnessed were solved by throwing money at whatever problem arose. The current inflation problem is different.
  • This situation is also vastly different from the late 1970s when Paul Volcker curbed inflation by prolonged high-interest rates. Chronic underinvestment in the resource sector and labor issues will cause inflation to remain sticky.
  • The traditional 60/40 portfolio allocation will struggle in this environment. Pozsar recommends a 20/40/20/20 (cash, stocks, bonds, and commodities) allocation.

Commenting further on the commodities allocation Pozsar echoed the words of Dalio on “gold, inflation and growth”:

“Within that commodities basket, I think gold is going to have a very special meaning, simply because gold is coming back on the margin as a reserve asset and as a settlement medium for interstate capital flows. I think cash and commodities is a very good mix. I think you can also put, very prominently, some commodity-based equities into that portfolio and also some defensive stocks. Both of these will be value stocks, which are going to benefit from this environment. This is because growth stocks have owned the last decade and value stocks are going to own this decade. I think that’s a pretty healthy mix, but I would be very careful about broad equity exposure, and I would be very careful of growth stocks.”

Servant Financial client portfolios have long held, meaningful allocations to gold.  Below is a summary of gold allocations by client portfolio risk profile:

The chart below provides the performance of a Moderate Risk client portfolio after management fees against a traditional 60/40 global composite portfolio (without management fees) over the past twelve months ended October 20, 2023, and highlights the benefit of holding traditional gold and precious metals and digital gold over this time. (Past performance is not indicative of future performance.)

Moreover, bitcoin broke emphatically through the $34K level on October 24, 2023, and is up some $8,400, or 32%, in the past 30 days after the United States Court of Appeal issued a court mandate this week requiring Grayscale Investment’s application for a spot Bitcoin exchange-traded fund (ETF) to be reviewed by the Securities and Exchange Commission (SEC).  The mandated SEC review could potentially pave the way for the conversion of the Greyscale Bitcoin Trust (BTC) from a trust (trading a week ago at a 12% discount to the net asset value (NAV) of underlying bitcoin held) to a spot ETF trading much closer to NAV. Servant predicted this “Bitcoinalization” as we coined it back in July of this year.

The title of this month’s newsletter is a hat-tip to the highly successful “Got Milk?” ad campaign of the 1990s and early 2000s.  Trends in consumption and investment evolve, affected by the cyclical and episodic nature of humanity and a myriad of factors from health and ethical concerns to technological innovations and geopolitical events. Just as the dairy industry has faced challenges and adapted, the gold investment landscape is also undergoing a transformation and monetary renaissance. The intrinsic value of milk as a household staple of a well-balanced diet is akin to the enduring value that gold brings to a well-diversified investment portfolio.  Just as there have been resurgences in milk consumption through innovation and adaptation, the allure of gold, gold miners, and other scarce stores of monetary value remains. A “Got Gold?” mindset offers investors a timeless refuge, especially in an era characterized by economic uncertainties, inflation, and geopolitical unrest.

 

Blessing for Peace

May those who make riches from violence and war,

Hear in their dreams the cries of the lost.

Excerpt from the poem by John O’Donohue

 

Jeromeggedon and Calamity Janet

Written 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 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.

 

 

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