LEVATUS Investments | Unraveling the Inflation Conundrum
‘Ripple effects occur when an initial disturbance to a system propagates outward to unsettle an increasingly large portion of the system.’
The inflationary ripple effects from COVID are likely to be with us for years to come.
Susan Dahl | CEO LEVATUS
Photo by Fabio Santaniello Bruun
We are happy to share the below excerpt from our July 2023 letter to clients, ‘Unraveling the Inflation Conundrum’. The path of inflation and its amplitude will have important implications for both portfolio management and financial planning in the years ahead, it will also require a risk framework that looks somewhat different than the one that has worked over the past decade.
The Fundamental Question – Are you getting paid enough for the risks?
The amount of risk one undertakes to achieve a return is a central question in investing. Whether the potential return justifies the risk is where sound portfolio construction begins.
For LEVATUS client portfolios, overall asset allocation has remained relatively conservative since early 2022. We expect the push and pull of inflation, as well as innovation, high interest rates and tightening financial conditions to continue to keep markets in a wide trading range for the time being. Patience is likely ones most valuable asset in this environment. The incremental risk that a rapidly shifting economic backdrop causes cracks in the system, and a more significant market drawdown, makes the risk-reward of a 5% annual yield on US Treasuries quite favorable.
In absolute terms, high quality bonds with shorter-term maturities pay investors handsomely for the risk they undertake. Opportunities in the middle part of the yield curve are also becoming more attractive, as US Federal Reserve rate increases in the short-term part of the market begin to push up yields further out on. The same cannot be said for the corporate bond market, which we continue to avoid. In our view, investors are not being paid sufficiently for the risk of serious credit deterioration in the face of reduced liquidity and tougher refinancing terms.
In Growth accounts the secular trends we wrote about in our annual ‘Investment Growth and Where to Find It’ research piece remain areas of focus. Many of these themes have gained much attention as 2023 has progressed. While valuations in some parts of equity markets are expensive currently, we expect opportunities to emerge for patient investors. This will be especially true as the outlook on inflation gains clarity. As we have mentioned in previous conversations, the outlook for inflation is central to our fundamental investment analysis. In our view, the outsized vulnerabilities to markets (the ones that take us outside of normal economic cycles) are at their core connected to inflation.
Two Headed Dragon of Inflation
Debt Dynamics
Debt dynamics refers to the patterns and trends in the accumulation, sustainability, and repayment of debt over time. It examines the interplay between factors that influence a country’s ability to manage its debt burden. High interest rates, due to rising inflation, increase the interest cost of debt and is a serious negative consequence of debt accumulation.
Since the outset of the pandemic, there has been a tremendous accumulation of debt, both in the public and private sector, that is not sustainable. For the moment, resulting liquidity is keeping both the economy and markets aloft.
The timing of the unwinding of accompanying credit risk is hard to predict, but cracks in the system with the collapse Silicon Valley Bank are early warning signs.
High inflation, which will cause interest rates to remain elevated, is a particularly difficult problem when there is a lot of debt. As bonds mature and need to be replaced with new ones, interest costs spiral higher, eventually becoming unsustainable. This is one of the reasons we are focused on the movement of inflation as a key element of strategic investment decision making.
Risk of Stagflation
The combination of stagnant economic growth and high inflation creates a uniquely challenging economic environment. Traditional economic policies designed to address one issue, such as stimulating the economy, can worsen the other problem.
Inflation is a critical factor in terms of its impact on the range of potential market outcomes. Historically, a low growth-high inflation situation known as stagflation has often been the worst situation for markets, tending to cause much greater than normal equity market drawdowns.
Artificial Intelligence and its impact on technological innovation has the potential to both ease inflationary pressures and boost growth in the medium term. This is an exciting area of focus for us.
The Reality of Economic Scenarios and Stagflation
The reality is that most normal economic cycles are not that compelling. In general, the ebbs and flows of economic cycles are short lived, with businesses occasionally reducing investment and employment while consumers reduce expenditures until confidence returns. Even at the heart of a normal economic slowdown, businesses still sell things, governments pay interest on their bonds, the majority of people go to work and live their lives, and along the way innovation emerges to improve efficiency and output.
This is all true, until above trend inflation becomes embedded in the economy. In this case, higher prices diminish people’s purchasing power and standard of living even for those fortunate enough to have jobs. If this occurs at a time when the economy is experiencing abnormally slow growth, additional economic stress is unleashed. Historically this type of stress known as stagflation causes market corrections that are bigger than normal.
Available data in combination with this historic perspective, drives our view that inflation remains at the heart of accurately assessing potential outcomes. More precisely, inflation will drive our analysis as to the likely risk of stagflation during the remainder of this economic cycle. While inflation has cooled from the breakneck pace in 2022, the most recent data in August saw an energy driven turn upward.
Prospects for Inflation
Positive base effect is beginning to wane, which means that it will be more difficult to reduce year-on-year inflation going forward. (i.e., Current rate of inflation is relative to the 9% inflation high points of last year. This will be the easiest comparison.)
Sticky high prices remain an issue but will likely stay below inflation of 5% associated with stagflation.
Trade disruptions remain inflationary stemming from trade restrictions on items like semi-conductors imposed for national security reasons.
Wage pressures are forcing companies to raise prices to maintain margins, particularly in the services sector.
Technology has traditionally played a key role in keeping downward pressure on inflation by improving efficiency and swapping out higher input costs that should continue with the next chapter of innovation.
Next 3-6 months will tell us whether there is more to inflation than the residual effects of COVID and the outsized fiscal largesse of the U.S. Government facilitated in part by the accommodative policies of the Federal Reserve.
Prospects for Recession
Index of U.S. Leading Economic Indicators has been in decline for 14 consecutive months and is of such magnitude as to suggest a high probability of recession.
The 2-year U.S. Treasury bond yield and the 10-year Treasury bond yield have been inverted since March 2022 signaling a strong risk of recession by 2024 based on historical experience.
An abundance of job openings, gains in average hours worked and continued stable low unemployment diminish prospects for recession in the short term.
Personal consumption expenditures, which account for more than two-thirds of U.S. GDP, remain robust along with consumer sentiment that is at a 22-month high.
Macroeconomic Policy and Systemic Risks
A discussion of the complexity and confusion associated with financial markets and the economic backdrop where all this takes place would not be complete without mentioning the macroeconomic policy and systemic risks that could have a significant impact on future investment returns. While each of these risks are multi-faceted, this synopsis will be confined to what is currently foremost on investors’ minds.
When dealing with macroeconomic policy risks, most attention is squarely focused on when will the Federal Open Market Committee (FOMC) stop raising its policy interest rate. Taking Chair Jay Powell at his word, this cessation will come when the FOMC’s preferred measure of inflation returns to 2 percent. The primary danger here is that a further tightening of interest rates could throw the economy into recession, bringing with it all the usual economic and financial misery that have been associated with past recessions. The economy so far has held up well in the face of FOMC’s draconian tightening, but the economy could wobble and decline quickly as has happened in the past.
A sudden rise in unemployment or other negative event could push the FOMC to cut interest rates before inflation reaches the 2 percent target. As in the past, this action could reignite inflation and potentially push the economy into a period of stagflation. History has shown that the U.S. equity market has experienced some of its worst performance during stagflation. Given the other risks described in this note along with the current high valuation of the equity market as a whole, it would not be far-fetched to suggest the possibility of a major double-digit correction in equity prices.
Systemic risk by its nature is often hard to pinpoint. We have seen this once again this year with the sudden difficulties experienced in the banking system. The rapid rise in interest rates and unstable funding cast a light on poor risk management and regulatory shortcomings relating to smaller banks. From a broader perspective, this raises the question what could happen next when you have unfavorable debt dynamics with high interest rates that have not been seen in roughly two decades. Sudden changes in liquidity could expose weaknesses in the rapidly expanding private credit market. How this will crossover and translate in public fixed-income markets and equities is anyone’s guess given all the structural changes and reliance on algorithmic trading that has taken place since the global financial crisis.
Lasting Impact from Innovation
Innovation has the capacity to improve efficiency, productive capacity, and quality of life. In short, innovation can help an economy to grow faster without the commensurate risk of inflation. Innovation can also help to bring existing inflation down by easing labor shortages and wage pressures.
The recent wave of innovation centered around natural language machine learning and artificial intelligence is the most significant leap in innovation in decades. The application of this innovation will have a profound impact across many industries. While the early days of adoption are likely to create more disruption than efficiency, in the medium term this technology has the capacity to improve efficiency and reduce inflationary pressures on the scale of the industrial revolution.
The Long Waves of Innovation
Theory of innovation cycles developed by Joseph Schumpter
What This Means for Equity and Bond Markets
Starting Point Matters
Bonds and stocks find themselves at very different starting points. When considering the potential for future returns and the extent of likely downside risks the starting point matters. For each person, the degree to which it matters is impacted by factors such as - proximity to ‘needing the money’, and the likelihood of negative events that are beyond the scope of typical market occurrences.
EQUITIES
Current valuations are high in many parts of U.S. Equity markets.
High starting valuations limit upside unless growth remains robust.
Recession indicators are already rising.
Medium term opportunities across industries in those areas leveraging Artificial Intelligence for efficiency and output gains are interesting at the right price.
BONDS
Short-term interest rates are higher than they have been in 15 years, offering a good entry point.
High grade bonds like US Treasuries are more attractive than corporate debt, which does not currently pay investors enough to compensate for credit risks.
High interest rates on U.S. Treasuries create significant downside protection via the coupon, and attractive total return.
At 5% annual Yield to Maturity, US Treasury bonds offer an attractive entry point.
Bottom Line
One of the side effects of high inflation is that investors are finally able to achieve an excellent rate of return on low-risk assets like short term US Treasuries. This high rate of return allows investors to wait, watch and see how risk factors affect the global economy, corporate earnings, and government debt dynamics. This high rate of return on low-risk assets like short-term Treasuries gives flexibility and time. With equity valuations where they are, this is exceptional relative value.
With the liquidity that has defined the last decade slowly receding, we expect bouts of volatility to continue to arise as conditions shift. Within this we expect ‘quality’ to continue to be the most important factor driving returns, and that innovation will increasingly become a key driver of both growth and risk, with many traditional industries potentially left behind. Eventually we expect that technological innovation will drive productivity and quality of life higher together. That said, disruptive innovation is sure to create bumps along the way. A rigorous investment process that prioritizes visibility to long term objectives is at the center of our focus on quality.
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ABOUT THE AUTHOR
Susan Dahl is a seasoned executive, industry leader, and dedicated client advisor, with over thirty years of international and domestic financial experience. Susan is known for her ability to unravel complex questions, and has a steadfast commitment to well designed process. This background has translated directly into her work on investment process design for private wealth clients, as well the innovative LEVATUS approach to financial advisory services; a modern design that addresses quality of life in specific, direct and tangible ways. A deep and diverse background that extends from global investing to risk management to process development and planning, has laid the groundwork for an advisory solution that asks more of wealth. Susan shares some her most recent work in this TEDx , Can Happy Make You Money?
ABOUT THE AUTHOR
Keith Savard has more than 40 years of economic/finance research and investment experience in the United States and overseas. He has worked as a staff member at the Board of Governors of the Federal Reserve System and as an international economist at the U.S. Department of State. A solid background in macroeconomic analysis and financial regulatory and monetary policy issues, combined with sovereign and credit risk skills, has enabled Keith to offer investors actionable top-down investment strategies and expertise facilitating a broad-range of asset allocation decisions. His deep knowledge and understanding of emerging markets, gained through extensive travel and meetings with cabinet-level officials, company CEOs and local investors, affords opportunities to invest confidently beyond the U.S.
The information provided is for informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.
Views and opinions are subject to change at any time based on market and other conditions. Any projections, market outlooks, or estimates in this presentation are forward looking statements and are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Levatus LLC is a registered investment advisor. Levatus provides investment advisory and related services for clients nationally. Levatus will maintain all applicable registration and licenses.
