It’s Just the Cycle
Has the world gone crazy? It really seems that way to me each morning when I start reading about the overnight events around the world. There is so much change occurring that in many ways, I think we have become inured to the developments that we would have considered insane not too long ago.
In times like these, I turn to wise people from our past that were able to encapsulate the angst of society in a few lines. Bertrand Russell, the British philosopher, cogently reminds us that “all movements go too far”. The quote resonates with me because economic downturns are nature’s way of eliminating the excesses of the previous cycle yet central banks and governments won’t allow these necessary adjustments to occur. This may change in 2022.
The important takeaway is that it’s all part of a cycle and a cycle is nothing more than the oscillation of values around a central tendency. We can apply this framework to everything from social cohesion to political movements to demographics to stock prices and interest rates. The real trick is to see past the noise of society in order to focus on the central tendency of everything. If we can be 60% successful in these analyses, our clients will do extremely well.
It’s been a wild ride over the past three months but it’s largely been profitable for our clients. Our heavy focus on cyber security, defense, and food paid off in the first quarter.
From the chart below, you can see that the S&P500 lost 5% in the first quarter on a price basis while the Nasdaq composite lost 9%. It took a very sharp rally in both indexes in the final days of the quarter to keep first quarter losses at a manageable level. At their worst, the S&P500 and Nasdaq were down 10% and 20%, respectively.
I don’t have a lot of faith that the equity markets will post gains for the year because it appears to me that we’re going to face a combination of economic downturn, higher short term interest rates and inflation. We’ll talk more about all three later in this piece.
The next chart gives us an indication of an economic slowdown. It’s the S&P500 Bank Index and it usually does poorly when the market starts to discount a higher level of losses on loans in bank portfolios. These losses are consistent with economic downturns.
Bank stocks lost 8% for the quarter but were down 12% at their worst levels which they are rapidly approaching once again. I can’t see a scenario where banks thrive in the next couple of years. The combination of recession, higher inflation and excess debt is unlikely to prove positive for bank earnings.
As I’ve been writing about for the past year or so, the Federal Reserve really hasn’t had a big impact on domestic price inflation. Instead, their biggest impact has been on creating “asset price inflation” in the form of stocks, bonds, and housing among others.
You can see the relationship in the chart provided below. The blue line is the Fed’s balance sheet, roughly described as “money printing” even though it’s not exactly accurate. The red line is the value of the S&P500 stock index.
You’ll notice that between 2018 and 2020, the market rose even as the Fed’s balance sheet declined. This difference can be attributed to the Trump Tax Plan, which lowered corporate tax payments, allowing companies to buyback enough shares to push the markets higher. Otherwise, the relationship between stock prices and the Fed’s balance sheet holds all the way back to 2009.
Since the 1990’s, we’ve ceded much of the control of the financial system to the Federal Reserve Board. Much of the reason is centered on the above explanation where they have kept interest rate policy so incredibly loose that stocks have risen dramatically since 1990. They’ve been able to keep interest rates low because we’ve shifted much of our nation’s industrial operations to Asia and other low-cost regions which proved disinflationary for consumer prices. But now, the global supply chain has been broken by Covid and it can’t be fixed without a sharp drop in global consumption, led by the US. So the Fed has no choice but to engineer a slowdown in consumption, if they can.
Rising consumer prices have been driven by forces other than the Federal Reserve’s balance sheet. Below are the four reasons that I attribute to the rising prices, none of which can be directly blamed on the Fed’s policies.
- The price of oil and natural gas has spiked largely due to the Biden Administration’s
efforts to reduce carbon emissions combined with the war in Ukraine
- Supply Chain problems since Covid.
- Food inflation caused by the following reasons:
a. China’s massive flooding over the summers of 2020 and 2021
b. Scarcity of fertilizer, pushing up fertilizer prices
c. Russia/Ukraine War – together they account for 28% of global wheat exports
- US Covid relief measures – As best as I can piece together, the federal government
injected somewhere around $4.5 trillion into the economy through either direct
payments or forbearance on financial obligations.
Higher Energy Prices
The combination of the Biden Administration’s efforts to reduce carbon emissions in the US by reinstalling the US’s commitment to the Paris Accord and by Biden’s Executive Order called the Federal Sustainability Plan, the administration committed to reducing US carbon emissions by 65% by 2030. These actions were correctly read by oil and gas companies as a signal to reduce spending on exploration and production of oil and natural gas. In effect, the Biden Administration clearly stated that they wanted to replace fossil fuels with green technology. You can see this clearly if you visit the White House’s website at whitehouse.gov.
The chart below shows the price of West Texas Intermediate Crude and it has basically tripled in price since the last Presidential election. If the electorate is truly committed to reducing carbon emissions, this will be accepted by most as simply the cost of positive change.
We can see the impact of curtailed supply in the two charts below that show the amount of oil and gasoline supplied to the US market over the years. The decline in output is a sign that energy companies are responding to signals from Washington about what to expect in the future.
But this jump isn’t all on the Biden Administration. The move from $90 to over $100 is the result of the war in Ukraine. The rise in oil prices since the war started are comparatively low because Russian oil is still flowing to countries such as China, India, Germany, Italy, and the Netherlands among others.
Supply Chain Issues
This is pretty straight forward because the problems are ongoing. The Port of Long Beach has experienced a decline in ships waiting to off load from 101 to 41 in recent weeks but this is largely due to China closing ports such as Shanghai and Ningbo due to continuing problems with Covid. Once these ports re-open, the number of ships off the coast of California should spike once again.
The problems with the supply chain stems from two issues. The first is that the US stimulus checks put a lot of money in people’s pockets in a short time, throwing off the normal annual cycles of demand. The second issue is that China doesn’t have a vaccine that works with the result being that they continue to shut down cities and ports, impacting everything from production to transportation.
There are a number of things which combined to push up global food prices. For starters, China, which is the world’s largest importer of wheat, increased wheat imports by 16.6% to 9.77 million tons in 2021 thanks to heavy rains ruining harvests in 2020 and 2021. Given that China imports nearly 20% of global wheat, this growth rate is significant and largely responsible for the rise in wheat prices from late 2020 through 2021.
The war in Ukraine is responsible for the spike in 2022 as Russia and Ukraine export roughly 29% of the world’s wheat. Ukraine has 15 million tons of wheat ready to be shipped but the Russians have effectively blockaded shipping in the Black Sea.
US Covid Relief Measures
$4.5 trillion is a lot of money, especially when it was spread over roughly one year. When we consider that US Gross Domestic Product was measured to be $20.9 trillion in 2020, the stimulus equaled roughly 21.5% of GDP. That’s a lot of money to hit the economy at one time, particularly as the majority of it, roughly $3.6 trillion, involved payment to individuals, corporations, and state governments.
In a short period of time, many people were forced to work or attend classes from home and that required a lot of new computers. The effect was a sharp reduction in semiconductor chip inventories and a massive imbalance in the global supply chain that we’re still trying to fix.
Injecting money into the economy following Covid lockdowns was the right move but we went too far, ultimately causing more harm than good. In economic parlance, we passed the point of “diminishing marginal returns”. Further stimulus efforts by the government would likely drive inflation much higher than present levels.
Taken together, I don’t see how raising interest rates will fix any of the above issues but the Federal Reserve has little choice but to raise short term interest rates. The result will likely be lower stock prices and a recession because moderate Democrats appear to be against additional stimulus packages due to their effect on inflation.
We’re going to get a look at what our economy can produce without massive stimulus packages muddying the waters. Below is a chart of GDPNow, which is an estimate of GDP growth based on current indicators. The chart also shows where current indicators differ from estimates made by Blue Chip economists, basically the best mainstream economists.
After being strong in 2021, estimates of GDP growth for 2022 keep falling and now are just a hair above 0% growth. Keep in mind that these measures are showing warning signs before the Federal Reserve starts to reduce the size of its balance sheet.
Higher interest rates combined with higher prices for essentials such as food and energy will hurt consumption in 2022. Combine this with an absence of government stimulus and 2022 can be a trying year for us all.
It appears that we’re going to bring some industries back to the US. In particular, Intel is building a major semiconductor plant near Columbus, Ohio. Austin, Texas has also seen some increases in semiconductor production activity.
Until the past fifteen years, Intel was always cutting edge when it came to both designing and producing chips. Unfortunately, their model stopped working as companies learned to specialize in one or the other facet of the business. That said, I’m looking to Intel to restore its competitive advantages in producing chips. This would allow the US to reduce reliance on Taiwan, which is the dominant nation for producing cutting edge semiconductors. As we all know, mainland China has expressed a willingness to invade Taiwan if necessary to absorb the island nation into Greater China, much like they’ve done with Hong Kong and Macau.
It may take some time to bear fruit but I’m very enthusiastic about Intel the company and what this move means for restoring the US to the forefront of technological innovation. You can see from the chart below that ramping up chip production is neither quick nor easy.
I left Russia/Ukraine until the end of this piece because it represents something of a fork in the road for the US. One road takes the US to further dominance as Ukraine, as our proxy, is able to defeat Russia’s armies in the field, thereby weakening Vladimir Putin to the point where he abandons all hopes of restoring the Russian Empire. This road would allow Europe to exploit Russia’s vast resources for its own enrichment.
The second road is darker for the US. If Russia succeeds in keeping Eastern Ukraine, Putin will control the Black Sea and all of Ukraine’s access to exports of grain and other commodities. Furthermore, because the US took the unprecedented step to cut Russia off from our SWIFT banking network, which allows money to be moved anywhere in the world in support of trade, other countries will look to eliminate this networks monopolization of world trade. Effectively, this would end the US dollar’s status as sole reserve currency.
It’s clear that Russia is no longer a Superpower to rival the US but they are still a regional power to be reckoned with and can still cause enormous damage to the US if scenario two prevails. It’s not enough for the Ukrainians to stop Russia and draw new borders where Russian armies have succeeded. The Ukrainians need to push the Russians out of Mariupol at a minimum while concurrently securing their trade routes through Odessa. How this plays out is anyone’s guess but whatever happens will have far ranging consequences.
The GeoVest Approach
Mark Twain once wrote that “history doesn’t repeat itself but it often rhymes.” It’s another way to say that the world runs in cycles. The conditions may not match the past perfectly but “structurally”, things look pretty similar to other historical periods.
As much as I dislike the vitriol and poor manners that span the political spectrum, as a society, we’ve experienced this all before at turning points in the cycle. This is why it is so important to have a perspective that is both open-minded to real change yet grounded in the fundamentals that support successful investing.
The US economy is going to change dramatically over the next ten years. It may include electric cars and green technology or it may be a return to fossil fuels with a focus on cleaner burning technologies. The die has been cast but the future is still dependent on a few variables to fall into place. This is why we’re invested in assets that aren’t dependent on the vicissitudes of future conditions. They’re the right investments for today.
I continue to believe that our economy is structurally weaker than it appears today, thanks to the trillions of dollars in stimulus spending. This is why I believe the Federal Reserve will have to aggressively slash interest rates either later this year or early in 2023. At that time, we expect to be ready to shift into assets more appropriate for a changing US economy. Thank you and it’s our continued pleasure to serve you.
Philip M. Byrne, CFA
Chief Investment Officer