By: The Century Management Portfolio Management Team
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What should investors consider during periods of high inflation?
The stock market, as measured by indices like the S&P 500 and FT Wilshire 5000, has been very resilient from the bottom of the Great Financial Crisis of 2008/2009. We believe the primary drivers of this performance have been low interest rates, low inflation, and cheap energy. Given the increase in interest rates, inflation, and the higher cost of energy, we believe it is unlikely that these broader stock market indices, which have roughly 24% invested in the technology sector and just 5% invested in the energy sector, will repeat the same level of performance in the foreseeable future. (Note: the last time petroleum inventories were this low, energy outperformed tech by 115% over the subsequent five years!)
While no two periods are the same, we believe a lot can be drawn from what worked in the 1970’s, when the US had even higher inflation than we have today. It was during this high inflationary period that we started Century Management (circa 1974) and successfully managed client portfolios, especially relative to the major market indices. Importantly, we learned a lot about what types of investments did better than others, and those lessons of the past help to form our thinking today.
During periods of higher inflation coupled with a potentially declining US dollar, we believe hard assets such as commodities (i.e., oil and gold through stock in operating companies or trusts that hold the physical commodity, not the futures contracts), certain real estate, stocks of companies with pricing power, and very short-term, high-quality government and corporate bonds (generally with maturities of 3 years or less), are the asset classes that have done the best in similar environments. Thus, we’ve positioned a meaningful part of client portfolios in these areas.
At the same time, we believe that there are many technological innovations on the horizon that have the potential to be as great as anything this country has ever seen. For this reason, we invested a sizable portion of client portfolios in these types of companies.
We increased our cash position and it currently sits slightly above our 20% long-term average. With the increase in interest rates, we are actively managing larger portions of this cash in short-term US Treasury Bills where yields are currently in the ~4% range. We believe this cash management strategy allows us to lower the risk in our portfolios while we research and patiently wait for new investment opportunities to present themselves.
The Federal Reserve, Debt-Financed Recoveries, High Inflation, Risks, and Opportunities
The majority of economic discussion in recent years has centered around the Federal Reserve’s (the “Fed”) response to higher inflation, geopolitical concerns, technology, and energy. The Fed’s course of action will determine whether we have a deep recession, a shallow recession, or no recession at all. More recently, problems in the banking sector emerged to the forefront as management mistakes in risk oversight and lax federal and state regulatory enforcement led to the failure of Silicon Valley Bank and Signature Bank.
We believe decades of policy errors brought us to this point. Yet regulators and policy makers continue to double down on the same old playbook. Historically, the formula for fighting inflation started with the Fed increasing the federal funds rate sufficiently to quash demand, slowing the economy, and thereby reducing inflation. It often comes at the cost of a recession that leads to large fiscal and monetary stimulus to restart the economy.
While fiscal and monetary stimulus strategies have often been viewed as “successful” when recovering from prior recessions, we believe this time is different, as inflation is at a 40-year high, and we have the highest debt-to-GDP ratio in our country’s history! As a result, the cumulative impact of debt-financed recoveries has had the adverse effect of higher inflation and puts our country’s future as the global financial leader at risk. At the same time, we believe deglobalization will keep inflation elevated, while growing geopolitical threats are coalescing to challenge US leadership and the world order.
The bottom line is that debt-financed recoveries cannot last forever. Eventually, there will be a day of reckoning. And while difficult to predict, a reckoning appears closer every day and we see little evidence that any serious course correction is taking place.
Overseas, the war in Ukraine is strengthening the Chinese-Russian alliance. In addition, China recently brokered a deal between historical enemies Saudi Arabia and Iran, while Russia brokered a deal between Saudi Arabia and Syria. These alliances could have significant global economic implications going forward and certainly must be monitored closely.
With regard to China, they have been quite outspoken in their desire to replace America as the world leader, as well as replace the existing world order with its own China-centric vision. While military conflict is not certain or imminent, at the annual meeting of China’s National People’s Congress and in four additional speeches, President Xi has said he is preparing for war. Whether it’s an increase in their defense budget (which has doubled over the past 10 years), plans to make China less dependent on foreign grain imports, or implementing new military readiness laws, something changed in Beijing that policymakers and business leaders worldwide should not ignore.
We believe that the elevated level of US Government debt, along with significant inflation, currently makes the US somewhat vulnerable from an economic and geopolitical perspective, and US adversaries may think they can exploit that. War, whether a physical engagement or a cold war that increases military spending, is highly inflationary.
Just how much is the US federal government debt and its interest expense?
- The United States has $31 trillion in US federal government debt.
- The weighted-average maturity of the US federal government debt is just 6 years.
- As debt matures and is reissued at higher interest rates, it will consume more of the federal budget, crowding out other discretionary spending such as Social Security and Medicare.
- In 2022, the US federal government revenues were $5.03 trillion, while spending was $6.5 trillion, creating a $1.47 trillion federal deficit financed by additional debt.
- The current gross interest on debt is $650 billion, with an average interest rate of 2%. If the debt level stays the same and the average interest rate increases to 4%, the gross interest cost would double to $1.3 trillion, which is 25% of our current US federal government revenues.
- This ignores the fact that, on average, the US federal government debt increases about 8% annually. As a result, we believe the US is quickly headed toward a debt-doom-loop, which is a cycle where rising interest costs create bigger federal government deficits, requiring more debt issuance, resulting in larger interest expense. This would likely force the US to print more money to pay for the higher interest expense, thus creating even larger federal government deficits.
- Should this increased debt and interest expense occur, it would be highly inflationary.
Additionally, the current US energy policy discourages production of fossil fuels in the US. When combined with more demand coming from a post-COVID reopening in China, letting the Organization of the Petroleum Exporting Countries plus Russia (i.e., OPEC+) largely control the swing production of oil, while we deplete our Strategic Petroleum Reserves (i.e., now down to 1983 levels), you create the potential for significant increases in the price of oil and natural gas. Since oil and natural gas is used in over 6,000 products, this would also add to the inflationary pressures we are already dealing with today.
Most countries have problems unique to them. It is important to highlight that the US retains significant and durable advantages over most other countries. US technology leadership, for example, has long been a source of economic growth and productivity improvement.
As the expansion of artificial intelligence, genomics, robotics, digital manufacturing, and quantum computing takes hold, we see great potential for profound innovation and tremendous investment opportunities. This increased productivity will help offset some of the inflationary pressures we have today. For example, quantum computers can perform calculations that are 158 million times faster than today’s fastest computers. As these quantum computers move from labs to production, nearly every industry is likely to be positively impacted with greater efficiencies.
The United States has overcome many significant challenges throughout history. While today’s environment is no-less challenging, and we are likely to see continued volatility in the market for some period of time, the US possesses significant and durable attributes that give us confidence that it will overcome the challenges ahead. It is for this reason that we continue to invest in America.
Disclosures: Century Management ("CM") is an investment adviser registered with the US Securities and Exchange Commission. Registration does not imply a certain level of skill or training. CM is also registered as a Portfolio Manager in the Province of Ontario. More information about CM’s investment advisory services can be found in its Form ADV Part 2A and/or Form CRS, which is available upon request. Past performance is not indicative of future results. CM reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that the investment recommendations or decisions we make in the future will be profitable. The discussions, outlook and viewpoints featured are not intended to be investment advice and do not consider specific client investment objectives. Not every client's account will have the exact same characteristics. All investments involve risk and unless otherwise stated, are not guaranteed. Principal loss is possible. Forward-looking statements are not guaranteed. CM-2023-04-10