As we were finishing this letter, news broke of the renewed conflict in Israel started by a Hamas terrorist attack. There may be strategic and tactical impacts on our portfolios and investment decisions, but it’s too early to tell what they may be. Our thoughts and prayers are with the people suffering there.
On the investment and markets front, 2023 has been anything but boring. With the exception of all things AI, markets have overall gone aggressively nowhere. As of today, the Dow Industrial average has turned negative on the year, Oil and Oil stocks have diverged in price, gold is slightly down-to-flat, and the long-awaited/predicted recession is still lurking. The NASDAQ and Crypto have been the highlights of 2023 with the caveat that the majority of the YTD returns of ~ 30% have been the 6-7 Mega Cap technology stocks. And then there are interest rates which are at 18 to 20-year highs across the yield curve and 30-year mortgage rates approaching 8%. Commercial property owners and home buyers are a long way from the very comfortable, and historically low, 3% 15- and 30-year rates just 2 years ago.
As for the most-anticipated recession in history, we are still waiting. Will we have, or are we in the middle of, a soft landing, a hard landing, no recession, the recession which has already occurred, or recession in 2024? Honestly, we don't know. We do know the Federal Reserve is always looking for an excuse to lower rates and lower them quickly to meet its dual mandate of full employment and low inflation. Inflation appears to be coming down while employment has remained stubbornly high, but the biggest issue for the Fed (though apparently not for any of the major candidates for President) is that Federal Debt has ballooned with stimulus and regular program spending while the cost of servicing this debt has increase dramatically. Per the CBO and the Peterson Institute:
The Congressional Budget Office (CBO) just released updated budget and economic projections, which highlighted the nation’s unsustainable fiscal outlook. One of the most significant findings from that report is that the federal government’s borrowing costs have increased rapidly over the past year and will grow through the next decade. Most notably:
• Interest payments on the national debt were $475 billion in fiscal year 2022 — the highest dollar amount ever.
• Interest costs grew 35 percent last year and are projected to grow by another 35 percent in 2023.
• Relative to the size of the economy, interest costs in 2030 will reach 3.3 percent of gross domestic product (GDP), exceeding the previous post-World War II high of 3.2 percent of GDP, which was recorded in 1991.
• Within 10 years, net interest costs will exceed federal spending on crucial programs like Medicaid and defense.
• Spending for net interest will become the largest “program” in the federal budget within the next 30 years, outpacing spending on Medicare and Social Security.
Rising interest payments can crowd out other priorities in the federal budget and lead to a cycle of higher deficits, growing debt, and even more interest payments in the future.
What conditions might give the Federal Reserve "cover" to lower rates? Look for: a recession in an election year, a government shutdown, a prolonged autoworkers strike, a banking crisis, and now a 1970s spike in oil prices and inflation from the renewed conflict in the Middle East. All of these scenarios are very possible at this point. In light of these obvious challenges, markets have sold off. This is consistent with history as markets typically drop in the September / October time frame. Importantly,
Interest Rates. Short term rates have screamed higher and now the “bond vigilantes” are coming to the fore demanding higher returns for buying ever-increasing issuances of Treasury Bonds most of which will now go toward paying the interest on the Federal Debt. And still there are stimulus monies being being paid out from the COVID era packages (anyone heard the ERC commercials?) and the so-called “Inflation Reduction Act.”
Inflation. Inflation seems to have abated and is trending back to 3%, but that is still much higher than the 2% target of the Federal Reserve. Concern about inflation is worsened by moves in oil and housing prices, neither of which can be solved with the Fed raising short term interest rates.
Oil. Before the renewed conflict in Israel/Gaza, the global oil market was short 3 million barrels of oil a day. OPEC+ seems to have the United States right where they want us because we refuse to drill; oil demand is increasing, OPEC+ are cutting production to increase prices, while Russia sells its oil at depressed prices to our major economic competitors China and India. We expect this situation to worsen as the Gaza conflict renews the Oil States weaponization of energy supply.
Housing. Housing demand in the US is greatly outstripping supply despite mortgage rates approaching 8%. We already had a shortage of single family and multi-family homes, and then the Federal Reserve rapidly increased short term rates raising the cost of labor and construction. Worse, long bond rates are now catching up to short rates. The majority of US households have 30 year mortgages at sub 4% rates. Few homeowners want to sell a good house at 4% and move to another, more expensive house at an 8% mortgage. In this way, the lack of supply of housing stock is made worse, and so it goes.
On the positive side, we have what our favorite macro strategist calls “The Exponential Age.” We are in the early stages of the intersection of AI, quantum computing, fusion and fission energy, and access to space courtesy of SpaceX. The combination of these technologies, tempered we hope with humanocentric boundaries, could revolutionize the EV transition, medical treatments, material sciences and knowledge of and access to our larger universe. There are many reasons for hope...but for humanity’s propensity to self-destruct.
To sum up, we have high rates, slowing inflation, lack of housing supply, higher and potentially much higher oil prices, all in the initial outworking of the Exponential Age. Where do we go from here?
We believe the stock market is in a process of bottoming in the near term. Rates in the bond market are peaking, inflation is at bay and oil prices will likely spike higher. Once the Fed has found its cover to lower rates, they will likely in 2024. From an investment perspective,
• We continue to take advantage of short term bond yields by buying Treasuries to hold to maturity.
• We are averaging into the technology sector to take advantage the Exponential Age.
• We are patient in real estate looking for distressed or at least lower priced opportunities 6-12 months in the future.
• And we are leaning on our constellation of private equity, venture capital and private credit allocations to provide long term cash flow and growth.
As always, we appreciate the trust our advisory and co-investment clients place in us by investing alongside us in public and private opportunities. We will continue to do our best to navigate these turbulent markets and unsettling geopolitical seas to guard and enhance your family capital. Please do not hesitate to call, text or email us!
Warmest regards, Jeff & Biff
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