FWIW # 28 Investment Markets Update

Interesting times, to say the least. There are so many important moving parts influencing the investment markets, it’s hard to know where to begin. Let’s start internationally and then examine domestic factors.

The first major influence is the Ukraine War. The world seems to be placing this conflict in the same category as the various wars since WWII, in which the opposing parties waste substantial matériel and lives only to come to a stalemate that was obvious from the beginning. This is one possibility, but one that is unlikely. It is unlikely for two reasons:

1.Ukraine has (had) vast agricultural assets. Combining those assets with Russia’s agricultural abilities would give the Russian government substantial leverage over the global prices of several commodities to go along with its major influence in the oil and gas markets.

2.It is nearly impossible to find a historical situation in which economic sanctions have overturned the political leadership and military of a country being sanctioned. The reality is there are always businesses and other countries willing to ignore the sanctions. In the case of the Ukraine war sanctions, India and China are buying all the oil Russia will sell them at a discount.

It’s illogical to think Ukraine can beat the Russians in this war, even with the equipment assistance of the US and EU. It’s also illogical to think that once Russia gets the eastern provinces subdued, it won’t go after the southern and western parts of Ukraine. Some observers extrapolate from the initial fiasco, when poor Russian leadership and inexperienced conscripts were turned back by the Ukraine forces, to prove the Ukrainians can win. The Russian military leadership now, as well as the troops, are combat-experienced, elite soldiers who are slowly beating the Ukrainians.

All the money being spent on the arms and relief supplies the US is sending Ukraine is deficit spending off budget through debt, the same way the Iraq and Afghanistan wars were financed. The EU support is starting to slip. Italy’s government collapsed due to supporting Ukraine. Germany and France are wavering in their support. The longer the war goes on, the higher and more embedded inflation will be around the world, including in the US. War has always inflicted two changes on the world: both the winner and loser experience high, uncontrollable inflation, and as a conflict approaches a climax, there is no way of controlling or predicting what either combatant will do out of desperation. The Ukraine war dictates holding common stocks, keeping new fixed-income securities to short maturities, and building liquidity to protect against an inevitable sudden change in the war’s status.

The complexity of the investment markets has increased. You should understand the world is on an unhinged fiat governmental money system, meaning there is no fixed currency that can act like a “safe haven” for investors and speculators. In the past, if a developed country was experiencing an inflation rate of 8% to 9%, the value of the currency would be plummeting. In this unhinged monetary world, the US dollar is rising to levels not seen in two or more decades. Why? The principal reason is the flight of scared money from Europe. Add to that deluge the money around the world seeking a return on short-term securities invested in US treasuries at current yields, higher than they’ve been in years, and you can understand why the US financial markets are stable rather than drained by money fleeing our high inflationary currency. With the (1) inflationary prospects of the war, (2) capital flight from Europe, (3) combined stability of stocks (lower but stable), and (4) recent yields in the 3% zone, a strategy favoring owning stocks and staying short-term with debt securities is prudent.

Risk assets usually respond inversely to changes in currency value. A rising currency value, everything else being stable, would most likely point to a lower stock market since the value of the stocks is based on their value in their home currency. For instance, if a share of PFE is priced at $40, and there is no economic reason for that to change, and the value of the US dollar goes up, the stock price of PFE should decline so that it maintains parity with the price before the currency change. Since currency value is only one of a multitude of stock-price-influencing factors, the daily changes are minuscule. However, when a currency makes a major shift over several weeks or months, the adjustment is noticeable.

For the US dollar to have climbed to a 20-year high, the stock market should be under much greater price pressure than it is. If the dollar stays elevated relative to other currencies, either the stocks will be pricing in future expected inflationary increases in asset values, revenue, and net earnings, or they will be vulnerable to adjustment downward. No one can tell which factors will dominate stock prices in any given period; it’s just important to understand the various relationships appear to be out of kilter. The US dollar value and stability in stock prices are out of sync. If the dollar’s relative value in the currency markets declines, stock prices are likely to remain stable with an upward bias from currency adjustments. If the dollar value remains high or goes higher relative to other currencies, stock prices are vulnerable, particularly if inflation recedes in response to higher interest rates and a shrinking monetary base, since a certain amount of inflation expectation is built into the current market level. Inflation is real and not reversible. Corporate costs rise before revenues and profits reflect adjustments to offset inflation, so even though stocks are vulnerable to a decline, it’s better to hold positions.

Then we have the Federal Reserve. It’s difficult to discuss what has been going on with the Fed over the last four years because the logical conclusion must lead to the complete compromise of its independence and integrity by political leaders in Washington. It is beyond logic to believe the Fed and the Treasury Department made mistakes when they said inflation was transitory and kept interest rates too low. No one at the middle or senior level of these organizations lacks the education and experience to know the ramifications of their policies over the last four years. It’s clear their transitory announcements last year were designed to allow them to continue their inflationary policies until any change in policy direction would not impact the political leaders’ preferred social programs.

After apologizing for its “mistake,” the Fed has taken small steps to lessen the accommodative monetary policy under the guise of tightening. It is not tightening; it is moderating its accommodation. The most impact is coming from the abrupt slowdown in the growth of the monetary base. Inflation will decline from the 9% level, but only to the 4%–5% level for several years, a bout of inflation that will financially devastate the lower and middle classes in this country. In addition, Fed policies will eventually drive any remaining creditors away from high-quality fixed-income investments and into unregulated lending as the Fed continues keeping the real interest rate negative (nominal interest rates minus the inflation rate). Until the real rate of return is greater than the inflation rate (the embedded 4%–5%), investment markets will be distorted.

The longer the Fed pursues the policies it has in place, the deeper and more severe the eventual adjustments will be in the economy and investment markets. The Fed knows the interest rates must have a positive real rate of return to stymie inflation. If it doesn’t take steps to allow positive real rates, the economy will stagnate. As we have said many times, it is critical to own individual companies that you have confidence in, so when the inevitable selling pressure drives the prices lower, you will not panic. Even though there is a net negative real return on high-quality, short-term, fixed-income securities today, committing fixed-income capital for more than five years (there should be a series of maturities from one to five years) is a mistake. Either inflation will stay high for longer than expected, eroding the value of longer-term fixed-income assets, or the deep price adjustments in risk asset values will present opportunities you will want to seize.

The Republicans are jumping with glee at the pending midterm elections, assuming they will take control of both the House and the Senate. In their eyes, they can’t lose. They may be unpleasantly surprised. Their crowing about what they expect is keeping them from realizing they are deeply divided into two camps: establishment Republicans who have their fingerprints on the waste and corruption in Washington as much as the Democrats do, and Republicans led by a leader who is destined to crash in flames since he hurts Republicans he does not like rather than helping the American people escape from the overt takeover of our democracy by the socialist left. The legislative triumphs by the Democrats these past two weeks, in which they’ve cajoled 14 Republicans to vote for the semiconductor giveaway and the deal between Senators Joe Manchin and Chuck Schumer increasing taxes, huge climate spending, and health care initiatives, will influence major swing states in the election. Republicans need to give the American people alternatives to the socialist programs of the Democrats. They don’t. As with the infrastructure bill last year, Republicans enable the Democrats and have nothing to show the American public except talk. The Republican handling of the abortion issue has been incompetent. They should have emphasized that the Supreme Court ruling returned choice to the people. Republicans should be the champion of every state having a referendum like Kansas to let the people decide the state’s response to the ruling. It’s unlikely the Senate will remain 50–50. The likelihood is the Democrats will maintain and increase their majority in the Senate. That possibility will lead to more inflation and a tighter control of the Fed by the political sector, meaning less inflation fighting and more embedded inflation with a slowdown in the economy. Holding common stocks and real estate as inflation hedges will be important.

Always remember inflation does not disappear. The 9% increases in prices experienced over the last year through June will remain, even if the annual rate comes down to 4% a year for several years. The longer the debtor class controls the monetary authorities, the more difficult it will be to return the country to financial stability. Economic assets and liquidity are critical.