FWIW # 31 Hope Springs Eternal

The stock market ended November with an explosive rally in all sectors. The supposed catalyst for this bout of optimism was the signal given by Fed Chair Powell that the December interest rate increase would be less than 75 basis points. He indicates the increase will be 50 basis points, so look for a December rally if the number is 25. The thought behind the October and November rallies has been that the Fed will not increase interest rates as far as history indicates rates need to be raised to tame inflation. Stock losses for the year have been reduced. Most market participants experienced short-term happiness and relief until last week’s selloff. What are the implications?

First, if the Fed does not follow through with interest rate increases, inflation will likely become ingrained in the economy and psyche of the consumer, making it a systemic and very long-term problem for the middle and lower economic groups in this country, especially retirees and those who rely on government payments to maintain their independence. Look at the numbers. If goods or services cost $100 today, with the 2% inflation target of the Fed compounding for ten years, the same goods or services will cost $121.89. Looking back, since October 2021, the CPI has risen from 100 to 113.93 in thirteen months, so it is likely that the decade after October 2021 will experience much higher inflation overall than an average of 2% per annum. In a decade, the price of goods and services will increase to $134.39 if the Fed misses its target or, as some economists propose, changes the target to 3% annually. Always remember, inflation usual does not turn into deflation. Those with a fixed income or a salaried job will find themselves in difficult financial straits. While borrowers complain about paying a fair cost for the money they borrow, the higher rates will help the economy channel investments into projects that have the potential to pay for themselves rather than highly speculative ideas. Understand that any business idea or development worth doing can afford to pay the current and expected cost of credit. The rallies we have seen appear to disregard the second message from the Fed: rates will remain elevated for longer than the markets expect. This is evidence that the era of free money is over.

There is another aspect to monetary policy. Raising interest rates is only one component of the Fed’s strategy. The Fed is also taking steps to reduce its balance sheet. This is the true wild card of monetary policy. The Fed has raised the price of borrowing money (interest rates), and by reducing the balance sheet, it will reduce the amount of available money circulating in the economy. As the economy grows and less money is in circulation, those in need of borrowing will have to pay even more for money. This is how a truly free economy works, balancing the supply and demand of creditors and debtors. For the past twenty-five years, the Fed has tilted its policies toward the debtor. For a little while, the relationship will be more or less equal. No one knows how far the Fed will go in reducing its balance sheet, not even Fed officials. The explosion of money and credit in the economy was so huge between 2008 and 2022 that there is no precedent to serve as a guide. This is complicated by two factors: first, five of the newest members of the Fed Board have been appointed or elevated by the current administration. Second, the appointment of Austan Goolsbee, a former advisor to President Obama, as president of the Chicago Fed will strengthen the hands of the easy money (suppressed interest rates) faction at the Fed. From the minutes of the most recent meeting, it appears that a growing number of Fed governors want the Fed’s interest rate hikes to slow or stop. This action by the more liberal board members who are friends of Wall Street is to be expected. Why?

The Federal Government is the biggest borrower in the country. Over the past two and a half decades, Wall Street has amassed immense wealth by catering to borrowers. Allowing interest rates to rise to a market-determined level will cost the government and its Wall Street friends additional money. Allowing inflation to continue at an elevated rate benefits the Federal Government and Wall Street clients by depreciating the value of the dollar, allowing debt to be paid off with depreciated dollars. It is not in borrowers’ best interests to reduce inflation in a hurry. As an excuse for not restoring the dollar’s stability, there will be much fear talk about a recession or other dire circumstances arising from the raising of interest rates and reducing the Fed’s balance sheet. Always keep in mind that inflation negatively impacts the two lower economic groups, not the upper economic group, which can offset inflation.

Why am I telling you this again? Because it appears that the monetary authorities have capitulated to debtors. The implications for you are large. Remember our mantra not to sell stocks? You can now understand it better. There are too many unknown variables that will affect the stock market for anyone to predict its future direction. A portion of the decline that took place earlier in the year has been erased. I have no idea what the markets will do in the future, but I do know that there is a strong likelihood that inflation will not be brought under control within the next two years. As I stated in my book, 19 RULES FOR GETTING RICH AND STAYING THAT WAY, holding ownership in quality companies across the ten macroeconomic sectors (excluding the real estate sector) for at least ten years will help you offset inflation through a combination of dividend income and potential capital appreciation. Since investing in companies at a fair price is critical, it’s important to remember that even markets that are overall overvalued have sectors and companies within those sectors that are at a fair valuation. Be alert. Take time to look at your stock watch list and what prices are fair for owning those stocks. There are enough potential black swans flying around in any given month or quarter for fear to be triggered, giving you an opportunity to make a good total return investment. Since the ten-year Treasury yield is above 3.1% and below 4%, the money for fixed-income assets can be invested in maturities of 5 to 12 years. The market environment is confusing, which makes for good investing. Just be disciplined.

The executive and legislative branches of the Federal Government are currently working against the Fed and its tightening monetary policy. During the lame-duck session of Congress before the end of the year, you can anticipate more of these contradictory cross-purposes. The Democratic control of the Senate will increase in the coming year, so expect the expansion of government programs to continue. If the forgiveness of student debt becomes a reality, and it is now up to the Supreme Court to decide, the ultimate cost, estimated to be between $400 billion and $1 trillion, will be unfunded by revenue and will add to the deficit spending, necessitating additional borrowing or the Fed creating additional money. Inflationary pressure is increased by either method. The ongoing financial support for Ukraine, whether in the form of material or cash, is all deficit spending, requiring inflationary actions to cover the expense. The end of Title 42 immigration policy will cause another unfunded expenditure in the billions. The net effect of anti-inflationary monetary policies and inflationary fiscal policies cannot be predicted, given these ongoing actions. The bias, however, with all the factors discussed above, remains inflationary.

Outside of Washington, there is currently very little that can be done about the inflationary actions of the Federal Government. What you can do is focus on your portfolio’s current cash flow from dividends and interest and let inflation aid in the growth of your portfolio’s potential capital appreciation. Policies appear more likely to create stagflation rather than a recession, unless a policy mistake is made, so stay flexible, particularly with fixed income.

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