Wealthnotes February 10, 2022

Interest Rate Increases - The Guessing Game
How Much Risk In The Markets? - A Lot !

To say the least: “The financial markets have been chaotic”. I for one feel quite confident about where we are and where we are headed. Indeed, I have such a high conviction about market risk, that our portfolios are carrying over 50% cash alternatives. It is now all about capital preservation. Only a novice would be all in.

There has been a saying over the years about “Bathtub Hydraulics”. The more water in the tub, the higher the boats float.

Governments around the world have been running unprecedent fiscal deficits, manipulated negative real interest rates and massively expanded the money supply for over 12 years. Common sense dictated that it couldn’t last and that it would not turn out well.

It was fun but the tub is about to be drained, and the water level lowered, beginning in March and the pain will begin soon thereafter.

The economic stimulus was unprecedented. It inflated all assets and was a failure. It benefitted those owning assets, increased the wealth gap astronomically and did little to expand economic growth, which will remain at 1.5% and 2% when conditions normalize. It makes one question: “who’s in charge?”

The promise that it won’t end badly is about to be fulfilled and the authorities have few options to deal with it. That’s the truth.
The market is currently behaving the same way as every bear market in history. There is an initial decline, a reflexive rally, then a protracted decline, which reverses market excesses. Investors never know where they are in the process.

The term “volatility” is the new word for losing money.

The graphs below illustrate how the QE stimulus juiced the market since 2008, and the periods of zero returns when buying into or holding on through the market collapse.



In the 1970’s, The Federal Open Market Committee (FOMC) under Chairman Greenspan initiated a policy of managing financial markets by supplying stimulus to support the market. This action is called the “Greenspan put” after a “Put” derivative in the options market.

The FOMC believes that strong financial markets create a Wealth effect that supports economic growth. It has not worked but they have continued the policy to the point where observers question if they have ignored their true mandate, which is to control inflation and job growth.

In practice, those twin objectives conflict with each other. Job growth requires low rates and monetary stimulus while lowering inflation requires the reverse policy.



This graph illustrates that the decision to buy into market extremes or to hold through the collapse, results in long periods of zero returns. Numerous observers have calculated that it would take 12 years of zero returns to justify current market valuations.

The math and historic experience are compelling.

Inflation accelerated to 7.5% SAAR in the latest announcement. The shape of the yield curve was suggesting that bond investors were expecting inflation to subside as conditions normalize through the year. The number reported today softened their conviction and the yield on US 10-year Treasuries increased to 2.02%.

The most meaningful increases year/year in the CPI report were used cars +40.5% Gasoline +40%, Gas utilities +23.9%., meat 12.2% and new cars 12.2%.

The price of energy is alarming because it reduces consumption across the economy and increases the risk of a recession. Many forecast that oil will reach $100/bbl. If it does, a recession is almost guaranteed, and the market is not discounting a recession.

A mid-cycle slowdown is expected as conditions following the pandemic normalize. This means that earnings per share estimates come down followed by a lower multiple of earnings. A double whammy for stock prices.

Higher interest rates impose losses in the financial system by reducing the value of all assets. As the losses ripple through the system, liquidity is reduced, and liquidity is the lifeblood of the financial markets.

We have reduced our exposure to all marketable assets because there is no haven in bonds, stocks, or other assets. We are carrying over 50% in cash equivalents to protect capital.

This note is very negative about market prospects because conditions have changed. Markets are challenged by rising interest rates, slower GDP growth, high inflation, monetary contraction and falling investor confidence.

Please feel welcome to call or email me for more information.
 
Your complete Bear!
 
Bruce Sansom
Global Wealth Builders Ltd.