February 2023 Update

Back to the Grind

February saw profit taking in the second half of the month after a strong January rally.

Global equity strategies underperformed due to cash drag as we too slowly invested new subscriptions. The Global Infrastructure strategy outperformed strongly by over 1.5%.

Risk markets have yet to face the fact that inflation is a stubborn problem, and that interest rates are conceivably not coming down in 2023. Markets will soon realise we can't kill inflation simply by rate increases since we are also through other policies killing supply AND seeing public spending and subsidies increase. The Fed is having to fight loose fiscal policy and cope with deliberate supply side constriction - e.g. Energy policy and the somewhat mis-named Inflation Reduction Act. This supply side constriction is NOT something Volcker faced when he managed to squeeze inflationary expectations out. He had the assistance of declining oil prices, a massive increase in labour supply, (China), and the reduction of union power in the USA, and tax cuts which induced private sector capital expenditures which raised productivity (pre share buy-back mania). Volcker enjoyed a large supply side (Laffer curve) tailwind. Powell therefore has a harder job.

The ECB and Europe face similar problems having adopted the same 'free money for many years' playbook, and the same supply side destruction. There too the slow dawning is that rates are going higher and likely to remain higher than many would like, and for which no one is positioned.

The problem we face is that increasing interest rates much further to achieve a 2% inflation target will cause higher unemployment (U3 estimated to be at 6.5% in 2024 by a recent Cleveland Fed study) and thus possibly interest outlays on debt rising above other government expenditures such as Education and Defense. Very unpalatable to a marginal Democrat Congress. Additionally, as rates squeeze weaker balance sheets, retailers are reporting slower sales growth and defaults are already happening in bonds backed by office space - PIMCO and Brookfield are two of the unlikely defaulters; more are likely.

So, even while we see capital destruction, we aren't getting the rapid downward inflation response we would like to see. Adding to the risky mix is the fact that central banks are essentially now operating without any capital buffers on any 'mark to market' basis for their bond holdings acquired at ridiculous prices. The Bundesbank is the latest to 'fess up. We get that central banks are political constructs and maybe immune from capital adequacy rules but a loss is a loss and has to be accounted for somewhere.

Of course, as large defaults reverberate, they tend to infect other asset classes and correlations across a hitherto diversified portfolio rise, which means diversified is not so diversified. It's crunch time and there is still lots of undiscounted risk out there.

This belated attempt to deal with price and asset inflation and the level of debt we have deliberately injected into major economies in the last 25 years, means that one or more of the following 3 things are most likely to happen:-

  1. Interest rates are forcibly capped out and we have compulsory purchase of government and state debt issuance to achieve this - Financial Repression much like we had post WW2.
  2. The acceptable inflation target is raised from 2% to 4% + allowing rate rises to be more muted, and real rates to remain negative as long as the bond vigilantes remain sanguine - but this means the Phillips curve is back (oh dear) and we may well see a 1970s style stagflation - not good for wealth preservation let alone accumulation.
  3. We have a consumer recession and some asset price pain as the Fed asserts its independence by keeping rates where they are, but this creates more political tension and further government targeted fiscal largesse and tax increases on the 'wealthy' as governments look to temper the pain which they induced of course - in other words a muddle through which will eventually lead to shared fiscal pain - aka tax increases. The growth rate of most economies becomes impaired.

The 3rd of these remains our central case but central bankers will shortly be tested by the indignant howls of pain from the heavily indebted who played the speculatively financed investing game. What happened to personal responsibility?

Anyway, this incipient asset price pain in option 3 is a significant change from what has been a 25 year-long policy of "reflating the asset price souffle at any opportunity". So, what worked as investing strategy and what especially worked in ZIRP, is not going to work from here. Sell your concept investments while you can. Profits matter. Think hard about how to diversify since defaults cause problems in places you would have thought immune. There are no easy exits for policy makers and nothing but volatility for investors, but fortunes tend to be made on the downswing.

Delft Partners March 2023

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