Gold Shines Bright
The mighty U.S. dollar spent a good part of the year beating up on other currencies. From January to mid-October, the dollar rose 13 percent against the euro, 22 percent against the Japanese yen, and 6 percent against emerging market currencies.
And while the dollar rose less against emerging market currencies than against Europe and Japan, the thrashing was particularly brutal. Many emerging economies – like Sri Lanka, Zambia, Pakistan, Argentina, Turkey, and others – that borrow in dollars, are now on the hook to repay those loans using their local currencies of diminishing relative value.
Perhaps the worst of the dollar’s rapid rise is over. We don’t know. But over the last month the dollar has rolled over from the 20-year high attained on the dollar index.
Specifically, the dollar index is up over 10 percent year-to-date. Over the last 30-days, however, it has fallen more than 3 percent.
After slipping below 96 cents in September, the euro has risen to nearly $1.04. The British pound has also bounced from its September all-time low. The Japanese yen has slightly rebounded from a brutal skid to a 32-year low against the dollar.
Has the Fed contained inflation? Can it now slow the pace of interest rate hikes and then pivot sometime in 2023? Is the U.S. economy faltering?
Currency markets appear to think so. The common refrain is that the Fed will hike the federal funds rate by 50-basis points in December (not 75), that inflation has peaked, and that a new round of monetary easing is beginning to show on the horizon.
Maybe so. Or maybe the dollar’s November reversal is merely a head fake. Regardless, the path forward is not as clearcut as it might appear.
Pause Before Pivot
Consumer price inflation may have peaked. But a return to the Fed’s desired target of 2 percent will be wrought with monthly surprises. The path down will be sticky and volatile.
Fed Chair Jay Powell has studied the on again off again inflation of the 1970s. He knows how quickly consumer price inflation can spike up if the Fed is not aggressive in containing it. He recognizes the pitfalls of taking his foot off the break too soon. He doesn’t want a repeat of another decade long inflation saga.
The federal funds rate is presently at a range of 3.75 to 4.00 percent. A 50-basis point rate hike in December will take it to a range of 4.25 to 4.5 percent. But that won’t be the end of it. Last week, St. Louis Fed president James Bullard clarified that more rate hikes are coming:
“To attain a sufficiently restrictive level, the policy rate will need to be increased further.”
As part of Bullard’s presentation, he asserted that the federal funds rate would need to be somewhere between 5 and 7 percent to be considered “sufficiently restrictive.” Yet economists with Stifel, Nicolaus & Co. think a federal funds rate of 8 to 9 percent may be needed to do the job.
Thus, at a minimum, the Fed must hike rates another 1 to 3 percent to reach Bullard’s target level. Moreover, once the Fed reaches this terminal rate it will not immediately pivot, as many market cheerleaders expect. Rather, the Fed will pause and let these restrictive rates work their way through the economy.
High interest rates, relative to what we’ve seen over the last 20 years, are here to stay for several years – possibly longer. Moves to fine tune them downward too soon, as inflation appears to diminish, will result in inflation flare ups.
Consumer price inflation, like Hillary Clinton, won’t disappear quietly into the night. Mistakes in eradicating it could elongate the high interest rate episode for the entire decade.
The rate pause, in short, will be a period of price recalibration. Assets that are highly dependent on credit, like residential real estate, will be repriced lower to account for higher borrowing costs. Business loans will be reserved for real profit generating ventures.
Businesses that pursue growth for the sake of growth will vanish. They will either adapt to survive or they will go the way of the Stegosaurus.
The pool of cheap liquidity will turn to an expensive puddle. In fact, it already has. As we noted several weeks ago, funding of collateralized loan obligations (CLOs) has plummeted 97 percent from last year’s levels.
Out of necessity, net income after tax will be the driving metric. How much actual money is a business earning? How much of its own real earnings can it reinvest in growing the business?
Businesses that survive and thrive will be those that find ways to be self-supporting through their own contributions. Financial engineering gimmicks, like borrowing money using cheap credit to buy back shares, will no longer be viable.
Universities – the greatest cheap credit stimulated racket of all – may even have to taper their ridiculous tuition fees to attract the brightest young minds. In the interim, several key data points are signaling the economy may be screeching to a halt.
For example, the price of a barrel of West Texas Intermediate (WTI) Crude oil – the light, sweet stuff – is below $78. In June it was over $120. In other words, over the last 5-months WTI Crude has dropped over 35 percent.
Similarly, according to the World Bank’s Fertilizer Price Index, the price of fertilizer has fallen over 15 percent since April. But it is still up nearly 25 percent from this time last year.
What’s an investor to do?
Gold Shines Bright
Whether inflation has been contained for good or whether the Fed will pivot sooner rather than later really doesn’t matter at this point. The damage of rising interest rates has already been done.
Damage, to be clear, is also a great benefit. The damage, in this instance, is correcting the mistakes of over two decades of brain damaged monetary policy. Higher borrowing costs are bringing many absurd price distortions back into orbit.
For investors looking to accumulate capital and build wealth this is a very dangerous time. But it’s also a time full of opportunity.
The S&P 500 is down approximately 16 percent year-to-date. The NASDAQ is down over 28 percent over the same time. Will there be a Santa Claus rally?
From a historical perspective, stocks are still expensive. The Cyclically Adjusted Price Earnings Ratio (CAPE) for the S&P 500 is still above 29. That’s just a smidge below its valuation just prior to the epic 1929 stock market crash and the onset of the Great Depression.
Thus, it’s likely too early to be buying the broad stock market indexes. Yet there are many individual stocks, with low valuations and high dividends, that are very appealing at today’s prices.
Over the next 6 to 12 months, return of principle should have a greater bearing than return on principle for the prudent investor. Rising interest rates have made parking money in Treasuries a possible option.
One friend and reader let us know that Schwab was recently offering 5 percent on a 1-year Treasury note. On New Year’s Day 2022 this was somewhere on the order of 0.4 to 0.5 percent.
Five percent may not be a great return. In fact, it will result in a real inflation adjusted loss. Nonetheless, at the end of the year duration you get your entire principle back, plus the 5 percent. An investment in the S&P 500 may not be as fruitful.
The real opportunity, at this moment, is in real money – i.e., gold. Over the last month, as the dollar index has faded, the price of gold (in dollar terms) has shined bright.
On November 2, gold was trading at just over $1,615. Now it’s close to $1,750 per ounce – up over 8 percent in just over 3 weeks. Maybe this is a setup for a powerful move higher.
From our vantage point, it’s about time.
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