Ray Dalio once said that "there are two main drivers of asset class returns: inflation and growth". Obviously, one does not need to be a rocket scientist to understand which one of the two has been driving this economy over the past two years. However, the build-up to where we are truly started in 2008, when the Federal Reserve's balance sheet was just short of 1 trillion dollars. Through all the quantitative easing during the global financial crisis and Covid, it has been catapulted to almost 10 trillion dollars today. A factor 10 in a little less than 15 years - alongside most other central banks around the world which had led to a bullish decade in the stock market; unfortunately, most of it was not driven by real growth but expansionary monetary policy. In other words: inflation.
We believe that what we are seeing now is only the beginning of a corrective phase, footing the bill for what has been consumed on borrowed money over the last 14 years. Considering today’s interest rate announcement by Jerome Powell, our expectations are that interest rate hikes will keep on increasing aggressively and at the same time, the Fed will be acting on its "quantitative tapering" initiative of decreasing its balance sheet by roughly 100 billion dollars a month. Reducing the money supply at this pace, while making money substantially more expensive through rate hikes in parallel, is going to be a toxic combination for equity markets. Furthermore, we do not believe that the current Board of Governors at the Fed is competent to tackle the present crisis; only in January, the Fed's outlook for 2022 predicted United States GDP growth to be at a rate of 4 - 5% and inflation at around 2%. Utterly wrong, once again.
When one looks back, from Volker to Greenspan, Bernanke to Yellen, and now Jerome Powell, the Fed has been the direct cause (or at least complicit) for some of the biggest economic downturns in recent history. And our fear is that this is going to be another one of those unfortunate tales. As we pointed out early on, inflation was never "transitory" and even as the American central bank is trying to reverse course, too late and too aggressively, we expect that inflation is here to stay. While the expansionary monetary policies from the past have fueled stock market "growth", they ultimately also have spiked the cost for raw materials and energy, combined with short-sighted and restrictive energy policies, that now seem to be pushing the economy over the edge. With U.S. consumer debt approaching a record high of US-$ 16 trillion, a consumer savings rate having declined by more than half from 10.50% in 2021 to 5.10% in 2022, U.S. corporate debt at an all-time high of almost US-$ 12 trillion, and bankruptcies at a 10-year peak, we are in for a rough ride.
We see high energy costs to have become the key issue causing accelerated inflation and believe that only a substantial increase in "output" of oil and gas is going to tackle the major cause of the problem. However, we do not see this happen under the current U.S. administration nor any of the major European governments anytime soon (other than the United Kingdom, potentially). The Fed's goal to "reduce job growth” in order to “decrease demand" is not addressing the root of inflation and will further lead to a decline in economic growth, productivity, and increase poverty across the board with a sharp decline in consumer spending. In our eyes, another ignorant approach by the lawyers and members of "academia" who run the Fed and for some reason do not seem to understand the fundamentals of economics. Only once the Fed should start to pause its tapering efforts and put a cap on further interest rate hikes, we will see a reversal of the bearish stock market sentiment and would expect equities to rebound: “It all comes down to interest rates. As an investor, all you’re doing is putting-up a lump-sum payment for a future cash-flow”, another spot-on quote by Ray Dalio to end this month’s market comment.
Our recommendation is to keep 20 to 30% in cash for the time being (U.S. dollars and Swiss francs), focus on energy-, value-, dividend-, and defensive stocks as well as to continuously keep hedging long positions in the European equity market and U.S. consumer discretionary sector as per our previous recommendations.
Oliver E. Hohermuth, Principal and Chief Investment Officer