Thoughts on the Current Outlook

April 12, 2024 Jon Zeschin

Three Key Thoughts:

1.     Earnings Growth Supports Stocks
2.     Growing Economy AND Lower Inflation?
3.     Geopolitical Risks Stay High

Earnings Growth Supports Stocks
Buoyed by the expectation that the Federal Reserve would cut interest rates in 2024 and by reports of stronger than expected corporate earnings, the US stock market continued the rally that started in November of last year. The rally continues to be led by large technology companies, the most prominent of which have been dubbed the “Magnificent Seven.” The rally kicked off late last year when inflation dropped more than expected, making it highly likely that the Federal Reserve was done raising rates. But the rally was supercharged by the expectation that newly launched artificial intelligence capabilities would drive productivity and, more importantly perhaps, earnings growth for companies well positioned to take advantage of the AI boom. Several of the Magnificent Seven fit this profile but a couple did not, at least in the short term. In the first quarter, those two – Apple and Tesla – fell by the wayside.

So investors’ focus shifted to earnings growth, which continued at a surprisingly strong pace through the quarter. With the labor market remaining reasonably strong, consumer spending held up well. Companies in a broad range of industries from capital equipment to manufacturing to finance posted solid earnings too. Correspondingly, participation in the stock market rally expanded from the tech sector to many other areas of the market, including value and small cap stocks which had been left in the dustbin for some time.

Interestingly, the stock market rally has held up even as hopes of Federal Reserve rate cuts have faded. Recent inflation reports, including today’s CPI, have come in slightly higher than expected, likely pushing rate cuts further into the future. The rent component of inflation continues to stay particularly strong, contrary to anecdotal evidence of weakening prices, leading many commentators to pick apart the methodology used to report the statistics. Energy prices remain a wild card, as continued instability in the Middle East threatens the stable backdrop for oil and gas prices. For now, bond investors are adjusting back to a “higher for longer” rate regime and stock markets will focus more intently on the outlook for corporate earnings, making the next few weeks of announcements more important than usual.

Growing Economy AND Lower Inflation?
Many investors, including us, have been waiting for the Federal Reserve’s aggressive rate hikes to reverberate through the economy, slowing growth and weakening the labor market. We are still waiting. We believe that massive fiscal stimulus (budget deficits in excess of $1.5 trillion, roughly 7% of GDP) is largely offsetting the impact of the Fed’s tightening. There is no appetite in Washington DC, on either side of the aisle, to address this spending issue, which is destined to grow, using CBO projections, to 10% of GDP over the next decade. Viewed in this context, it’s not surprising to see the economy growing and the labor picture staying solid.

So how can we get this growth without re-igniting inflation? The answer is productivity. If we take the productivity improvements that the pandemic spawned along with the prospect of improvements with the broader implementation of artificial intelligence, we could well be starting a period of higher productivity growth, which gives us solid economic growth and low inflation. While this would be a very positive environment for financial assets, the biggest risk is that productivity doesn’t improve as much as expected and inflation spikes once again.

Coming back to what this means for interest rates, it is sensible for the Federal Reserve to take its time in cutting interest rates, while it observes what is going on in the economy. In particular, the Fed is very attuned to the risk of reflation, preferring to make sure that lower inflation is here to stay for a while before reducing interest rates. As other major central banks start to cut rates, we expect the dollar to stay relatively strong until our rates are reduced too.

Geopolitical Risks Stay High
The hot spots just seem to keep piling up: Russia/Ukraine, Israel/Hamas/Iran, Houthis/Red Sea, China/Taiwan and, lest we forget, North Korea. There are undoubtedly more, lurking below the surface. With this many major areas of potential conflict, the risks of more catastrophic violence are greatly increased. Adding even more risk is the fact that several of the major powers – Russia, China, Iran and North Korea -- are ruled by dictators who cannot be counted on to act rationally or even in the best interests of their own countries.

In this environment, a strong voice for peace and freedom is important. Unfortunately, that is lacking. The nature of the European Union makes it difficult for them to act in a unified fashion. Indeed, the Union was conceived to link the members economically to make conflict among its own members less likely. And here in the US, both Democrats and Republicans are leaning toward a more isolationist approach to US foreign policy. We believe this makes the world a more dangerous place, not less dangerous. We are in need of positive, transformational leadership in Washington but we won’t get it for at least another four years.

Investment Implications
As long as the economy keeps growing and inflation stays low, both stocks and bonds are likely to fare reasonably well. That said, the risks to both the economic and geopolitical environment can’t be ignored. We believe that well-diversified portfolios with substantial amounts of liquidity are best for this environment.

THOUGHTS ON THE CURRENT OUTLOOK

January 9, 2024 Jon Zeschin

Three Key Thoughts:

1.       Inflation Down, Stocks and Bonds Up
2.       Labor Market Slowing Gradually
3.       A Tricky 2024 for the Fed

Inflation Down, Stocks and Bonds Up
Lower inflation, solid labor market, a growing economy, lower interest rates: this “Goldilocks” scenario came together in the fourth quarter. Starting with the reports for October, inflation began to slow sharply. Stocks took off in November on the expectation that the Federal Reserve was finally done raising interest rates. Bond prices rallied strongly too as investors reversed their “higher for longer” thinking. And the Fed joined the party, confirming at their early December meeting that rate cuts are likely in store for 2024.

The rally in financial assets continued right up to year end, with the US stock market finishing close to, but not quite reaching, a new all-time high. Bond prices more than reversed the decline we saw in the third quarter, with the yield on the ten-year Treasury bond falling from its peak of 5% to less than 4% at year end. So far in 2024, a bit of the unbridled optimism has been tempered but the big picture remains very positive.

The drop off in inflation was broad-based but falling energy costs were the biggest contributor to the decline. Looking at the geopolitical situation today, you would think that oil prices should be higher – Russia engaged in war with Ukraine and the Middle East in turmoil. However, US oil production is at an all-time high, even as global demand is barely above pre-pandemic levels. As the world makes (slow and steady) progress on reducing reliance on fossil fuels, demand growth probably stays in check, keeping prices reasonable. That could change quickly if geopolitical conflicts accelerate. For now, though, energy is a stabilizing force on inflation.

Housing continues to exert upward pressure on reported inflation, even though anecdotally it seems that rents and housing prices have stalled. While it would seem logical for this component of inflation to fall from here, we need to keep in mind that we are very undersupplied on housing, relative to the demographic demand. For now, higher mortgage rates have slowed buyer demand, but this could change quickly if interest rates continue to fall.

Labor Market Slowing Gradually
Through December, the labor market remained reasonably positive, with jobs being added across many sectors of the economy. Two data points are of note, however. First, the biggest increase in jobs in 2023 came from governments, which added an average of 56k jobs per month in 2023, more than double 2022’s additions. Second, wage growth continues at a rate slightly above inflation, which might be expected to continue as compensation tries to catch up with past inflation.

Looking at the jobs creation picture over the last three years, however, indicates a very clear slowing. To some extent, slowing was to be expected from the torrid pace of 2021, when we were emerging from the pandemic. So to cut the three month average job gains in half from the end of 2021 to end of 2022 wasn’t surprising. But it was nearly cut in half again from the end of 2022 to end of 2023. Surely, these numbers fit with a slowing economy and, combined with the decline in the rate of inflation, argue strongly that the Federal Reserve will be cutting rates in 2024.

A Tricky 2024 for the Fed
With short term rates currently set at 5.5%, inflation now running at 3-3.5% and declining, and the labor market slowing, it’s a slam dunk that the Fed will be cutting rates significantly in 2024, isn’t it? Well, not so fast. After having been embarrassed by their incorrect “transitory” inflation call in 2021, the Fed wants to make sure that inflation is down to stay. They don’t want to have to reverse course abruptly as they did in 2022.

The Fed also seems wedded to the short-term data on inflation, the economy and the labor market. These monthly or quarterly numbers can be volatile and subject to big revisions. Ideally, the Fed would like to take its time to see real trends develop. But time in 2024 may be in short supply, which brings us to our final factor: the election.

Usually, the Fed likes to make sure it stays out of the way in presidential election years. This is likely to be true again this year as keeping the economy healthy is a huge priority for the incumbent. If the Fed keeps rates too high, the economy could well slow down too much. And, on the flip side, if they cut rates sharply, they could be seen as trying to help the economy in advance of the election. Bottom line, the Fed faces a tricky year of policy choices.

We expect the Fed will try to get some modest interest rates cuts out of the way in the first half of the year and hope that they can stay out of the way in the second half.

Investment Implications
We get a bit uncomfortable when the consensus becomes an “all clear.” That said, we think there are still opportunities to earn excellent “real” returns on bonds. After a very strong year for US technology stocks, market leadership may shift, making stock selection even more important than usual. We are positive about the prospects for several international markets, except China, as we believe supply chain diversification and a weaker dollar will be tailwinds.

Thoughts on the Current Outlook

October 23, 2023 Jon Zeschin

Three Key Thoughts:
1. Rates Bite Stocks
2. REAL Returns on Bonds
3. Geopolitics: No More World Order

Rates Bite Stocks

For most of 2023, the US stock market has been buoyed by the prospect that the Federal Reserve was almost done raising interest rates because they appeared to be winning the battle with inflation. And the Fed had apparently defied history and won its battle without inducing a recession. What a wonderful result, if it were all true!

For right now, the economy does appear to be avoiding recession, with the labor market still surprisingly strong (even though weaker than earlier in the year) and consumer spending still holding up well. However, the labor market is a notoriously lagging indicator so that could change in a hurry. Our bigger concern is the prospect that inflation could turn higher. The combination of aggressive wage demands in several unionized segments of the economy and higher oil prices portend upward pressure on prices.

Responding to these risks of higher inflation, yields on long-term bonds have jumped dramatically. In the last three months, the yield on the ten-year Treasury bond has risen a full 1%, from around 3.8% to 4.8%. As we saw in 2022, higher interest rates are generally bad for stocks, particularly higher growth companies, as their future earnings value is discounted more. True to form, the US stock market pulled back in the third quarter and, if it weren’t for the gains of a handful of very large technology companies, there would be no gains this year.

Another headwind for stocks: attractive REAL returns on bonds, which makes them more attractive in uncertain times. Taken together, we believe stocks are likely in a holding pattern until there is more clarity around inflation.

REAL Returns on Bonds

At 5.5%, the current target for the Federal Funds rate is well above the reported levels of inflation. Having a “real” (after inflation) return on bonds is a situation we haven’t seen since before the Great Recession of 2008-2009. Until this past quarter, rates on long-term US Treasury bonds had stayed close to the level of inflation, as investors expected inflation to fall.

However, with the labor market reasonably strong and inflation apparently leveling out at a rate well above the Federal Reserve’s target, the Fed signaled at its September meeting that more rate hikes are likely. More importantly, in our view, the Fed’s consensus forecast changed for 2024 to remove interest rate cuts. Investors took this cue to mark down prices on long-term bonds further, driving up yields so that both short-term and long-term bonds now provide a positive real yield.

Not only do higher rates generally mean lower prices on higher growth stocks, these real yields provide a reasonably attractive and much safer alternative to investments in riskier stocks. This type of attractive alternative to stocks hasn’t been available for more than a decade.

Geopolitics: No More World Order

Russia’s invasion of Ukraine shattered a relatively low conflict world that had existed for some time. That war has dragged on with no prospect for end in sight. Despite the obvious importance of stopping Russia’s expansionary aggression, signs of fatigue in Western support are clearly showing.

Meanwhile, China charts a course to a new future as it tries to expand its military and economic independence, the latter made difficult by serious structural problems that have yet to be effectively addressed. From the South China Sea to Taiwan, the Chinese military is making its presence known, combining new assertions of territorial rights with demonstrations of its growing military power.

The Iran-sponsored attack by Hamas on Israel is sure to lead to greater conflict in the Middle East. In the short-term, Israel’s response is likely to be massive. More difficult to predict, however, will be the impact on the regional alliances whose central players are rivals Saudi Arabia and Iran.

These are just three examples of conflicts that have arisen as the US has pulled back on its engagement in the world community. We don’t know where any of these will lead but all pose risks to a peaceful, growing global economy.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than upside. As noted, we can now earn a “real” return on most fixed income investments, so we are favoring those over cash, while we wait for better opportunities to expand long-term investments in stocks.

Brief Update with New Data

July 14, 2023 Jon Zeschin

This week, after the publication of our July issue of Thoughts on the Current Outlook, new inflation and consumer sentiment data was released. Headline inflation was reported at a 3.0% annual increase, lower than expected, helped significantly by lower food and energy prices. Core inflation was also lower than expected, but remained at a much higher level of 4.8% annual increase.

The University of Michigan Consumer Sentiment indices also showed a much more positive result, with both current conditions and expectations readings increasing significantly from June. While the reading is still low, the increase likely reflects optimism about employment prospects.

Neither of these reports change our expectation that so long as the labor market stays strong, so will consumer spending. And while we will make progress on inflation, the Fed will likely need to raise rates more to reach its goal of 2% inflation.

THOUGHTS ON THE CURRENT OUTLOOK - JULY 2023

July 11, 2023 Jon Zeschin

Three Key Thoughts:

1. Jobs, Jobs and More Jobs

2. Rates Higher for Longer

3. Xiconomics

Jobs, Jobs and More Jobs

In 2021, annual inflation (CPI All Urban Consumers) rose from 1.40% in January to 7.04% at the end of the year. In 2022, inflation continued its march upward, heading toward a peak of 9.06% in June. Realizing that this steep rise in inflation was not actually “transitory,” the Federal Reserve embarked on a very aggressive campaign to raise short-term interest rates starting in March of 2022. This program took short-term rates from zero to 5.25% today, an historically steep and fast rise.

What are the results? Inflation has clearly come down -- the most recent report shows annual inflation at 4.05%. But the Fed has set a target of 2% annual inflation. To achieve that goal, there is general agreement that we will need to slow the economy and, particularly, employment and wage gains. That has been difficult to achieve at least partially because fiscal policy, i.e., government spending resulting from the Bipartisan Infrastructure Law and the ironically named Inflation Reduction Act, is working in the opposite direction.

So far in 2023, job gains have averaged nearly 275k per month, while average hourly earnings increases have been steady, averaging 4.4%. The unemployment rate has also stayed steady, averaging about 3.5% for the last twelve months. Finally, total job openings have come down from the historic levels of several months ago but are still more than 2 million above the pre-pandemic high.

All of this is to say that the job market remains tight and reasonably hot. As long as this remains true, the economy will likely continue to grow, inflation will stay above the Fed’s target and the Fed will continue to raise interest rates further.

Rates Higher for Longer

The mini banking crisis last quarter led many to believe that the Fed was done raising interest rates. Indeed, we made the case last quarter that the crisis was a direct result of the Fed’s interest rate hikes so it was easy to jump to a conclusion that, having caused a small crisis, they might pull back. The idea that rate hikes might be over brought optimism to the stock market, where a strong rally took hold in March and continued through the second quarter. That optimism was fueled further by the Fed not raising rates at its June meeting.

While we are likely getting close to the end of the Fed’s rate increases, we don’t think we are there quite yet. Instead, we expect that short-term interest rates will stay higher than both inflation and long-term rates for some time to come. This is a very unusual situation but so long as the labor market stays strong and wage pressures continue, then the Federal Reserve’s 2% target will likely remain elusive.

Interestingly, the strong labor market has not carried over into consumer sentiment. As measured by the University of Michigan, sentiment is roughly where it was in the depths of the financial crisis in 2008. Meanwhile, consumers’ actual financial position is quite strong, with debt levels relatively low and incomes consistent. We can speculate on why sentiment remains poor – pandemic overhang, inflation worries, political divisiveness, to name a few possibilities – but consumer spending has stayed very positive, keeping our economy growing.

Xiconomics

After nearly three years of Draconian lockdowns, there was a great deal of optimism regarding the “re-opening” of China’s economy once those COVID restrictions were eliminated last fall. That optimism has now turned to realism that the structural problems plaguing the Chinese economy (most importantly, the residential real estate crisis, lack of consumer confidence, regulatory overhang, a rapidly aging population, high youth unemployment) are very much still in place, post-COVID.

President Xi clearly understands the importance of a growing economy to the stability of the country. However, his views of how to achieve that growing economy are very different than his recent predecessors. Xi envisions a strong and growing role for State Owned Enterprises (SOEs) and a central role for the Chinese Communist Party (CCP) in planning the areas of growth emphasis. This defining role for the CCP is in sharp contrast to the central role played by private enterprise in the growth successes of the past three decades. It remains to be seen how well government-centric priorities can be executed. For example, creating technological independence is a key goal, i.e., developing advanced chip-making and software development capabilities to dramatically reduce China’s reliance on the West in these areas. Of course, in these efforts, China will run headlong into US efforts to limit China’s access to key US technologies.

More important than this struggle over technology independence are the issues facing China’s consumer economy. Problems in the real estate market followed COVID as some overleveraged developers could not finish pre-sold apartments, leading to mortgage delinquencies, reduced demand and falling prices. Despite assurances and targeted relief from policymakers, the real estate market remains in the doldrums. This is weighing heavily on consumer sentiment because a substantial portion of consumers’ net worth is tied to real estate. Very high youth unemployment (20%) adds further gloom to the consumer picture.

The historical record for authoritarian governments guiding their economies to growth with centralized policies has few, if any, successes. We remain skeptical that Xiconomics will be the exception.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than upside. On the plus side, we can now earn a “real” return on short term fixed income investments, so we are favoring those over cash. We continue to focus on investing in stocks of companies that will thrive through and beyond the economic weakness that likely still lies ahead.

THOUGHTS ON THE CURRENT OUTLOOK - APRIL 2023

April 13, 2023 Jon Zeschin

Three Key Thoughts

Fed Hikes Bank Failures
US Economy Hangs On
Understanding China is Hard

Fed Hikes Bank Failures

From zero a little over a year ago, the Federal Reserve has raised short-term interest rates to 4.75%, an unusually steep rise by historical standards. Certainly, the Fed’s action was needed to fight stronger-than-expected inflation. But imposing that much forceful restraint in such a short time was bound to have unintended consequences. We began to see them in the first quarter.

Early in the year, investors expected the Fed to continue raising rates as we saw strong employment and inflation reports. Rates on one-year Treasury bonds rose to more than 5% and money market fund yields exceeded 4%. The spread between these yields and those paid by banks on deposit accounts was conspicuously large, setting the stage for major moves of deposits out of the banks.

But two other factors provided the necessary fuel for a problem: (1) some banks had invested their deposits into longer term bonds which fell in value over the past year as interest rates rose, leaving big unrealized losses; and (2) some had also courted high balance business accounts, with deposits well in excess of the FDIC insurance limit. Silicon Valley Bank had both of these problems and, once they were publicly disclosed, depositors fled and the bank failed. Concerns immediately spread to other, similarly situated banks, most of which were sizable regional banks. The Fed and the FDIC have put in place emergency measures to stop the bleeding but the impact of these events will continue to be felt as banks become more conservative in their lending approach, reducing the supply of credit to the economy.

For now, interest rates on short and longer term bonds have come down, making bank disintermediation a little less of a risk. However, if inflation stays strong, the Fed will likely have no choice but to continue to raise rates, putting more banks at risk of a deposit run and increasing the risk of a harsher recession.

US Economy Hangs On

Because the mini-crisis in the banking sector just happened in March, we haven’t yet seen the impact on the economy. For now, employment remains strong, if a bit weaker than earlier in the year, and demand for services is still expanding. Manufacturing has shown signs of weakness and some lower quality parts of the credit markets have seen more delinquencies. Probably the biggest area of concern is commercial real estate, particularly the office segment. So many employers have implemented reduced in-office schedules that the demand for office space is down significantly. As that lower demand translates into lower values, it will be more difficult for landlords to refinance their loans as they come due. The mini-crisis only adds fuel to this potential slow burning fire.

On the positive side, the consumer continues to be in very good shape. Incomes are up, even though they haven’t kept up with headline inflation. And leverage remains at pretty low levels, a legacy of financing done at the low rates that prevailed before 2022. We are still seeing strong travel and entertainment spending, as the COVID-deferred spending still has some distance to run. With consumer spending the key driver of the US economy, we expect to see positive growth for another couple of quarters.

China is Hard to Understand

Speaking of COVID, the most mysterious handling of the COVID pandemic must belong to China. After nearly three years of harsh lockdowns that destroyed consumer confidence, upset global supply chains and sidelined the real estate market, the Xi regime abruptly abandoned those policies late last year. While the country withstood the initial wave of COVID infections reasonably well (although official statistics seemed laughably low), the impact of the lockdown policy will be felt for years to come.

President Xi appears to understand the importance of re-igniting growth in the domestic economy but so far the playbook for doing so isn’t inspiring a lot of confidence. They have said that they wish to support private enterprise’s role in stimulating the economy but, at the same time, it must be done in ways the government wants. The old “build infrastructure” plan gets hung up on the amount of debt already outstanding from prior programs and the lack of actual demand for more infrastructure building. Meanwhile, international companies with manufacturing facilities in China are moving rapidly to diversify to other locations. This is a long process but it will hold back China’s growth for years to come.

For consumers, there has naturally been some bounce back from the very low spending during the lockdowns. However, for that to be sustained, we believe people need to be optimistic about their future. A prominent indicator for this lack of optimism is the fact that China’s population shrunk in 2022, with more deaths than births. The government has provided modest incentives for child birth but they haven’t yet provided the key ingredient: expectations of a brighter future.

Those who are optimistic about China point out that Xi’s policies are quite consistent with long term party principles that brought China’s growth so far over the last several decades. And that the “common prosperity” he seeks is also consistent with the Chinese belief system, honed over thousands of years. Finally, they point out that the Chinese Communist Party is above all pragmatic, constantly testing and adjusting their policies to seek the greatest good. While they sometimes move slowly and make mistakes, they have ultimately made the adjustments needed to keep the economy moving and their people happy.

We see both sides of these arguments and would welcome a return to growth in China. But we remain skeptical that the heavier hand of the CCP under President Xi will be able to succeed.

Investment Implications

We continue to be cautious about the current environment, believing that there may be more downside to the economy and markets in the near term than there is upside. That said, we can now earn solid returns on fixed income investments so we are minimizing cash holdings. We are focusing on investing in stocks of companies that will thrive through and beyond a period of economic weakness that likely still lies ahead.

THOUGHTS ON THE CURRENT OUTLOOK - JANUARY 2023

January 17, 2023 Jon Zeschin

Three Key Thoughts:
1. Inflation Progress?
2. China: COVID Zero to COVID 24/7
3. Expanding Return Opportunities

Inflation Progress?
Bond and stock markets have started the year out optimistically as they expect inflation to continue falling as it has over the last four months. If that fall continues, the Federal Reserve can ease off its interest rate hikes and we could see bond and stock prices rise, reversing some of 2022’s dismal results. The headline numbers just reported for the Consumer Price Index supported that optimism. However, a precipitous fall in energy prices was the biggest contributor to softening inflation. Food and shelter price increases remain reasonably strong. While we expect shelter costs to moderate slowly in the coming months, it is also likely that we could see higher energy prices as demand from China grows with its post-COVID reopening. The labor market also remains surprisingly tight, contributing to inflation by raising compensation costs for businesses and increasing demand for goods and services funded by higher wages.

Bottom line, the Fed’s inflation-fighting job is certainly not done yet and we won’t be surprised to see some significant bumps along the path to lower inflation. We are just starting to see the impact of higher rates on the economy, with recent surveys showing manufacturing activity already in contraction even while services have stayed in growth mode. It usually takes 6-12 months for Federal Reserve actions to work through the real economy and we are just into that time period now. Ironically, one way to make a great deal of progress on inflation quickly is for the economy to slow dramatically. That seems like a significant risk right now.

China: COVID Zero to COVID 24/7
China’s policies surrounding COVID are nothing short of baffling to the rest of the world. After nearly three years of stringent lockdowns, quarantines and contact tracing, China has completely abandoned this strategy and is supporting a full reopening. What is perhaps most surprising is that the old approach was held onto through President Xi’s re-election and then quickly shelved immediately thereafter. No rationale has been given but it seems clear that Xi recognized the dire impact the COVID Zero policy was having on the economy and on the psyche of his population. (For example, China’s birth rate dropped to nearly zero, contributing to an already looming demographic problem.) For now, we have no hard numbers to indicate how this reopening is going but anecdotal evidence indicates that, as would be expected, infections and deaths have soared.

While we don’t know how long it will take for this “cold turkey” approach to move through the population, China views the new re-opening strategy as part of a bigger plan to stimulate their flagging economy. The government has also taken steps to assist the ailing property market, a key part of the China growth story. And they have opened their borders, both inbound and outbound, so that travel can resume. So far, the Chinese stock markets have celebrated, rising more than 30% off their lows reached this summer.

We view all this change with some skepticism, as the government can just as quickly take away what they have given. However, assuming the plan sticks, we can look forward to a greater contribution to global GDP from China. While this is certainly positive, we should also expect higher energy and commodity prices from the resurgent Chinese demand.

Expanding Return Opportunities
Being cautious in the short term about the US economy and China re-opening doesn’t mean there aren’t some positives to focus on. With short term US interest rates now getting close to compensating for inflation, we can invest in higher quality short term bonds with annualized returns of 4-6%. For a low risk investment, this is a pretty attractive return.

The US dollar is showing signs of weakness, which makes sense if we are getting close to the end of the Fed’s hiking program. A weak dollar makes investments in non-dollar stocks and bonds more attractive.

Valuations of US stocks are far less challenging today than they were a year ago. We still believe that there is a significant risk that corporate earnings will drop more than anticipated in the coming year and that could bring stocks down. We view that as a short-term risk but a long-term investment opportunity. We are more optimistic about return prospects over the longer term than we have been in a while.

Our optimism is aided by believing that (1) the Federal Reserve is near the end of its interest rate hikes for this cycle and (2) markets typically bottom well before the economy does.

Investment Implications
We are investing clients’ cash in short-term bonds to take advantage of rising rates. And we continue to evaluate stocks of companies we believe will thrive long into the future and expect to use pullbacks in US stocks to add to exposure there. For the first time in a while, we are looking at when to begin to add to US small cap stocks, which typically do well coming out of an economic downturn. With China’s economy likely reopening and Europe faring better than expected with their energy challenges, we are also considering adding to investments in international stocks.

The short-term risks don’t yet justify our being aggressive in making these moves. But should we see more weakness in the economy and the markets, we will likely use that opportunity to add to investments that we believe will do well over the longer term.

Thoughts on the Current Outlook - October 2022

October 13, 2022 Jon Zeschin

Three Key Thoughts:

1. Sticky Inflation

2. Desperate Russia

3. Nowhere to Hide

Sticky Inflation

In March and August of this year, the US stock market rallied on the hope that inflation was beginning to come down. If true, this would let the Federal Reserve pause its aggressive program of interest rate increases. Both times, investors were disappointed as inflation reports continued at a high level. More recently, expectations about inflation have stayed high and markets have plumbed new lows for the year.

With longer term interest rates having risen alongside short-term rates, 30 year mortgage rates are now over 7%. This more than doubling of rates on new mortgages has frozen the residential home market on both sides. Buyers, already stretched by high prices, can’t afford the monthly payments demanded by higher rates. And potential sellers are reticent to list because prices have softened and, more importantly, they don’t want to exchange their low cost mortgage for a high cost one on a new home.

We are just starting to see the impact of higher rates in other parts of the economy, as it usually takes 6-12 months for Federal Reserve actions to work through the real economy. This time, that effect may come sooner and more severely given the speed and magnitude of Fed actions. Ironically, it seems that the public has already anticipated this outcome. They are pessimistic about the current economic situation and do not expect inflation to stay high. The Fed wants to make sure their expectations stay that way.

Desperate Russia

Much has been written about the shockingly poor performance of the Russian military in its invasion of Ukraine. Putin tried to keep his “special military operation” outside the view of the average Russian citizen but the battlefield failures made it necessary for him to initiate a conscription to replenish his troops. This hastily arranged draft sent many scurrying to exit the country but more importantly brought the military failures so far into stark daylight.

Predictably, and with Putin’s approval, hard line supporters have called for a major escalation of the war effort, claiming Russia itself is under siege. Of course, harsh treatment has been in store for those who protest or resist the draft. However, it is far from clear that Russia has the ability to escalate in a sustained way with traditional weaponry. Trained troops, equipment, transportation and weaponry are already very stretched with refreshment prospects uncertain. This leaves Putin in a desperate situation, making him both unpredictable and dangerous.

In addition, we believe he has played his energy card poorly. By cutting off natural gas supplies to Europe under the guise of pipeline “maintenance” and “leaks,” he is forcing Europe to adjust to alternatives very quickly. And they will never return as customers. Putin is then forced to sell oil and natural gas at discounted prices to China and India, neither of which is pleased with Putin’s war. With China’s economy already struggling, they hardly need Putin trying to economically cripple their largest export market, Europe.

The late Senator John McCain once labelled Russia “a gas station masquerading as a country.” Many other commentators have modified that quote to call Russia “a gas station with nuclear weapons.” Putin’s dream is to re-establish Russia as a great world power. Where he will take that quest from here is difficult to guess but it is clear that his gamble on taking Ukraine has not paid off.

Nowhere to Hide

The stagflation situation we find ourselves in now is not good for any financial asset. We are cautious about US stocks in the short-term as we don’t think that estimates of corporate earnings yet reflect the further slowing in the economy to come. With the Federal Reserve likely to keep raising rates through year end, bond prices will remain under pressure. And cash is a loser to still-hot inflation.

In short, there is no good place to hide.

If there are shreds of optimism, they are that (1) the Federal Reserve is likely to pause the rate hikes at year end to take stock of where the economy is and that’s only a couple of months away and (2) markets typically bottom well before the economy does.

Investment Implications

“When you’re going through hell, keep going!” Often attributed, perhaps incorrectly, to Winston Churchill, this quote is nonetheless apt advice for our current situation. We are investing clients’ cash in very short-term bonds to take advantage of rising rates. And we continue to evaluate stocks of companies we believe will thrive long into the future. With China’s economy staying weak, Europe dealing with energy shortages and high inflation and the US dollar likely to stay strong, we have significantly reduced investments in international stocks.

We don’t know when the situation will change for the better, but we are confident that it will. The US economy is still fundamentally strong, with advances in technology and health care spurred on by the lessons learned during the pandemic. Ultimately the forces of entrepreneurship and innovation will get us back on a solid growth track.

Thoughts on the Current Outlook - July 2022

October 10, 2022 Jon Zeschin

Three Key Thoughts:

1. Fighting Inflation First

2. Begging for Oil

3. China is Not Russia

Fighting Inflation First

In 1974, new President Gerald R. Ford inherited a major inflation problem, brought on by spending on the Vietnam War and then exacerbated by the oil embargo in 1973. To garner public support for inflation fighting measures, Ford’s team dreamed up a “Whip Inflation Now” campaign, encouraging citizens to do their small part to reduce inflation’s bite. One corny aspect of the plan was the now-infamous “WIN” button, which was broadly distributed to the public. The program was largely viewed as a failure and inflation remained an enormous problem for the remainder of Ford’s term and throughout the Carter years.

We don’t expect the Federal Reserve to start distributing WIN buttons any time soon, but they have certainly taken up the mantra. Chair Jerome Powell has said on several occasions that fighting inflation is the Fed’s first priority, even if it risks bringing on recession. Their preference would be to slow the economy just enough to bring inflation down, but this will be a very difficult challenge. The Fed’s tools are very blunt instruments – interest rates and bond buying/selling – while inflation is coming from several sources.

Inflation from housing costs and labor shortages are likely to remain sticky for a while as we are chronically in short supply of housing (relative to the demographic need) and labor (as our population growth hasn’t been sufficient to keep up with the demand for labor). Throw in high energy prices driven by our abandonment of energy independence and the war in Ukraine, and you have a very difficult set of inflation drivers for the Fed to address. We aren’t surprised to see them acting aggressively now in hopes of reducing demand for housing, labor and energy. Consumers are already feeling the pinch, psychologically anyway. The University of Michigan’s Index of Consumer Sentiment stands at 50, an all-time low for that index, mostly based on concerns about inflation. What’s rare is that this reading comes when unemployment is close to all-time lows.

Begging for Oil

Moving away from fossil fuels for the good of our planet is a goal easily embraced. However, having spent more than 100 years building a power grid and transportation infrastructure based on fossil fuels, the transition to new energy sources will be long and complicated. We believe using the high current price of oil to try to force consumers to transition to alternative fuel sources is destined to be a failure because we are missing two critical pre-cursors to a sustained move away from fossil fuels: technology and infrastructure.

On the technology side, we need major advancements in battery technology and power storage. Advancements in technology to improve battery life, speed charging time and reduce weight are being driven by market forces and progress continues. Absent major breakthroughs that improve functionality and reduce costs, a major shift to electric vehicles (EVs) isn’t likely until at least the next decade. With respect to power storage and transportation, solar and wind power are notoriously unreliable as Texas is experiencing at this writing. These are exceptionally difficult problems that will take time to solve.

The real laggard, however, is our current power grid. It is riddled with regional inconsistencies and inefficiencies and simply cannot handle even minor disruptions in supply or surges in demand. Burdening the current system with even more demands from EVs and other forms of electrification won’t work. We believe fixing this problem with require national leadership and effort.

For now, we are left to beg for oil from anyone and everyone in a vain attempt to moderate prices. Not surprisingly, our entreaties have fallen on deaf ears. Producers are happy to sell their current production at high prices, recognizing that they too will need to transition away from fossil fuels in the future. They also expect that investments to expand capacity now are unlikely to pay off over the long term. Further, they know that the US has the ability, but not the current will, to solve its own energy supply problem. We expect energy prices to stay high until demand is reduced by a slower economy, which the Fed is working on!

China is Not Russia

We have written in the past about our concerns regarding the direction that President Xi has taken China. Certainly, he has used the pandemic as an excuse to impose draconian limits on personal freedoms that the Chinese people were just getting used to having. At least as important though are the changes he has brought about economically. Imposing far reaching restrictions and fines on certain large businesses (real estate and education, for example) has dented investors’ confidence in the future viability of businesses that are not closely tied to the government priorities. And the Chinese markets have suffered as a result.

As these changes filtered through to the real economy, growth has slowed to a crawl and the government is beginning to put in place stimulus plans to try to re-ignite growth. While it remains to be seen how successful these stimulus plans will be, they highlight a major difference between China and Russia. In China, political loyalty is to the Chinese Communist Party (CCP), which has its own unique organizational structure and approach to governance. Despite the special “historical figure” status that Xi has achieved, he is ultimately accountable to the CCP. Assuming they can get past their COVID lockdowns, we expect Xi to return to a focus on the party’s long-term priorities of stability and manageable economic growth.

There is no similar accountability structure in Russia. Putin is accountable to no one, least of all the average citizen, for whom he has no regard. This is the biggest problem with the harsh sanctions that were imposed by western countries after the Ukraine invasion – they hurt the average Russian citizen but have no impact on Putin. So long as the US does relatively little to help our European allies with their energy needs, Putin remains in a reasonably strong position, able to prosecute a war of attrition funded by high energy prices. And, having controlled the messages they receive, he has no pressure from his domestic population to bring an end to his “special military operation.” Indeed, he can inflict deep economic pain on the west through higher energy prices and supply disruptions, even while fighting to expand his territory and influence.

Investment Implications

The Federal Reserve’s policies will slow down our economy, even as inflation stays high in the short term. How much slowing? How much inflation? These are key unknowns. As the markets sort this out, we expect more volatility. We are staying patient, keeping asset allocations stable and watching for new opportunities.

High Inflation + Slower Growth = Stagflation

May 11, 2022 Jon Zeschin

In our most recent Thoughts on the Current Outlook, we enumerated the reasons why we believe inflation will stay sticky for longer than many expected: high energy prices, continuing COVID shutdowns in China, an historically tight labor market and strong real estate demand.

Most concerning to us is the energy price situation. In the past, very high energy prices have often preceded recessions as pain at the pump typically acts as a tax on consumers, who react by reducing other purchases. While the Biden administration wants to blame Putin for the spike in oil prices, the reality is that oil prices were rising long before the invasion because the new administration abandoned US energy self-sufficiency. From the low 50s in January, 2021, crude climbed to the low 80s in October, 2021 and then to the low 90s in early February, 2022, a few weeks before the invasion. While hindsight is 20/20, one could certainly make the argument that the US had the power to bring down energy prices in 2021 by producing more oil (in 2020, we were net exporters of oil) and our failure to do so indirectly funded Putin’s war on Ukraine.

Unfortunately, it does not appear that we have learned anything from this experience and so have no credible policy to bring down energy prices. We are likely left only with the natural market remedy, which is demand destruction resulting from a weaker economy. Until this materializes, energy prices will be a strong driver of inflation.

Enter the Federal Reserve which now realizes it is well behind the curve in raising rates to cool the economy and bring down inflation with it. With 75 bps of increases already behind them, they expect to raise rates at least another 100 bps – 50bps at each of the next two meetings. We believe these steps alone would cool the economy somewhat. But a further contributor is that the enormous COVID stimulus programs of the last two years have now expired. The combination of these two factors could easily put us into recession.

Even if we avoid a recession, growth will definitely slow even while inflation stays high. Those of us who experienced it for a good chunk of the 1970s understand that stagflation – high inflation and slow growth at the same time -- isn’t good for any financial assets. Holding cash is a guaranteed loss of purchasing power to inflation. Bonds are the same, at least until yields are high enough to compensate for inflation, which we are a long way from right now. And stocks suffer as investors aren’t willing to pay much for future earnings which must be discounted at a high rate (inflation plus a risk premium).

So what could go right and help us out? First, China could get past its COVID restrictions and, perhaps more importantly, relax the Communist Party’s recent grip on the free markets that have driven its growth for the last 30 years. We are more optimistic about the former than the latter. But the reality of much slower growth may cause Xi Jinping to moderate his future policies toward the private sector. Relaxation of US tariffs on Chinese exports would also help (one positive policy the Biden administration has said it is considering).

Second, the US consumer may continue to bail out our economy. After two years of lockdowns, we are all anxious to do things we haven’t been able to do much of: travel, shop in stores, eat in restaurants and gather with family and friends. There is an enormous amount of pent-up demand that will likely continue to drive growth for some time yet.

Third, markets will adjust to the new environment and create new opportunities. We are likely only part of the way through this process but we won’t fully know it is done until we are well on the other side of those adjustments. In the meantime, markets are likely to be quite volatile.

Our approach is a combination of preserving capital where possible while also looking to invest in good long-term opportunities as they become available at attractive prices.

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Thoughts on the Current Outlook

April 14, 2022 Jon Zeschin

Three Key Thoughts:

1. Real Chaos

2. No Break in Inflation

3. Globalization and Peace No More

Real Chaos

Amid 2021’s rising stock market, we witnessed pockets of craziness as IPOs, SPACs and meme stocks soared to outrageous prices, driven largely by retail demand, often induced by social media. Having witnessed these bouts of euphoria previously, we were pretty sure that this chaotic party would end badly. Sure enough, as interest rates began to rise in January, the party ended pretty suddenly. The selling also pulled down the valuations of many very good growth companies whose stock prices had also risen to excess.

Then the real chaos ensued as Russia invaded Ukraine. We believed, incorrectly, that Putin might not invade because he had already maneuvered Europe into the position he desired, with high energy prices and a hearing on his security concerns. What we didn’t appreciate was that this invasion was part of a long simmering desire by Putin to eradicate Ukraine and continue reassembling the former Soviet Union.

After having been embarrassed by his army’s early failures to capture Kiev and overthrow the government, Putin is now expected to escalate the fight much further in the eastern part of Ukraine. Putin has already demonstrated that he has no compunction about killing innocent civilians or destroying the country’s infrastructure. In addition, he clearly has little regard for his own people who will be the ones to suffer under the sanctions imposed by the West. More importantly, Putin has no interest in peace so we expect this conflict to drag on for some time.

While it does, Ukraine and Russia are largely removed from the world economy, with only the sale of Russian oil and gas supporting that country. Oil and gas prices are likely to stay high as will another major export of both Russia and Ukraine: wheat.

No Break in Inflation

With this as backdrop, it is no wonder that consumer price inflation has risen to more than 8% at this writing. Here in the US, we already have a very tight labor market that is leading to higher wages, which will push up prices across the board. The energy price increases are now working their way through the US economy and, after abandoning the energy independence we spent forty years acquiring, the current administration does not appear to have a credible plan to bring down energy prices.

We were just beginning to come off the worst of the pandemic-induced shortages of goods when the Omicron variant struck China. Sticking to its COVID Zero policy, the Chinese government has instituted massive lockdowns, keeping the citizenry in their homes and factories idled. It will be interesting to see how long they continue this policy, as the rest of the world recognized that the Omicron variant spreads too quickly to be controlled by lockdowns but that its virulence is dramatically less than prior strains.

Finally, we continue to see exceptionally strong demand for real estate in the US. Some of this is generational and some is a desire for more space, a reasonable reaction to a two-year battle with COVID isolation. And likely some is a reaction to the fact that real estate has historically been a good inflation hedge. Regardless of the reasons, rising real estate prices will also continue to put upward pressure on inflation.

This reality hit bond yields hard in the first quarter as the rate on ten-year Treasury bonds nearly doubled from 1.5% at year end to about 2.8% at this writing. The Federal Reserve hung onto its “transitory” inflation wish for too long and now finds itself in the difficult situation of having to raise interest rates very rapidly to try to cool inflation. The Fed also realizes, however, that doing so flies in the face of an economy that is already weakening after the stimulus-induced growth of 2021. It is no surprise that talk of recession is now commonplace and mostly in the context of “when,” not “if.”

Globalization and Peace No Longer

Two fundamental assumptions were key to our investment of a portion of our clients’ assets in international stocks: (1) the world was largely at peace and (2) globalization of production and consumption gave rise to many new opportunities, particularly in serving growing middle classes in developing countries. These assumptions may no longer be true. The Russian attack on Ukraine and the distinct possibility that this is only the beginning of a larger set of conflicts means we can no longer expect peace. And the Europeans are learning a difficult lesson in the downside of counting on an unpredictable dictatorship to supply its energy needs.

China’s turn inward and toward greater self-sufficiency, which started prior to the pandemic, is being reinforced by its COVID response. Even as China wants to become more self-sufficient, the rest of the world wants to become less dependent on China. COVID taught us the downside of global supply chains. While they are great for cost efficiency when all works well, they can quickly become unreliable in the wake of unforeseen events.

These trends add more fuel to the inflation fire. Without the free movement of goods, services and capital throughout the world, production costs will likely keep rising and corporate profit margins may suffer.

Investment Implications

We remain optimistic that the reopening of the US and developed economies will continue, despite the recent setbacks from the Omicron variant of COVID. However, the reduction of government stimulus and Fed tightening will prove a challenge to continued growth in the economy, even as inflation stays strong. “Stagflation” is a term we expect to hear more of. We have modestly reduced allocations to international stocks and will likely use rallies to trim further. More volatility is likely for the remainder of the year and we plan to use that volatility to make investments we believe will do well over the long term.

Special investment update

March 8, 2022 Jon Zeschin

War in Ukraine

Like many others, we were somewhat surprised when Russia launched its military invasion of Ukraine. We believed, incorrectly, that Putin had already maneuvered Europe into the position he desired, i.e., driving oil prices up (to around $90 a barrel which looks cheap today) and getting a reasonable hearing on his security concerns regarding the expansion of NATO. Instead, Putin chose an invasion that quickly proved messy because of the strong resistance of the Ukrainian military and lack of preparation by the Russian army for this type of fight.

Having been embarrassed by his army’s early miscues, Putin chose to escalate the conflict significantly. He seems content to destroy the infrastructure of Ukraine and kill innocent civilians and, in the process, eliminate a productive and important contributor to certain parts of the world economy. In doing so, he has also decimated his own financial system, or at least that portion of the system with ties to the West. With the western countries having frozen a great deal of the Russian assets held outside Russia, Putin is reliant on continued purchases of Russian energy by Europe and the trade and financial support of China. This is hardly a solid foundation on which to finance a war or the potential future occupation of a relatively large country.

Short Term Implications

Oil prices are likely to go higher as none of the non-Russian producers have stepped up with more production. Adding further pressure is the fact that many shippers and refiners simply do not want to handle Russian oil, not only because of the reputational risk but also the real financial risk that financiers and ports may simply refuse to finance it or unload it.

The only two possible swing producers have been foiled by Biden Administration action. Saudi Arabia is not about to help us out while we are trying to negotiate a new nuclear deal with its archrival Iran. US producers are leery of ramping up investment and production because stated Administration policy is anti-fossil fuel. Despite having spent the last fifty years (since the oil embargo of 1973) working to achieve domestic energy independence, we have simply walked away from that achievement as if it we could eliminate fossil fuels tomorrow. Even the Saudis understand that fossil fuels are not in our long-term future but the transition to alternatives is going to take a long time, given the extent of our current needs and uses.

Speaking of going higher, inflation is likely to continue its rapid rise, driven by higher energy costs, rising wages and higher real estate prices. We have previously noted that we expected the US economy to grow more slowly this year as the massive government stimulus of the last two years is now gone. Add in the interest rate increases by the Federal Reserve as it starts its battle against inflation, and the uncertainties associated with war in Ukraine, and you have the ingredients for a slow growth, high inflation combination. In the 1970s we called it stagflation.

Long Term Implications

We have long been fans of ensuring that our clients have investment exposure to economies other than the US. This view was mostly about taking advantage of a full set of investment opportunities. But two assumptions were key to accessing that opportunity set. They were: (1) the world was largely at peace, at least relative to a longer span of history and (2) globalization of production and consumption gave rise to a great many new opportunities, particularly in developing countries, not to mention the exporting of deflation to importing countries. Unfortunately, these assumptions may no longer be true. The unprovoked attack by Russia on a neighboring sovereign nation harks back to the beginning of WWII. Even if the conflict is contained, the fact that this type of attack is now a possibility makes the peace assumption difficult to make.

We saw globalization begin to break down in the US/China trade negotiations under former President Trump. Just as Trump was pushing his America First agenda, so was President Xi planning to turn China more inward and toward greater self-sufficiency. Unfortunately, relations with China have not improved at all under the current administration and, even worse, Russia and China economic ties have improved, making it easier for Russia to evade some of the Ukraine-related sanctions and setting the stage for more strategic cooperation.

With globalization now on the downswing, we can add another log to the inflation fire. Without the free movement of goods, services and capital across countries, production costs are likely to rise and the profitability of many businesses will suffer. The supply chain issues we experienced due to COVID may be replaced by safer supply chains that will undoubtedly be more expensive.

A Couple of Positive Notes

We are quickly moving into the endemic COVID period, in which full reopening to group activities and travel is likely to continue. With high vaccination rates and effective new therapies, we expect to see a boost in economic activity that will partially offset some of the negative forces we outlined above. The fight against COVID these past two years has spawned a great deal of innovation in the technology and health care sectors. On the technology side, we believe that many more workers will be able to achieve the win-win of better productivity and more flexibility in their schedules. The speed with which the health care system responded to COVID will also spawn new care and treatment models as well as accelerating the already rapid pace of medical innovation.

Investment Implications

Late last year, we were cautious about committing new cash for clients because of the high valuation level of the stock market. While that caution proved to be warranted, it has been replaced with a new caution that the investing backdrop of the last few decades (peace, globalization, low inflation and low interest rates) is now under question. We are optimists by nature but the investing environment may be changing materially. What has not changed is that, over time, stocks rise based on earnings growth. While that growth may be more challenging in the short run, innovation is alive and well as COVID demonstrated. We will continue to diligently assess the changing environment, guided by our clients’ long term investment objectives.

THOUGHTS ON THE CURRENT OUTLOOK

January 14, 2022 Jon Zeschin

Three Key Thoughts

1. Record Number of Records

2. The Fed vs Inflation

3. Global Recovery Without China?

Record Number of Records

Despite a myriad of potential worries, the US stock market climbed to new record highs 70 times in 2021. The old Wall Street saying about the market climbing a wall of worry seems like an understatement. There was a mountain of worries to climb! To list just a few, we had the Delta variant of COVID, the vaccine rollout, the botched pullout from Afghanistan, inflation reports at a 40-year high and Congress debating major new spending bills and large tax increases. Then we finished the year with the new Omicron variant threatening the reopening and inflation running even higher.

But the US market saw that corporate earnings were increasing quickly as demand stayed strong for goods of all kinds, even while supply was constrained. And it also expected that inflation will moderate in the new year and that the Federal Reserve will begin to withdraw its bond buying and begin to raise interest rates. To the surprise of many – but maybe not the market -- Congress failed to enact another big new social spending plan and the higher taxes to pay for it. Finally, the employment picture remained very strong, with unemployment dropping sharply and job openings plentiful. On the whole, the market judgment was that the economy and earnings are getting better, not worse, and that is what matters most.

2022 may be a bit more challenging, however, as the markets will likely need to digest somewhat higher interest rates and likely slower growth in the economy and corporate earnings. We expect wage pressures to begin to make a dent in corporate profit margins as workers continue to demand and receive substantially higher wages. The grocery worker strike that started this week in Denver is, we believe, one of many such actions we will see across the country this year.

In addition, the massive stimulus that the US government provided the economy over the last two years to offset the impact of COVID is largely going away. While some lip service is being paid to resurrecting the Biden Administration’s Build Back Better plan, it doesn’t seem likely to move forward in 2022, meaning the economy will have much less government stimulus applied to it.

The Fed vs Inflation

Into this interesting set of circumstances comes the US Federal Reserve with a dual mandate of price stability and full employment. They believe they have largely fulfilled their goal of full employment and the state of the labor market would certainly seem to bear that out. With unemployment at 3.9% and job openings in excess of 10 million, the only weakness is in labor force participation which, at 61.9% stands 1.5% below the prepandemic level.

But price stability is a long way from being where Fed would like it. After more than a decade of trying to boost inflation to a higher level and failing, the Fed is now facing inflation of 7% (the latest CPI reading) even while it is still carrying on its monthly bond buying and keeping interest rates near zero. The Fed has already announced that it intends to drop its bond buying relatively quickly in 2022 and expects to consider interest rate increases. But the Fed is also quite aware, as we pointed out above, that the massive government stimulus of the last two years is going away, just as the Fed reduces its stimulus. Whether the economy can withstand this withdrawal of both fiscal and monetary stimulus at the same time will be one of the key questions for markets to answer in 2022.

We expect the Fed to be more cautious than the inflation and employment data might imply because they would likely prefer inflation to run a bit “hotter” than in recent years over the possibility that they push the economy into recession.

Global Recovery Without China?

China continues to cling to its “COVID Zero” policy of harsh lockdowns and testing protocols at the first sign of any outbreak, regardless of how minor. Xi’an, a city of 13 million, has been locked down for more than two weeks now and other smaller cities are beginning to experience the same. Many companies are warning of production shortages if these shutdowns extend or expand. And Omicron has just reached China’s shores. Other countries have found that this variant spreads so quickly that lockdown efforts are largely useless to contain it. We think the next several weeks could be quite interesting as China tries to host the Olympics while keeping the virus at bay.

More importantly, however, is that much of the rest of the world is well along in dealing with the Omicron variant and some are predicting that this will ultimately spell the shift of COVID from deadly pandemic to more routine virus inconveniences. If that were to be true, we could see economies reopen much more broadly, igniting production that meets unfilled demand and reduces supply backlogs in many parts of the world economy. However, China’s participation in that recovery remains a key question as they still face major potential disruptions from Omicron if they stick with their current policies. It is impossible to tell how this will progress but if recent history is any guide, this will proceed quickly. It could well be a very interesting few months ahead of us!

Investment Implications

We remain optimistic that the reopening of the US and developed economies will continue, despite the recent setbacks from the Omicron variant of COVID. The reduction of both government and Fed stimulus this year will prove a challenge to continued growth in the economy, but we expect the Fed to be the buffer, letting inflation go on longer. The rest of Washington is likely on hold through the election so that is a net positive.

We are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks, which we expect more often than we saw in 2021.

Thoughts on the Current Outlook

October 14, 2021 Jon Zeschin

Three Key Thoughts:

1. We Didn’t Start the Fire

2. Inflation: What Sticks?

3. China: Rapid Change

We Didn’t Start the Fire

In 1989, Billy Joel wrote the song “We Didn’t Start the Fire” to show a young Julian Lennon that life was just as challenging for Billy growing up in the 50s and 60s as it was for a 21 year old Lennon in 1989. If you aren’t familiar with the song, it is a stream of consciousness recitation of some of the main events that took place from 1949 to 1989. The song ends with a reference to Tiananmen Square, which was just a few months before the fall of the Berlin Wall. Billy Joel might be challenged to reduce each year since then to one line.

My reason for bringing it up is I was struck by hearing the song’s lyric “It was always burning since the world’s been turning” juxtaposed against President Biden’s recent mild complaint about the number of issues he has had to deal with at once. Well, unfortunately for the President, it has always been so and isn’t likely to change anytime soon. One of the best things he could do is not create problems where they didn’t exist before.

The current fire in Washington is about “infrastructure” in its various potential forms. A bipartisan physical infrastructure bill passed the Senate but not the House, as some members don’t want to move that bill forward without the second “human infrastructure” bill being done at the same time. That stand-off has led to efforts to try to slim down the size of the second bill. Our concern revolves around the various and sundry tax proposals that have been floated to pay for the second bill. It is impossible to predict where all of this debate will come out. For now, the markets prefer inaction.

Besides this fire, there are many others burning, including: rising prices for food, fuel and housing, an increasingly aggressive China, the immigration crisis at our southern border, fallout from the Afghan pullout and North Korea military testing, to name a few. Oh, and there’s an historic pandemic that we could get better under control if we could figure out how to get more people vaccinated.

Inflation: What Sticks?

Yesterday, the Social Security Administration announced that recipients will receive a 5.9% increase in their benefits in 2022. This is the biggest increase in 40 years and a good reflection of how quickly inflation expectations could get embedded in consumers’ thinking. The big question facing the Federal Reserve as it tries to decide how much stimulus the economy still needs is whether the inflation we are now seeing is “transitory” or “sticky.” Home price increases and wage pressures will be sticky for a while as we can’t “produce” more homes or workers quickly. On the other hand, we think price increases induced by supply chain problems are likely to be temporary as we work through the backlogs at ports, shipping companies and raw materials producers.

We wouldn’t be surprised to see prices for oil and natural gas stay high, or even go higher, in the near term as it appears that we have abandoned the energy independence we achieved a few years ago, in favor of more environmentally friendly policies. While that is a great long-term goal, the short-term impact will be greater dependence on imported energy, the price of which is outside of our control. Indeed, those foreign producers know that traditional fossil fuel consumption will likely decline over the very long term, giving them an incentive to maximize profits during periods of strong demand.

Speaking of strong demand, the proliferation of “We’re Hiring” signs throughout the country is staggering. On a recent driving trip through Montana, we encountered several fast food restaurants that could not open their dining rooms for lack of employees. When high demand meets low supply, prices rise and that is what we are seeing in wages. But we also have had a longstanding labor supply problem because our birth rate is not replacing the working population and we have dramatically reduced the amount of legal immigration over the last decade. What we wouldn’t give for a rational set of immigration policies – we aren’t getting our hopes up!

China: Rapid Change

The Xi regime has laid out three guiding principles for policymaking: security, stability and common prosperity. From these basic building blocks have come a flurry of regulatory actions over the last year. Starting with the quashing of the IPO of Ant Financial and progressing through actions damaging businesses in the social media, private education, gambling and gaming sectors, the Xi regime has created a great deal of uncertainty surrounding their relationship with private enterprise.

Perhaps more importantly, their efforts to rein in the red-hot residential housing market have run headlong into the financial distress of the country largest property developer, Evergrande. It is not at all clear how policymakers are going to (1) resolve Evergrande’s liquidity crisis; (2) maintain confidence in the housing market; and (3) cool price increases. This problem is particularly acute because of the great importance of home equity to the net worth of Chinese citizens, particularly the hundreds of millions of city dwellers.

Meanwhile, China has stepped up both its rhetoric and its military maneuvers aimed at Taiwan. While all of these activities could be viewed as consistent with positive social goals, as well as being consistent with the three guiding principles, they also come directly ahead of the expected re-election of President Xi to an unprecedented third term next year. To us, this smacks more of power consolidation than social welfare.

Bottom line, many investors are being cautious about the implications of these rapid changes for future economic growth in China and the continued evolution of their markets.

Investment Implications

We remain optimistic that the reopening of the US economy will continue, perhaps at a more measured pace. Inflation and the Fed’s reaction to it will be front and center over the coming months, which could introduce more market volatility for both stocks and bonds. Right now, Washington is doing what is does best – nothing. We are hopeful that continues. We are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks.

Thoughts on the Current Outlook

July 12, 2021 Jon Zeschin

Three Key Thoughts:

1. Party On!

2. Bond Bulls vs Inflation Data

3. China: The CCP at 100

Party On!

A little more than 30 years ago, Wayne Campbell of Aurora, Illinois introduced us to Wayne’s World, a self-produced live TV show broadcast from Wayne’s basement on the local public access channel. At Wayne’s side was his best friend, Garth. Wayne was of course played by Mike Myers and Garth was played by Dana Carvey. Their misadventures and celebrity guests were the stuff of regular spots on Saturday Night Live for several years. The two coined several catch phrases of the 1990s but perhaps none so long lasting as “Party On, Wayne” and the retort “Party On, Garth.”

Despite not quite reaching the Biden Administration’s 70% vaccination goal, the economy seems to be very much in “party on” mode. People are traveling, going out to eat, attending live concerts and, yes, even thinking about returning to the office. Highways and airports are packed, restaurants are booked up and concert venues and sports stadiums have capacity crowds. And that return to the office, well, maybe we need to think about that one a bit more.

Jobs are plentiful as businesses try to staff up to meet resurgent demand. And potential employees, emboldened by the expectation of continued labor shortages, are asking for higher wages and more flexibility to work where and when they want. Similarly, great demand and short supply has the housing market making new highs, seemingly by the day. Oil prices have also soared past $70 a barrel, more than tripling off of the lows of last year. For many months, lumber prices were the poster children for post-Covid inflation as enormous demand from renovators and builders met supply limited by Covid-imposed production shutdowns.

While we have started to see these pressures appear in inflation statistics, we don’t yet know how permanent or pervasive they will be. It seems likely to us that home price increases and wage pressures may be sticky for a while as we can’t “produce” more homes or workers quickly. On the other hand, we think it is likely that oil and other commodity prices will level out and even decline as supply catches up to and then exceeds demand. We believe the same thing may be true with respect to other price increases induced by supply chain problems (think computer chips for cars and home appliances, for examples).

Bond Bulls vs Inflation Statistics

Not surprisingly, recent reports on retail and wholesale inflation show the sharpest increases in decades. We fully expect this to continue for at least several months as both the “stickier” elements of inflation and the temporary inflation drivers push prices up across the board. The Federal Reserve has indicated it is willing to let inflation run “hotter” than its long-term target of 2% for some undefined period of time, before beginning to roll back its bond buying and start raising short term interest rates. We expect that “undefined period” is likely to get shorter as the inflation reports come in over the coming months.

However, a very odd thing has happened in the bond markets. You would usually expect that this type of inflation outlook would drive longer term bond yields higher, perhaps significantly so. But let’s trace the recent roller coaster ride of the yield on the 10 year Treasury bond. Starting at about 1.90% at the beginning of 2020, it dropped to about 0.53% in August of 2020, before starting a gradual climb back. That climb continued into March of 2021, when the yield peaked at about 1.75%, nearly a complete round trip. However, since then the yield has plummeted about 45 basis points, reaching 1.30% at this writing, even as the inflation numbers are ramping up.

Part of this strange behavior is the Fed’s continuous buying of bonds. But that has been going on since the depths of the pandemic so it isn’t new. Clearly a good many bond investors believe that inflation will cool off, dramatically so, in the not-too-distant future. There is a case to be made that today’s supply chain induced shortages will lead to tomorrow’s glut of goods for which demand has been sated. Or a new Covid variant could stymie the reopening. A third outcome is that bond yields will have to jump quickly to adjust to a new era of inflation. Nobody knows how this will turn out. Stay tuned!

China: The CCP at 100

Marking the celebration of the 100th anniversary of Chinese Communist Party, the Xi regime combined tough talk of China’s inexorable rise with initiatives designed to foster self-reliance and innovation. Interestingly, these initiatives have been paired with continued efforts to put the CCP in full control of economic and personal freedoms. The Party has already demonstrated its power by reining in some of China’s most successful companies under the guise of “protecting” Chinese citizens from the loss of control over personal data. (For a government that has long made private citizens’ data its own domain, the irony in that statement is stunning!). The latest target is companies that wish to list their shares outside of mainland China. In the wake of the harsh limits placed on Hong Kong citizens, these actions may seem mild but they are cause for concern about China’s interest and willingness to engage with the rest of the world.

More puzzling is trying to make the link between the innovation that China sorely needs to keep its growth engine alive and its desire to generate this internally, while controlling the lives of its citizenry. As Americans, we tend to link economic creativity and growth with personal freedom. China is making a big bet that the CCP can drive the innovation it needs while limiting personal freedom. It hasn’t been done before. Then again, modern China has done lots of things in the last 30 years that few thought they could.

Investment Implications

While new Covid variants are a risk to reopening, we believe that the combination of vaccination success and massive government stimulus will continue to win out. This is mostly good news for investors. We remain cautious that other government policies – particularly on taxes and regulation – will likely move against investors. As a result, we are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks.

Thoughts on the Current Outlook

April 14, 2021 Jon Zeschin

Three Key Thoughts:

1. Stimulus on Top of Rebound

2. Rates and Oil Jump

3. Inflation Coming: Temporary or Permanent?

Stimulus on Top of Rebound

It was definitely expected that the Biden Administration would kick off its legislative agenda with an enormous stimulus package. Perhaps the only small surprise is that they chose to do it via the budget reconciliation process with no Republican support. With that success, it is now clear that the new administration intends to push through as much of its agenda as possible while the Democrats control both houses of Congress without seriously attempting to get bipartisan support.

The new stimulus bill comes on top of very strong economic and employment reports so we expect that labor and materials shortages will become quite prevalent. You might wonder why labor would be in short supply with the unemployment rate still at 6%. Quite simply, for many lower paid potential workers, they can make as much or more by collecting unemployment as they can by working. The Federal supplement to regular unemployment benefits brings the total benefit to roughly the equivalent of $15 per hour on a 40 hour week. We hear this story repeatedly in discussions with small business owners who are struggling to find workers.

Materials shortages will continue as we work through the supply chain issues caused by COVID interruptions to production and shipping schedules. Pricing for many commodities and building supplies have soared in recent months as demand has bounced back sharply while supply is still constrained. It is going to take some time, along with a more complete vaccine rollout, to alleviate these shortages. If the current “fourth wave” of the virus hampers the effectiveness of the vaccine distribution, then the supply shortages could well continue for some time.

While we don’t know all of the details associated with the tax increases planned as part of the infrastructure bill, we have seen some headlines come out piecemeal. The corporate tax rate will be raised, along with some sort of minimum tax proposal based on earnings reported in financial statements. Tax rates on individuals earning more than $400,000 per year will also be raised, along with an increase in the capital gains tax rate. Surprisingly, the financial markets have not reacted to the prospect of higher corporate taxes yet. Ultimately, the final details will determine the winners and losers and those likely won’t be sorted out until this summer.

In the meantime, stock investors have cheered the liquidity provided by both the Federal Reserve and Congress. And they are also excited about the strong rebound that is happening as the economy reopens. Bond investors, on the other hand, are nervous about whether this liquidity and growth will lead to a sustained rise in inflation.

Rates and Oil Jump

Yields have risen back to where they were in late 2019 which is an enormous percentage increase off of the historic lows reached a year ago. However, in absolute terms, we are still in a broad downward-trending band in interest rate levels that started 35 years ago. With the rate on ten-year Treasury bonds still below 2%, we are certainly at a point where the potential decline in rates is much smaller than the potential increase. However, with rates this low, price swings can be very large with small absolute changes in rates. And the most important input to long term bond prices is inflation expectations. In the short term, those pressures are likely to be upward.

After bottoming just below $20 per barrel about a year ago, oil has tripled to about $60 per barrel today. Some of that increase is just an expected return to a more normal demand environment and the broad range in which oil had traded for several years prior to the pandemic. The oil market has fundamentally changed over the last several years, with costs of extractions declining, providers being more proactive about adjusting output and demand generally plateauing. With the Biden Administration’s green energy initiatives, it seems to us that oil will become a less important economic input, even as supply remains relatively plentiful.

Inflation: Temporary or Permanent?

With all of this talk of supply shortages and oil price increases, are we in for a big rise in inflation over the next few years? We don’t think so because there are several important factors that while likely keep inflation in check. First, the enormous amount of debt incurred by the US and other governments to fight the pandemic will ultimately be deflationary. Second, the pandemic spurred great advances in technology and health care. These advances will be positive for productivity but negative for inflation. Third, just as the current supply chain bottlenecks cause prices to rise, their resolution will spur some price competition and lower prices. Finally, the long-term story of demography – the rapid aging of the population in the developed world – puts a lid on growth and inflation.

Investment Implications

The race between reopening and new COVID strains/cases makes the current environment a bit uncertain. However, we believe that the combination of vaccination success and massive government stimulus will ultimately win out. This is good news for investors, for the most part. However, we are cautious that other government policies – particularly on taxes and regulation – are likely moving against investors. As a result, we are keeping asset allocations close to long term targets, with sufficient cash available to take advantage of short-term setbacks.

Thoughts on the Current Outlook

January 14, 2021 Jon Zeschin

Three Key Thoughts:

1. A Blue Breeze Moves In

2. Will Inflation Return?

3. Looking Through the Chaos

A Blue Breeze Moves In

In last quarter’s Thoughts, we called out the possibility of a “Blue Wave” in the November election that could fundamentally change the “lower taxes, less regulation” mantra of the last four years. We can’t really call what has now transpired a Blue Wave – it is more like a Blue Breeze that has descended on Washington DC. In December, stock markets cheered the prospect of a divided government, as it appeared that the Republicans would retain control of the Senate so long as they won at least one of the Georgia Senate run-off elections. However, mishandling of the latest stimulus bill, the President’s bizarre election-related behavior, and an enormous turnout effort by the Democrats allowed them to win both Georgia seats. The resulting 50/50 split gives control to the Democrats as the Vice President can cast the tie-breaking vote, if needed. With this narrowest of margins, the Democrats will be able to control the agenda but compromise will likely be needed on major initiatives.

Surprisingly, stock markets cheered this result as well. However, they did so with a twist as the leadership switched from technology and consumer discretionary stocks to energy and banks. We wonder how long this leadership shift will last under a Biden administration which will undoubtedly be in favor of phasing out fossil fuels and more regulation for the banks and other financial companies.

For right now, the market is focusing on the likelihood of far more stimulus to help the unemployed, small businesses and state and local governments which have been devastated by the pandemic. In addition, the market is expecting the vaccination rollout to accelerate, allowing the economy to reopen somewhat faster than it would on the current pace. Combined with the support of the Federal Reserve (low rates and bond purchases) and the new Treasury Secretary (former Fed chair Janet Yellen), it is clear that stimulus will be the order of the day for some time to come. With this backdrop, we expect the economy to bounce back strongly in the second half of 2021.

Beyond the two main initiatives noted above, we don’t know what the Biden administration’s priorities will be. With the shift in Senate control, it will be much easier to get new cabinet appointees confirmed. So the new administration should be able to articulate its plans relatively soon. We will be particularly interested in tax policy as this has the potential to negatively affect financial markets.

Will Inflation Return?

If there is a dark cloud on the horizon for investors, it is the prospect of higher inflation returning faster than expected (and hoped for, by the Federal Reserve). We have been living in a relatively ideal environment for stocks with earnings growing (at least in several key sectors) and interest rates at extremely low levels. This combination makes high price/earnings ratios tolerable. But if inflation returns – and if inflation expectations and interest rates move higher – then we can expect that stock prices will get marked down harshly. Historically, these kinds of adjustments tend to come quickly as investors who had previously ignored small increases in interest rates suddenly realize that higher rates have a real impact on stock prices.

We believe there is a risk that we could apply too much stimulus to the economy and create an inflation problem where one doesn’t exist today. However, we are far away from that right now, with recovery from the pandemic a huge hill yet to climb.

Looking Through the Chaos

To say that the last twelve months have been chaotic would be a colossal understatement. Yet we sit here with stock markets at all-time highs, seemingly poised to go higher by the day. The recovery in employment from the initial pandemic shock has stalled, the vaccine rollout in going slower than expected and, at least for another week or so, we have chaos in Washington. Stock markets even rose when rioters attacked Congress on January 6th! How do we make sense of this?

Stock market trends are about one simple thing: are the drivers of value (economic growth, earnings, taxes) getting better or worse? If the answer is better, then stock prices go up. If the answer is worse, then prices go down. We see this pattern repeated over and over. Yet it is difficult for us to understand when we see so much chaos in the daily news.

Right now, the markets are seeing progress on vaccine distribution (though slower than we all would like), leading to a reopening of the economy and an unleashing of a great deal of pent-up demand. On the political front, markets are expecting more stimulus, a more rational approach to government and relatively benign tax and regulatory policy. These expectations reinforce the bigger reopening story and make today’s bad news far less important.

Investment Implications

We have long discussed the three themes that have been prevalent for more than a decade now: US stocks over foreign stocks, growth stocks over value stocks and US dollar denominated assets over non-dollar assets. In the fourth quarter, these trends reversed and that reversal has continued into the new year. We will be looking at ways to adjust portfolios if we believe it is warranted. To a great degree, we are already positioned for an international stock turnaround, which is further benefited by dollar weakness.

Thoughts on the Current Outlook

October 13, 2020 Jon Zeschin

Three Key Thoughts:

1. Like Trump, COVID Wants the Headline

2. Post-Election Prep: Blue Wave Alert

3. China’s Recovery Continues

Like Trump, COVID Wants the Headline

Perhaps we shouldn’t be surprised that President Trump and COVID-19 would one day meet face to face. Ever since his improbable run for president began, Trump has done his best to always “be the headline.” And so it has proceeded throughout the Trump presidency that he has always strived to deliver the biggest, the best or the smartest, regardless of whether those claims had any support. Ironically, it was in those moments without much fanfare that he actually had some notable achievements.

Then along came COVID-19, a challenge unlike any other Trump, or our country for that matter, had faced in modern history. Defying conventional wisdom about viruses, it spread asymptomatically. As we scrambled to ramp up the supply of ventilators, it proved that ventilators might be more harmful than helpful. COVID even tricked our own immune systems to attack so virulently that patients were killed by the immune response. All the while, COVID kept coming back to the headline, and it hasn’t really let up since February.

Last quarter, we coined the phrase that we are starting the “learning to live with COVID” phase. Just like we adjusted to intrusive new security measures after 9/11, we are gradually adjusting to a new environment in which we are all more cautious about how we go about our daily lives with COVID always in the background. We believe this phase will continue well through the time when vaccines are widely available.

Today, we have two major concerns about the ongoing economic impact of COVID. The first is with small businesses, thousands of which are struggling to stay positive and stay afloat. If their progress is interrupted, the economy will have a very hard time mounting a sustained recovery. Our second concern is with school re-openings. While local districts and regional politicians control the decisions, we cannot expect our economy to get back to normal until schools are fully re-opened. That doesn’t mean we advocate opening them at all costs – it is just a fact that so many parents’ work lives revolve around their ability to have their children in school, those parents will not be fully productive workers until their children are safely attending school. We don’t have answers or predictions about either of these concerns – we will just be watching them to see how or whether they can be resolved over the coming months.

Post-Election Prep: Blue Wave Alert

The markets, meanwhile, have focused on the improvements in the economy, coming out of the major shutdowns in the second quarter, with stocks reaching new highs in August. The enormous stimulus programs from the Federal Reserve and Congress have helped the markets stay optimistic about continued recovery. September saw a bit of a hiccup as further stimulus plans stalled in Congress. While both sides have an interest in reaching an agreement, the Democrats believe they have the upper hand because they are pretty confident of a “blue wave” that will sweep them into the presidency and control of Congress. Right now, the markets seem to agree that more stimulus is coming, whether before the election or soon after.

If the blue wave becomes reality, we will need to consider the kinds of changes that may take place in Washington that could impact the economy and corporate earnings. In very broad terms, higher taxes on corporate earnings and a less friendly regulatory environment are likely to be negatives for the stock market. However, more stimulus will be positive in the short run unless it becomes a source of inflation that drives interest rates higher. Bottom line, it is time to be thinking about the possible policies and their implications but not a time for drastic changes to portfolios. We have warned on several occasions about the danger of making investment decisions based on political outcomes. The US economy is driven mostly by strong, fundamentally positive factors that are more powerful than the marginal changes politicians can make.

China’s Recovery Continues

In China, the success of their harsh, swift shutdowns and the government’s use of technology to control the spread of COVID-19 are sources of national pride. And President Xi has seized on this pride to launch new initiatives focused on making China more self-sufficient. In particular, he is focused on building technology capabilities that China currently must either import or license from the rest of the world.

Meanwhile, the economic data coming out of China points to the continuation of a strong recovery from the COVID-induced slowdowns of early this year. And their stock market also continues to do well, with the second best performance of any country in the world so far in 2020.

Last quarter, we mentioned Xi’s move to place Hong Kong under full control of the Communist Party. Apparently, his bet is that more closely aligning Hong Kong with the mainland will help its economy grow more than it would by being a unique standalone entity. Certainly, this also fits with his plan for China self-sufficiency. What remains to be seen is how the rest of the world responds to a much less free Hong Kong.

Investment Implications

We have long discussed the three themes that have been prevalent for more than a decade now: US stocks over foreign stocks, growth stocks over value stocks and US dollar denominated assets over non-dollar assets. There have been a few hints at change recently, but the actual shifts have been small. We will continue to look for signs of changing currents that would cause us to reconsider asset allocations.

Thoughts on the Current Outlook

July 10, 2020 Jon Zeschin

Three Key Thoughts:

1. Markets Ignore COVID Resurgence

2. Election Cycle Heating Up

3. China Flexes its Muscles

Markets Ignore COVID Resurgence

COVID-19 is demonstrating that it intends to be with us for a long time. As we emerged from the lockdowns of March and April, it was certainly reasonable to expect that we would see some increase in the number of cases. However, the volume of cases in certain states has been surprising, prompting many cities, counties and states to re-establish restrictions or closures. While these measures will most certainly delay the economic recovery to some extent, the financial markets have yet to react in any meaningful way. Indeed, US stocks have recovered almost all their losses from the first quarter as have the credit markets.

We think there are several possible reasons for this. First, the Federal Reserve has launched an extremely strong response, intended to stabilize the credit markets and provide liquidity to the economy. And they have said their programs will continue for as long as needed. That is about as supportive as a central bank can get! Second, the initial economic reports – jobs and consumer confidence, for example -- have been surprisingly positive so even if they become a bit less so, the trend remains in the right direction. Third, the stock market’s more recent gains have been focused on stocks that are seen as winners in “a living with COVID” world. Fourth, the choice between Joe Biden and Donald Trump for President may be perceived as less threatening to the markets.

Looking forward, the Federal Reserve’s stance is not going to change anytime soon so the course of the virus and its impact on our daily lives remains the biggest wildcard. It really is impossible to predict how this will play out over the coming weeks and months. Progress has been made in treating serious infections more effectively and unprecedented work on a vaccine continues. But we think the market is increasingly focused on what happens as we learn to live with this threat for some time to come. Some of the early winners in this world are already apparent but there will be profound changes to how we live and work that will take time to understand and play out.

The Election Cycle Heats Up

As if we do not have enough uncertainty in our daily lives, we are facing very important national elections in November. The participants in the presidential race are largely decided and battle lines are being drawn. Usually, an incumbent president has an enormous structural advantage over any challenger but two partially overlapping developments have diminished the advantage this time. First is the economic devastation created by the pandemic – in just a few months, we went from a strong economy and extraordinarily low unemployment to a tumbling economy and record joblessness. The second is the discussion surrounding systemic racial injustice and the appropriate policy responses. We believe that both issues will dominate the campaigns, not only for president but also many congressional races.

We said these issues are partially overlapping for two reasons: (1) COVID-19 infections have hit minority communities harder and (2) the economic impact from the shutdowns and restrictions have also been felt disproportionately by minority and lower wage workers. Income inequality has been a lurking issue for some time and the pandemic has blown it wide open. We expect to see civil unrest continue as politicians search for policies to address the problems.

More broadly, the markets will certainly be watching for specific policy proposals from Mr. Biden and gauging those against the odds of his winning election. Of special interest will be his stance on corporate tax rates.

China Flexes its Muscles

As the source of the COVID-19 pandemic, China is hardly held in the highest esteem by the rest of the world. However, to the Chinese, the success of their harsh, swift shutdowns and the government’s use of technology to control the spread of new cases are sources of national pride. The economic data coming out of China supports their view of a successful handling of the crisis. Correspondingly, their domestic stock market has been on fire. Of course, like any good autocratic leader, President Xi has been quick to seize on the national pride theme to expand his power and influence.

Most notably, Xi has effectively torn up the handover agreement regarding Hong Kong and is moving to place it under full control of the Communist Party. It is not yet clear what impact this change will have on Hong Kong as a financial hub. Regardless of the specifics, we do not think it is a positive for international companies doing business there. With the rest of the world pre-occupied with their own pandemic-related problems, there is no one to challenge Chinese assertiveness.

It is no surprise that China, having come so far economically in the last 30 years, would be in the position of challenging the US for global economic influence. But President Xi’s strategy of combining continued market reforms with ever tighter controls over the personal lives of Chinese citizens is puzzling, even to many students of the country. As China continues to build its economic power and influence, and Xi consolidates his domestic power further, we should expect more clashes with the rest of the world. But that does not necessarily mean we should avoid investing in a market that is growing and increasingly innovative.

Investment Implications

The investment lesson of the 2008-2009 bear market was to stay invested, while harvesting tax losses to the maximum extent possible. This is a playbook we followed over the last few months but most important was staying invested to take advantage of the bounce. Expecting a difficult road ahead for the economy, we have yet to add exposure to “early cycle” investments like US small cap and lower quality credit and will look for signs of more sustainable recovery before doing so.

Thoughts on the Current Outlook

April 12, 2020 Jon Zeschin

Three Key Thoughts:

1. COVID-19 24/7

2. Deep Recession but How Long?

3. Stocks for the Long Run

COVID-19 24/7

From the earliest signs of the outbreak of a novel coronavirus in China in December to the full lockdown across Italy to hundreds of thousands of cases in the US, the last four months have been a blur. Seemingly in an instant, we went from prosperity to despair. What made this threat so devastating psychologically is that it was unpredictable, uncontrollable and of unknown duration.

As we deal with what we hope are peaks in infection rates and deaths, our daily lives are filled with news about COVID-19 and new routines spawned by the need for social distancing. We are just beginning to see the effects of a nearly complete stop imposed on major portions of our economy. Millions have lost their jobs and thousands of small businesses are failing. While we hope the good news about the near term course of the virus continues, we know that the devastating economic effects will be with us for a while.

The Federal Reserve acted very quickly in cutting interest rates and starting a number of programs intended to stabilize the financial system and credit markets. And, fortunately, the Federal government has stepped in with unprecedented relief. In a shockingly bipartisan effort, Congress enacted new programs to provide lifelines to millions of people in need and incentives to businesses to keep people on their payrolls. They are discussing plans for more stimulus, as it becomes clear that the scope of the damage to jobs and economic activity is astounding.

Deep Recession but How Long?

With major parts of the economy simply shuttered indefinitely, there is no question that we are now in a very deep recession. The unemployment rate will go from historic lows to Great Recession highs in a month. Businesses of all sizes will struggle to survive as their revenues have plummeted. The service industries – particularly those in travel, leisure and entertainment, which have become such an important driver of our economy -- will take a long time to re-open and return to some sense of normalcy. Many will take this opportunity to re-think their business models and adjust them to a different future.

On the positive side, many of us have discovered just how productive we can be WFH. It used to be that “working from home” was a pseudonym for mostly taking the day off. In the last month, it has become normal for so many of us – even TV news anchors and late night talk show hosts – and we have discovered that we really can get a lot of work done. We suspect these new experiences will accelerate changes that were in their infancy across a wide range of businesses and education providers.

We expect the technology and health care sectors to continue to lead the US economy forward, even as many other service industries struggle to right themselves. Just as BYOD (bring your own device) revolutionized business communications over the last decade, we believe WFH will drive a faster move to the cloud and a focus on the infrastructure needed to support a geographically dispersed workforce.

Right now, our health care system is in crisis mode, dealing with the critically ill while working furiously on treatments and vaccines. Once the immediate crisis has passed, we expect to see changes in methods and regulations that will allow our health care delivery system to become much more efficient and allow development of new tests and treatments in a more timely manner.

One of the great marvels of our economy is its ability to adapt to rapidly changing conditions. We will see that phenomenon play out over the coming months and years. In the short term, the pain will be great but we are optimistic that the future will be brighter.

Stocks for the Long Run

Market reactions to the shutdowns necessary to try to control the spread of COVID-19 were swift and fierce. From their record high on February 19th to their low on March 23rd, US stocks dropped 34%. The speed of this decline was without precedent. Investors in bonds had a similar reaction as anything but US Treasury bonds sold off harshly. Even high quality municipal bonds and short term investment grade bonds fared poorly as only the safety of US Treasuries would suffice. Ironically, long term US Treasury yields were also exceptionally volatile so investing in these was treacherous as well.

A combination of three important ingredients has buoyed the markets since March 23rd. First, the Federal Reserve’s various programs have calmed the fixed income markets significantly, allowing more normal market relationships to be re-established. Second, there is confidence that the Federal government will provide a great deal of relief to those individuals and businesses most hurt by this crisis. Finally, and perhaps most importantly, there is an emerging view that we are near or perhaps even past the peak in new COVID-19 infection rates.

We are confident that the Federal Reserve will continue to be effective within its limits. And, if bipartisanship can be sustained for a while longer, the Federal government does seem focused on many of the right priorities. We are less confident in the course of this virus and how changes in its course might affect our ability to re-open the economy. For right now, optimism has allowed stocks to regain more than half their losses. We will be surprised if this holds through the dire economic news we expect to see reported for the next several months.

That said, interest rates are once again at or near zero, providing no return to conservative savers. With values having declined substantially from their peak, we believe stocks will likely be the better place to be for those with a longer term investment horizon.

Investment Implications

The investment lesson of the 2008-2009 bear market was to stay invested, while harvesting tax losses to the maximum extent possible. This is a playbook we are following once again. In addition, we will carefully evaluate expanding exposure to “early cycle” investments like US small cap and lower quality credit, where the potential rewards may now outweigh the risks.