Greetings and Happy Summer! I hope that your rivers have plenty of clean water, your temperatures are reasonable and that your health and relationships are strong.
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"Life is a train that stops at no stations; you either jump aboard or stand on the platform and watch as it passes." Yasmina Khadra
"Our life is a constant journey, from birth to death. The landscape changes, the people change, our needs change, but the train keeps moving. Life is the train, not the station." Paul Coelho
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Interest rates, (like a train), DRIVE a credit-dependent economy. Period.
Drive - definition (verb): "Propel or carry along by force in a specified direction."
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As I've insisted for years, there are clear, definitive, observable, interest rate cycles observed in the financial economies of the world. Interest rate cycles are certainly influenced by both inflation (excesses), and disinflation (corrections).
"Cycles are best understood as stemming from excesses and corrections." - Howard Marks - Oaktree - July 10, 2023
Remember I said in my Insights back in March of this year that 'Inflation is SO yesterday'?
"Forget all the propaganda we're hearing - that the chairman of the Federal Reserve has a tough problem, that this is going to be a long fight, things are 'sticky' and so forth. Things aren't sticky." - Steve Hanke - Professor, Johns Hopkins University - July 13, 2023
This lack of inflationary impulse may send the neophyte stock market bulls further momentum buy signals because the brunt of demand destruction that occurs when rates move this far this fast hasn't been fully realized yet. The little secret is that despite earnings being largely negative, and despite credit quality erosion within the economy, stock indexes have risen in many cases.
Reports of inflation and unemployment (lagging indicators), and even GDP of +2.4% the latest report, are grossly exaggerative and very misleading at this point in the cycle when you consider the CYCLE.
Let's continue to focus mostly on LEADING indicators (while not dismissing the coincident and lagging indicators for sure):
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Interest rates as a leading indicator. Margin rates at investment firms are around 12% for most loans under $1mm. Many private equity firms are being forced to borrow money at interest rates in the teens whereas they were around 5% under a year and a half ago. These sudden moves matter a bunch.
You've heard me say that Delta Airlines has gone from borrowing 7 year money from sub 3% to over 8%...
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Fade the Mt. Denali peak and look for a ski slope (a Rocky Mountain ride if you will), DOWN the other side of the mountain in the future...
We won't be talking about 'Higher for longer' in 2025. The economy cannot handle these levels of rates. The Fed lowered rates pre-Covid after the prime rate being at 5.5% turned out to be too much for the economy. Does anyone really believe the economy can handle a prime rate at 9%? For how long? Two weeks (sarcasm inferred)?
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SOFR (Secured Overnight Financing Rate), replaced many LIBOR (London Interbank Offering Rate), interest rate contracts as of 6-30-23
[click here]<>Fed's note on LIBOR to SOFR transition-6-30-23
*NOTE: I point out the Tuesday, Sept 17, 2019 SOFR reading of 5.25% because that was a day that was a level that forced the Fed at that time to step in and help overnight funds trading due to a level that turned out to create too many problems. As of July 28, 2023 (last week's 5.3%), we've now surpassed that previous 'stress' level.
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Pre-retired client to me:
"Okay, okay, nerd; what are you buying me to keep me safe, help me not lose too much money, and give me income so I can afford to be/stay retired?"
Bond buy list:
Municipal and Govvy:
~10 year A+ rated municipals that are yielding 4-5% per year;
Federal Farm Credit bonds just shy of 7 years yielding 6% per year;
Secondary market CDs w 5% short-term yields w FDIC insurance priced at par or under;
FDRXX Fidelity Government Reserves Money Market Fund-July 2023 (Fidelity Govt Money Market been around since the early 1970's is yielding 4.98% (as of 8-2-23 (per Fidelity website));
Corporates:
A select handful of corporate bonds that are correspondent to stocks of public companies Warren Buffett and Berkshire Hathaway (who is reportingly buying US Treasuries at these levels (just sayin')), that are yielding 6-8% per year that are BB+ rated or higher (I don't wish to list here);
...(see chart of 7% level below)
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Growth:
Select Japanese dividend-paying stocks with low price to sales ratios; in the US, it's traditional energy equities like Exxon, Chevron and Kinder Morgan; and defensives like Walgreen's, Kroger; Utilities like Southern Company, and reasonably priced food stocks like Flower's Foods and ConAg. We've been trimming tech stocks like AAPL, MSFT, and even CSCO for a couple of years now. And I know, I know (believe me I know)...they've run higher despite softer revenues and earnings, but I just don't think that bidding up the price to stratospheric levels ahead of a recession is a smart idea. We've seen 5-7 names that have driven the broader indices higher and when breadth is that narrow, it's typically a negative development.
Glaxo over Lilly
GSK is priced at 1.9 x sales with a 4% dividend and a 40% payout ratio, has reduced $6B in debt (thru their Haleon consumer businesses spinoff);
LLY is priced at 15 x sales with a 0.99% dividend and a 67% payout ratio, has increased their debt by $6B.
I'll fade Lilly and buy more Glaxo please and thank you.
The point is to invest in such a way to have dependable, sustainable, income to distribute. Not income that is subject to dividend cuts or even being wiped out all together like the case of Budweiser's dividend cuts (pre-Bud Light controversy), and Disney's dividend suspension.
I know I mentioned in March how precarious I felt the regional banks, many real estate investment trusts and private credit (in general), are...I am still thinking that way and we are zero-uber-light those areas still.
In the driver's seat as a creditor
The governement, it's agencies, municipalities and corporations cannot cut or suspend their bond interest payments to a creditor (bondholder), without declaring bankruptcy. Bondholders are 'up the capital structure', as a mentor of mine used to say.
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Alright, let's start to wind this missive down...
The New York Fed suggests that the U.S. consumer is not in as great of shape as the popular narrative suggests. For example, their July report indicates that for every household loan category they track, the banks'/lenders' 'decline rate', to consumers' loan applications is higher than at any point in their historical reporting of all of the series of data points.
Also, it pays to pay attention to the turn in the delinquency cycle (chart below):
*NOTE: You can ignore the red 'Student Loan' line for 3 years up until October of this year as those payments have to resume. My thought is that that payment resumption will likely cause the others to hook higher in months ahead.
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Why is reporting on debt balances, composition of debt, and delinquency data important?
History shows that after an extended period of debt growth (leveraging), comes the flattening of the debt growth, and then the dreaded repayment (deleveraging).
That period of debt repayment and 'contraction in credit' that economists call it, tends to usually coincide with lower than average capital market interest rates.
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EARLY...I know...
WIth the 10 yr UST stubbornly holding onto the 4% level and even trying to test the November 2022 high of 4.22% (let's watch that level), it has been TOUGH to 'read the tea leaves' of late to say the least.
Let's maybe think of it this way as investors:
We've had 7-8 years of bond yields being way too low and thus bond prices as being too high for that long, but the last two years has seen bond yields too high and thus their correspondent prices too low. AND last year was the worst bond year on record. SO, since we've got that one behind us and may not see another one of that magniture for another 40 years, so let's try to keep things in perspective.
To say again, this has been a VERY, VERY difficult investment environment. One 10+ year client has already fired me for us being essentially flat for three years. This is despite my direct competitors being down -20% for the same time period. And they are huge firms with tens of billions of dollars under management in a similar sleeve. But I get it. That's not what our goal is. Ever. But, all I can say is I've lived through this pendulum-swing into extreme-greed-territory ahead of a recession two times already and this is the third iteration. It's not going to end well. What? The boom-bust cycle. What happens when bonds have a +20% year and the stock market is down -25%?
The 10 yr UST at a 4.25% level? With Covid and Ukraine war I thought it might peak at those levels in this cycle. I surely did not expect the Fed to go to 5.5% on the Fed Funds rate for this cycle. It's really an indication of just how much budget-busting robbing from the public purse occurred with all of the freebie loan handouts more than anything fundamental (to be blunt). Notable are Powell's words last week when he said that he expects the current neutral rate is around 2.5%. He also said he expects to lower interest rates next year (2024). If he is right about the neutral rate, that would imply a Fed Funds interest rate cut of 300 bps from current levels. I'm not predicting that, I'm simply passing along and reporting what he said last week. And by the way, have you heard ANYTHING about that? The stock market has become such a momentum casino that fundamental analysis is simply ancient hieroglyphics...
Observations
The Fed has been way too bullish on their interest rate forecasts since Bernanke (Covid '19 pandemic and first shooting war in 80 years and entire economies being 'turned off' and 'turned back on' aside>supply chain havoc).
"The debt crisis in Japan is especially relevant to the United States. In America, debt is on a similar trajectory as the one experienced in Japan. Like Japan, the United States will probably not experience insolvency in the near term. The Congressional Budget Office projects retardation in economic growth will continue over the next three decades, with annual growth rates falling below 2% (CBO 2020). Over the next 30 years, the United States will look more like Japan in other ways as well. When high debtor countries, such as Japan and the United States, experience 'debt fatigue', the outcome is less certain." Authors: Poulson, Merrifield & Hanke (Public Debt Sustainability: Intl Perspectives (2022))
In closing, by way of reminder: Muni spreads might widen, but may not; corporate spreads probably will, and the bank drama is not over, and the U.S. consumer is not in as good of shape as the narrative suggests (and remember, the consumer is over 70% of the U.S. economy and so reading that mostly right is a big deal), AND lastly, there is a limit to just how far the Fed can go with their huge, sustained increase in interest rates, and they're nearly done raising the Fed Funds rate, (they won't want to do much in a 2024 election year), SO...the BEST, risk-adjusted rewards as an investor, for 2024 and 2025 are in the bond market, NOT the stock market. That's of course an opinion, not a guarantee, but I do have some history on my side with that statement.
Deep breath
I have unfortunately, had to say goodbye to a few clients this year due to their untimely passing. Please know that if you are a family member of a client who has passed away, I am praying more for your family this season than normal; I feel the loss every now and then and I sympathize greatly with you and your family and friends for your loss. On the other hand, there have been some wonderful stories of weddings, promotions, business sales, retirements, goals successfully reached and some beautiful, wonderful babies born lately into client families' next generation and it's a beautiful, beautiful thing for which to be thankful.
On that note, I'll end this note.
Have a wonderful rest of your Summer and start to your Fall!
I have a great job and people like you make it possible. THANK YOU.
Yours,
Jack Parsons CTFA, AEP
President & Chief Investment Officer
Vickery Creek Capital Management, LLC
Sources: Bloomberg, WSJ, Marketwatch, CNBC, NY Fed Research & Statistics Group (Center for Microeconomic Data)-July 2023, St. Louis Fed, Atlanta Fed, San Francisco Fed, Rosenberg Research, Richard Koo (Nomura Securities), Fidelity Institutional Wealth Services, “NY Fed DSGE Model Forecast-July 2023”-Liberty Street Economics, "Public Debt Sustainability: International Perspectives", Poulson, Merrifield, Hanke, Lexington Books-Jan 2022, "Inflation is 'history' for the U.S., says veteran economist Steve Hanke (Johns Hopkins)-CNBC-July 13,2023, "Fiscal Policy Under Low Interest Rates" - Olivier Blanchard; MIT Press, "Is the COVID-19 Pandemic a Supply or a Demand Shock?"-St. Louis Fed (Brinca Duarte, Faria-e-Castro)-2020-#31-"Economic Synopses' (Series), Chicago Fed National Activity Index for August 2021, "Grande" Difficulties in Chinese Property Market-Rabobank-Oct 2021-Australia Economic Update, "The Sahm Rule and Predicting the Great Recession Across OECD Countries"-working paper NBER-Sept 2021-Prof. David Blanchflower (Dartmouth), “A Tangled Web: Impact of Supply Chain and Inflation on the US Economy” – Moody’s Analytics, 2021 – Dec 7, “The War on the West” – Douglas Murray – Broadside Books,NY Fed Secondary Market Corp Credit Facility (policy & implementation group), 'Blackrock Sees Shallowest Interest Rate Hike Path in Decades'-Blackrock Investment Institute-Bloomberg Surveillance-Sept 27, 2021, Wal Mart Corp, "Australia Economy Could Slide Back Into Recession, Citi, AMP says"-Bloomberg-Aug 30, 2021, "Changing role of neoliberalism across the stages of economic development"-Richard Koo-Nomura Research Institute, Japan-2021, "The Aftermath of Debt Surges"-working paper NBER-Sept 2021-Kose, Ohnsorge, Reinhart, Rogoff, "Corporate Buyout Loans Near Highs of 2007"- WSJ-Matt Wirtz-Sep 26, 2021, Dr. Howard Hendricks: 1968 talk to an assembly of folks in The Navigators, [Columbus Bible Studypodcast], Liberty Street Economics: 'The New York Fed DSGE Model Forecast-Sept 2021', 'Low Interest Rates'-Speech Remarks-Stanley Fischer-Vice Chairman-Federal Reserve-40'th Annual Central Banking Seminar-NY Fed-Oct 5, 2016, KB Homes Investor Presentation; Capital Structure page 23-First Q 2023, "The International Experience of Central Bank Asset Purchases & Inflation"-NY Fed-Liberty Street Economics-(Benigno, Pesenti)-Oct 20, 2021, Thompson-Reuters, Securities & Exchange Commission, FINRA, iR Research,Vickery Creek Capital Mgmt., LLC