The World As It Is
Even in the midst of disfunction one has to find one’s own clarity to survive so here is some of mine at this point. Higher interest rates here are not a function of economic strength but what’s at work is quantitative tightening along with deficit spending that is skewing the supply of treasuries offered for sale.
What the heck does that mean? During the last few years, the Fed and monetary policy has been hugely accommodative. In order to buffer the economy, they used quantitative easing (something begun during the '09 financial crisis) which effectively sees the Federal reserve buy back bonds to reduce interest rates and push cash into the economy in order to manage interest rates and hopefully spur growth. Well, that party has come to an end. The balance sheet of the Federal reserve is extended and so, now, the process is being reversed. In this instance the Fed sells Treasuries to reduce their balance sheet and sop up extra liquidity to help slow economic growth. Basic result = supply of treasuries for sale goes up.
The next problem is deficit spending. Our country has been in deficit spending for more than 20 years. Just to explain, during deficit spending you spend more money than you bring in. And how do you fund deficit spending? Well in many cases you sell treasuries to finance that spending. So, again, you are increasing the supply of treasuries on the market. And since, at this moment, there is uncertainty about the economic future, the supply of treasuries is exceeding demand and when this happens rates rise. Do I know how this end. Nope. What I do know, however, is that the increase in the Fed interest is going to play through to interest on the debt (now 33 trillion). In the good old days at 1% this amounted to around 330 billion of the budgets and could be adjusted into the annual budget. But what happens at 5%? Well, this equates to roughly 1.5 trillion in just interest payments. How does this relate? Well right now the entire annual budget for the United States is somewhere around 6 trillion so the interest payments of 1.5 trillion would be roughly 25% of the total budget. Now, of course, I would expect the lawmakers to hide from the issue by simply rolling it into debt but guess how this happens? More treasuries get sold. View on stocks
So how does this impact my view on stocks? Longer term there is always a place for well-run, well-placed companies in the economy. In ways, invention will always be moving forward. I tend to have more faith in such companies than I do in the ability of our elected officials to make the right decisions or – at the very least – do the math to recognize the problems. I do believe they will get it over time as the electorate demands it, but for now I don’t see immediate help here. This leads me to conclude that there will be opportunities, but they will be highly targeted. The environment where macro tailwinds push along all stocks is gone. Those companies who effectively meet their customer’s needs and do so efficiently will set themselves apart over the next 5 to 10 years. In many ways this isn’t a bad thing. During periods of loose monetary and fiscal policy you get a lot of distortions as less attention is paid to efficiencies and effective corporate stewardship and more attention is paid to sexy ideas. I am not saying you can’t have both but the days of selling a cool idea without backing up the profitability metrics is over. As always, I hope this note finds you well.