March 8, 2023
“Enlightenment is: Absolute Cooperation with the Inevitable”
Anthony de Mello
Why do I contemplate my own mortality often? It may be that I have dealt with the grief of losing loved ones both old and young, or it may be that I spend time practicing contemplation and meditation. It may just be that I am hyper-rational, and I should focus on the obvious. But, whatever the reason, I think it probably serves me well. Why?
It allows me to simplify my life.
It allows me to acknowledge that life is short.
It allows me to focus on the question: If I die tomorrow, am I at peace?
It allows me to make definitive decisions relatively quickly and easily.
How do I attain peace?
Sometimes focusing and understanding what does not or has not brought peace in the past, can help bring the answer.
Having spent time focusing on the pursuit of selfish comforts and desires and realizing that this is generally a lonely and empty endeavor, the opposite of selfishness becomes the rational answer.
The opposite of selfishness is giving to others with no expectation of benefit in return.
By focusing all my energy on helping others, there is no reason to stress over: news, societal trends, opinions of others, politics, cynicism, etc. I have done the best I can serving others, and I have no need to worry.
There are always people close to me that are in need: spouse, children, family, friends, clients, employees, partners, and so on. You never need to go looking for someone that needs help; you just need to focus your attention on them.
The positive cycle as I see it:
We serve others, we help them achieve comfort and success so that they can have time to help and serve others, we find peace. Rinse and repeat! I will be long gone soon; it doesn’t matter. I am insignificant. Why? All that matters is that I contributed to this positive cycle. I used the gifts and opportunities I’ve been granted to help others use their gifts to help others, and so on and so on. The world literally becomes a better place. In my mind:
There is nothing else that matters.
This contribution is enough.
The more I contribute to the cycle, the more peace I attain.
The perverse side of life is that we all love our own selfish comforts, and we all pursue these comforts to some degree. For survival, humans have always needed food, clothing, and shelter to survive. We will fight to secure our own needs. This survival instinct is within us, we continue to pursue more even when we have enough secured for ourselves. It’s only when we go below the surface of life, reflect, and realize that we already have more than enough, that we can start living a full and peaceful life by helping others.
By focusing on my mortality, it allows me to live my mission of contributing to the positive cycle with less distraction. It’s a struggle to find the right balance. It is important to build resiliency in body, mind, and soul, to meet the challenge.
Building resiliency was one of the main reasons I took a month-long trip in February across the USA. If absolute cooperation with the inevitable brings enlightenment, I think resiliency is essential to see the inevitable and allow you to cooperate with it!
Why all this focus on my mortality and enlightenment? It is the foundation for my approach to my life and my work. This includes portfolio management. The de Mello quote above is exactly what needs to be done to successfully navigate markets: absolute cooperation with the inevitable!
What is inevitable (as far as I can tell) in the financial markets? What must we cooperate with to become “enlightened”, and hopefully richer, in pecuniary terms?
1. The cash in your account today will be worth less in the future than it is today.
My main job is to protect against this erosion of purchasing power of goods and asset prices.
This erosion will not happen in a straight line. Most people will focus on the price changes in the short run (both negative/fear and positive/greed), and that usually causes investors to make mistakes.
By focusing on one’s liquidity needs, risk tolerance, and a long-term plan, we should be able to help protect and grow wealth.
2. Capitalist / Democratic countries with strong legal systems tend to innovate, grow, and evolve.
This creates opportunities to earn money by investing in a diversified portfolio of stocks and bonds over long periods of time. It is not a zero-sum game.
Well-meaning governments, central banks, and investors will make mistakes which provide opportunities to invest counter cyclically.
By paying attention to evidence, probabilities, cash flows, and cooperation with the inevitable in point 1 above, we hope to grow wealth with lower volatility than the overall market indices.
What sums up my thinking currently?
We are trying to survive in a difficult market with many cross currents. This is why we continue to position portfolios defensively for a given level of risk tolerance across our portfolios. We are happy to be paid the current higher interest rates on offer.
We suspect inflation was predominantly last year’s problem. Sure, there are still signs of inflation, but it does not seem entrenched in the economy.
The Federal Reserve must talk and act tough as data for growth and inflation is higher than expected. We suspect they will (and perhaps have already) hiked more than needed because they have painted themselves into a corner. Bottom line, I believe the Fed will kill inflation (and hurt growth to some degree). Current levels of interest rates are probably a short-term gift that won’t last for a long period of time.
We hear a lot of talk that the end of zero rates and central bank balance sheet expansion is over. Maybe, but if growth falters, I suspect that central banks go back to the same playbook. How low rates will go in the next cycle is an open question, but I bet they will be lower.
Governments and Central Banks have taken a lot of mark to market risk out of the economy. All else being equal, there should be less distressed selling of assets during this cycle.
Household and corporate balance sheets are in good shape (in aggregate) because of the Covid money giveaway and low interest rate policy which allowed borrowers to lock in low-rate interest loans for extended periods. All else equal, this should help the economy through a potential recession.
Below is more of my stream of consciousness and thoughts to give you a better idea (or perhaps confuse you) on my thought process. You can stop reading here if you are happy with the summary above.
As always, I am happy to discuss my views; please just email me.
Inflation and Interest Rates: The Fed kept monetary policy way too loose in 2021, they are likely too tight already in 2023. As I have said before, the one thing that is certain with central bankers is that they will make policy errors. I am not judging them for this; it is a tricky business to navigate uncertainty and politics at the same time. The Fed needed to contain inflation and they aggressively hiked interest rates from 0 to soon to be 5% (and maybe more) within a year! You have heard economists say: “monetary policy operates with a lag”, Yes it does, and yes it will. Why? It changes the behavior over time of all players in the economy. Lots of businesses were built in the last decade that require new cash to continue to grow. These businesses experienced price appreciation because of investor “FOMO” (the fear of investors that they would miss out on these incredible new opportunities; SPAC’s, Crypto, private investments, etc.). You cannot blame them; cash was earning approximately 0% approximately one year ago today. No longer; that same cash can earn nearly 5% with very little risk of capital loss.
Behavior has already changed in many ways. From our own business and the business of other RIAs across the country, I’ve observed the following:
Investors hold more cash.
Investors own more short-term fixed income.
Investors own less equity overall.
Investors have paid down high interest rate debts.
On the other hand, businesses that need cash are having a harder time. I’m being told that money is harder to come by for those that need it to continue operations. This makes sense as investors can take less risk and earn a substantial government guaranteed return.
We have seen price increases in goods, services and in labor, during the past year primarily (I suspect) because pent up demand occurred after Covid, AND there was plenty of money available to everyone from both the government and the Federal Reserve. Now however, the Fed’s priority (as they’ve communicated) is to ensure that inflation does not become “entrenched” in the economy. My translation: The Fed’s primary objective is lower inflation, and they will risk a recession, unemployment, and lower asset markets to accomplish this. As I have written previously, I take them at their word, and I believe they may have already done enough to accomplish their task.
The Economy and Markets: If I think the Fed may have overdone their tightening already, should I be worried that stock, bond, and other asset markets are vulnerable to further downside? Should I be more concerned about a recession? I’m inclined to believe that there are significant differences to this cycle. So, despite one of the most aggressive Fed rate hiking cycles in history, I suspect the economy in the coming few years is on better footing than many expect. I won’t go too far into the weeds for the lay reader, but some of the major differences as I see them are:
Transfer of systemic risk from the private market to the government. Not to get too detailed, but the systemic risk of a 2008 style crisis is much lower because the government has been and is willing (and for now has the ability) to take risk onto its balance sheet where needed. Losses can be spread over long periods of time, and there is less reason for panic selling to raise cash quickly.
Household net worth (despite the decline in stock and real estate markets in the past year) has gone from $104 Trillion in Q1 2020 to $135 Trillion in Q1 2023 according to the St Louis Federal Reserve. There is simply a great deal more wealth in the hands of households from the great Covid giveaway. This is a huge increase in a very short span of time. Consumption should hold up far better than in previous cycles because of this.
As discussed above, investor risk in equities has been reduced: excess savings is earning a very healthy rate of income. We have a healthy respect for what excess cash can earn now. We are less likely to throw it away on speculative investments that often are just a sexy narrative with little chance of profitability. Cash flows are important to investors now, and that is healthy for the economy because we are making more rational allocations of capital.
Demand for housing seems to be outstripping supply. Activity in the real estate market is showing signs of weakness. Our real estate partners continue to tell us about the lack of inventory that is the cause of the slowdown. If people have a 3% mortgage, how can they move to a larger home if their new mortgage will be more than double the rate? Housing starts are weak probably because the high cost of capital. It’s hard to see panic selling in this kind of market; I suspect prices will remain supported.
The Government Deficit: Global debt levels domestically and globally are worryingly high compared to history. The media and politicians are starting to focus on government obligations because they are unsustainable. Shouldn’t I be more concerned about this? My process is to weigh these risks among all the other risks, and that is why I focus on what changes will have the greatest impact over the next 12 to 24 months within our longer term 5-to-10-year investment horizon. There are reasons for some optimism that the media doesn’t talk about in proper context:
The government will indeed be paying higher rates on their debt, but savers and creditors are going to be earning higher interest income. The point is that it isn’t all one sided negative.
I do get concerned when the USA spends (and wastes) money without regard for the consequences (as I expressed during the Covid spending spree). The government generally (except in cases of a debt crisis) has long periods of time to work these issues out. Government debt is clearly becoming a topic of concern and discussion in political and media circles, and I suspect it will focus attention on addressing waste.
Remember that the USA prints the paper currency on the debt they issue. The value of this paper currency declines over time through inflation. Hence, the current debt obligation for the US Government declines through time.
The Fed will likely start an interest rate cutting cycle in the future which will once again lower the interest rate burden of debtors.
International Markets and Politics: There are clearly a lot of changes happening on the world stage. I do not want to make this a judgement of how I believe governments should govern. I only want to list what seems clear to me (this may be naïve, but it is how I see things):
Western liberal democracy is not compatible with the governing approach of China and Russia. There are many other countries as well, but these countries are where the biggest changes are taken shape.
The USA will promote western liberal ideas through more rigid and more aggressive tactics.
It looks to me that liberal democratic countries will align more closely and strongly together despite the economic risks.
Russia / Ukraine is a proxy for the new world order; countries must choose their alignment.
China is powerful, they desire to be self-sufficient and to grow their world view. Without Russia to keep the west in check, their domestic/international challenges grow. China has been clear in their support of Russia (out of necessity).
The US is making it clear that if there is too much military support of Russia, they will put more economic pressure on China (tech and other industry sanctions). This is a pain point for supply chains globally. There is a willingness to hurt the global economy for the greater goal of maintaining the liberal democratic world order.
Companies are already recognizing this and are working quickly to move supply chains as much as possible to India, Southeast Asia, Latin America.
How do I think things will play out?
I see Russia’s position as untenable, but who knows what the resolution of that situation will look like internally. It could potentially be worse with a new government.
I see China as keeping its options open. They continue to play the long game. They are the ultimate pragmatists. Just look at Covid policy and then its abrupt reversal. They can play tough, but if Russia falls into disarray, they will likely engage the West on more conciliatory terms in the short term.
In the meantime, I see China continuing with their economic growth agenda. They should add liquidity to the global financial system through both fiscal and monetary stimulus because it is imperative to keep their economy moving forward given the challenges they face domestically and internationally.
There are potentially positive and negative scenarios to weigh here. I suspect China is idealistic in the long run, but pragmatic in the short run to achieve their long-term goals. I see potential for a dialing back of tension at some point which would be a net positive for world growth, but it is a tough call to make.
The New Paradigm?: There has been a lot of talk in my circles that the world of central bank balance sheet expansion is over. Zero interest rates are over, and that the world now will have to deal with the reality of borrowing and spending in a high interest rate world. Time to pay the piper so to speak in this unsustainable situation. It’s possible, but I am not so sure. If I am a central banker at the Fed, and I’ve been able to put out fires since the tech bubble burst in 2000, and I have seemingly gotten better at this game, I might be inclined to continue with this same prescription for as long as I can. Essentially, without a significant economic crisis where the prescription is not working anymore, I will continue with the same course until disaster forces me to change course. I am not confident that the world has changed yet. What does that mean in layman’s terms? If inflation slows, and unemployment is rising too much, I’m going to be cutting rates quickly.
Someday I do believe the longer-term debt cycle will end, but I may be dead and gone by the time that happens, so my focus in the meantime needs to be on managing portfolios based on the probabilities I see in front of me.
Noisy Data, Changing economic relationships, Technological innovation:
I realize that a lot of what I am suggesting above is predicated on the view that growth and inflation are slowing and that I do not see inflation entrenched in the economy. I could be wrong, but to me the balance of risks suggest that rising interest rates are doing their job. Covid, work habits, government spending, and many other changes in behavior have made forecasting economic relationship much harder in the short term than they would have been previously. Technological gains across a multitude of industries are likely increasing productivity across the globe. Energy is transitioning slowly to a more climate friendly future. There is so much that nobody understands. I urge you to focus on the big picture which is economic development and growth; this never seems to stop.
There has not been a great deal of change in the portfolio since the start of the year. You could refer to our 2023 Observations and Outlook here for more detail: https://www.augustwealthadvisors.com/post/2023-observations-and-outlook
The small changes we have made have been to sell some individual companies and equity indices that performed well in the first two months of the year, and we purchase slightly more fixed income (bonds). Yield to maturity on most of the ETF’s we own, currently range from 4% to 10% for varying degrees of credit and duration risk. This higher allocation to bonds simply represents:
More certain cash flows across our portfolios in an uncertain environment.
Even if inflation does not fall below the Fed’s target, we feel we are being amply compensated.
The belief that economic growth will slow, but not enough to cause a major recession nor a major credit blowup (the government and companies will be able to service their debts).
Risks to the portfolio:
One risk to the portfolio is that the Fed hikes much more than forecast. Both fixed income, equities, and commodities would likely decline further. However, this is in essence why we remain positioned relatively defensively. We are comfortable for now because we still have short term concerns for lower equity prices.
The other risk is the top of the interest rate cycle. Many investors (understandably) want to hold cash and short dated government bonds because they are getting paid a high rate of interest. As of today’s typing, two-year US Government notes are yielding approximately 5%.
Why do I worry about this? I get paid 5% / year for 2 years for doing nothing! Well, if the Fed has already tightened too much, the economy slows, inflation slows, what will the Fed do? The Fed will start adding liquidity (potentially aggressively) by cutting interest rates. The price of the 2-year notes will go up (price moves inversely to interest rates) in the short run. If I want to re-invest in those notes, I will have to invest at a much lower interest rate. As stated above in point 1, my job is to protect against purchasing power in the long run. If rates go back toward 2%, I will not feel adequately compensated anymore! Then what?
What do I think could happen?
Rates drop (liquidity added to economy)
Dollar declines (from historically high prices against many world currencies).
International markets outperform on a local currency basis.
Commodities and commodity currencies go up in price.
Longer duration assets such as tech companies go up in price.
Because I must protect cash against erosion of purchasing power and higher asset prices, I must be careful when the portfolio becomes too defensive. I don’t feel like the risk is imminent, but it seems to me that many portfolios are already positioned defensively like ours. Hence, I will start strategizing about the next cycle now!
Joseph Cardello, Principal
August Wealth Advisors, LLC
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Westport, CT 06880
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