<September 19, 2023>
The song “Cat’s in the Cradle” by Harry Chapin was released in 1974. The song is narrated by a man who is too busy to spend time with his son during childhood. The child grows up to become a man and finds himself too busy to spend time with his father. At the end of the song, the father reflects on his son’s life and realizes his boy grew up to be just like him. For many of us growing up in the 1970’s, the song struck a chord. It certainly did with me.
For much of his life, my dad was our family’s sole income provider. When he retired and finally had more free time, I was beginning my career and was eager to emulate his work ethic. Like my dad, I too wanted to be a provider. I spent long hours at the office, often going in on weekends and holidays. After our children were born, I continued to spend much of my time working or thinking about work. And in 2016 something I never expected happened. I recommended returning capital, fired myself, and was suddenly unemployed!
Fortunately, it wasn’t too late. Our children were still young, and I had the opportunity to make up for lost time. I spent the first weekend unplugged from my career in Lake City, Florida, watching my daughter play softball. And when I got home, I threw a baseball in the backyard with my son. Just as Harry Chapin predicted—we had a good time then.
As a proponent of capitalism, I find the Federal Reserve’s intervention in the free markets appalling. Nevertheless, I’ll forever be grateful for the Fed’s quantitative easing and its massive wave of asset inflation. Without the Fed’s bubbles, I may have never stepped away from my career and discovered a healthier work-life balance.
Based on current equity and bond prices, the last thing we’d call financial markets is balanced. Just the opposite. Bonds are screaming something isn’t quite right, while stocks are suggesting things have rarely been better. It’s quite simple in our eyes. After many years of 0% rates and $8 trillion in quantitative easing, the Federal Reserve created two enormous asset bubbles in stocks and bonds. The bond market bubble has popped while the stock market awaits its pin.
Given valuations, we believe equity investors are anticipating the bond market bubble will return. While reinflating asset bubbles isn’t easy, we don’t blame equity investors for their rationale. The Fed’s track record of resuscitating bubbles is well documented. After the 1999-2000 stock market bubble burst, the Fed aggressively cut rates, encouraging the housing bubble and another stock market bubble. Once stock and home prices crashed in 2008, the Fed came to the rescue again, inflating a variety of asset bubbles over the next decade. In effect, the modern Fed, with its “powerful tools,” has conditioned investors to expect a quick and aggressive response after each bubble’s demise.
And it’s not just equity investors that need the Fed to return to its easy money ways. As the U.S. government’s debt and interest expense soar, the pressure to reduce rates and resume debt monetization is increasing. Further, as the debt maturity walls of corporations and commercial real estate approach, the drag from higher rates on earnings and the economy will increase. Banks also need lower rates as their deposits are leaving to find higher yields. Moreover, the Bank Term Funding Program that has allowed banks to value their collateral at par ends on March 11, 2024. The Fed will either need to extend the program or reinflate the value of the collateral (bonds) by cutting rates.
The frozen state of the real estate market is also pressuring the Fed to cut rates. In a recent interview with Bloomberg, real estate mogul Barry Sternlicht explained the mindset of real estate investors, saying, “Right now you have an unusual situation in the real estate market because everyone is looking at the yield curve and rates will be lower later. Everyone says survive until 2025. Hold on to your assets.” In effect, if you can make it to 2025, you’ll be fine as interest rates will be lower and low-cost credit will be flowing again. It’s simply a waiting game.
Surviving until 2025 appears to be the playbook for many borrowers and asset holders. Higher rates don’t matter if you don’t have to pay them, or they don’t dent your portfolio's value. And for equity investors, why wait? Based on valuations, it appears stocks have already discounted lower interest rates in 2025, and 2024 for that matter!
At this stage of the market cycle, it’s very unusual for us to agree with the crowd. However, we too believe the Federal Reserve will be forced to cut rates prematurely. What we don’t agree with is what happens next. Equity valuations suggest it will be business as usual with the return of easy money forcing investors into risk assets, driving stock prices up further. We’re not so sure. Things are much different today compared to past periods of monetary easing.
We believe wealth inequality has become too extreme and contentious for another round of runaway asset inflation. As noted in Scared Money Don’t Make Money, the working class has been left behind and appears committed to making up lost ground. Housing affordability has been particularly troubling. Home prices inflated significantly during the last round of quantitative easing and were never allowed to correct this cycle. If the return of monetary easing causes home prices to rise from already unaffordable levels, we believe there will be backlash. The Fed needs to be very careful here. The working class and younger generations may discover who is responsible for their inability to own a home.
The return of easy money and asset inflation will also increase the risk of reigniting consumer prices. During past periods of ultra-easy money, much of the Fed’s inflation was contained in asset prices. More recently, asset inflation has shown signs of spilling over into goods and services. Rising portfolio values have encouraged experienced workers to retire early, resulting in lower labor availability and productivity—both inflationary. Further, more businesses are discovering the advantages of catering to the wealthy and are setting prices accordingly. With bulging home and portfolio values, higher income consumers are more likely to accept price increases and are generally more profitable. Last week, Kroger discussed this trend, saying, “If you look at the higher income household, that growth continues. That customer is meaningfully more profitable because of buying a lot of fresh product and buying bigger-sized products and things.”
In addition to focusing on the wealthy, companies have structurally changed their marketing and pricing strategies (Make Less Make More) over the past several years. Fewer businesses are striving to gain market share through discounting and volume. They are much more strategic and have learned that more isn’t always better. Higher prices and less volume can go a long way in maximizing returns on increasingly expensive capital, labor, and equipment. In effect, the mindset of companies on pricing, volume, and profitability has changed. The return of easy money and sharply rising asset prices could accelerate corporate trends in pricing and demographic targeting.
Tolerance for another inflation mistake by the Federal Reserve is also different today. While the rate of inflation has come down, the inflation accumulated over the past two years was meaningful and continues to weigh on most Americans. Simply put, prices haven’t come down and purchasing power hasn’t returned—the hurt remains. If the Fed loses control of inflation again, there will likely be consequences, including social and political pressure for change. In our opinion, the days of excessively enriching asset holders over the working class comes with considerable risk for policy makers.
The financial markets are out of balance. To justify current valuations, equity investors need the Fed to cut rates and reinflate the bond market. Once easy money returns, equity investors are anticipating additional capital gains just like past periods of negative real rates. We disagree and believe too much has changed. Accumulated inflation, wealth inequality, and structural shifts in labor, pricing, and demographic targeting have increased the risk of another Fed-induced easy money mistake. In our opinion, the next great opportunity in stocks won’t be because loose monetary policies work, it will be because they fail and are proven counterproductive. When investors realize the old playbook of effortlessly riding the Fed’s wave of asset inflation no longer works, we expect valuations and opportunities will improve. We believe those positioned differently, patiently, and with liquidity will be rewarded. You know we’ll have a good time then.
Eric Cinnamond
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Definitions:
Maturity wall: The period in which many existing debt arrangements come due or approach maturity.
Quantitative easing: A monetary policy in which the central bank increases the money supply in the banking system, as by purchasing bonds.
Negative real rates: A negative real interest rate means that inflation is higher than interest rates.
Yield Curve: A graphical representation of interest rates on debt for a range of maturities.