The Perfect Storm
The Perfect Storm: Rising Rates, Falling Earnings, and Inflation
After 6 years of Z.I.R.P. (Zero Interest Rate Policy), it appears we are finally coming to an inflection point. All indications are that the Federal Reserve will raise interest rates by 25bps in December. While most economists and strategists acknowledge that a 1/4 point increase in interest rates should not have a significant economic impact, investors and markets are looking beyond the initial rate hike and trying to ascertain how quickly rates will rise and how high.
These are unusual times, possibly unprecedented. We have never been at zero interest rates this long and we have not seen a rate hike cycle begin with inflation so low (the Consumer Price Index ("CPI") is currently running at approximately 1.6%). Some might argue that CPI is a poor measure of inflation. They would point to the price appreciation we've seen in real estate values, rental rates, collectible art, healthcare , and college tuitions. They would remind us that the data is being skewed by the dramatic fall in oil prices and commodities in general as a result of the strong U.S. Dollar and falling demand out of China. And they would be correct. The questions we should be asking are: what is the correct way to measure inflation and are these trends transient or here to stay? Chair Yellen believes that the decline in commodity prices is temporary yet the FOMC doesn't see CPI getting to its stated 2% target for more than 2 years.
My fear is that policymakers tend to look at inflation from an academic perspective. That is, they assume that inflation will be well-behaved and will slowly move back towards their target. But is that how prices move in the real world?
Take the Minimum Wage for example. In New Jersey, the Minimum Wage is $8.38/hour. There is pressure building to raise that to $12 or $15 per hour like many other States have already done. An increase to $15/hour would be an increase of nearly 80%. Surely, we would expect businesses to immediately pass the majority of that cost onto their customers resulting in significantly higher prices on goods and services (inflation). And if they're not able to pass on those costs? We would expect them to lay off workers resulting in higher unemployment.
Either condition could derail our economic recovery. So the Federal Reserve is left to try to "thread the needle" and keep our fragile economy humming along. Unfortunately, we are dependent on so many other things going right. We need China to smoothly transition from a Manufacturing economy to a Consumption economy. We need Abenomics in Japan to finally bring the country out of recession. We need Quantitative Easing by the European Central Bank to stave off deflation. We need to contain ISIS and Al-Qaeda. And it happens to be an election year (read: more uncertainty).
What does all mean for investment portfolios? Normally, in periods of rising uncertainty, investors would reduce their exposure to Stocks and seek the safety of US Treasurys (or other perceived safe haven investments). But Treasurys carry significant interest rate risk in a rising rate environment. What about Stocks? With the strong US Dollar and weak global demand, we're already starting to see pressure on revenue and earnings. And after a 6 year bull market, many stocks are trading at elevated multiples. We believe that this investment environment calls for greater emphasis on security selection and risk management. We think we will see a wider gap between the winners and losers and among the various sectors of the market. We may finally see the shift back towards Active Management and Value-oriented investing.
Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results Opinions are subject to change.