Irrational Exuberance Redux, the Fed, and a Look at 2023

Irrational Exuberance Redux, the Fed, and a Look at 2023.

Our central bank's 12- year inflationary credit expansion, accompanied by artificially low-interest rates, with the added benefit of unprecedented fiscal stimulus, accelerated numerous capital misallocations resulting in tech bubbles, significant equity overvaluation, and real estate gone wild, to name a few, deluding most investors into a false reality. In short, our money supply was unregulated. Under scrutiny, the Fed might say, "mistakes were made." The proverbial piper still needs to be paid.

That summarizes our last decade.

Looking ahead, we've had recent "good news" that employers added 223,000 net new jobs last month while the unemployment rate decreased to 3.5% from 3.6%. The la­bor par­tic­i­pa­tion rate climbed 0.1 per­cent­age-point to 62.3%, as the number of unemployed fell 278,000, in­clud­ing 146,000 who were job­less for six months or more.

The Bureau of Labor Statistics released its consumer price index (CPI)^[1] data for December on 1/12/23. All expectations were met: 

• CPI - 0.1%, 
• CPI ex-food and energy was + 0.3%, 
• CPI year over year was + 6.5%, and 
• Core CPI (excludes food and energy) year over year was +5.7%.

The drop was partly driven by a fall in energy prices, including gasoline, which was 13 percent lower in December. Given the war in Europe, this will not be easy to maintain. At the same time, service inflation (e.g., airlines, rents, utilities, etc.) which is 57% of CPI, remains sticky and is at 40- year highs - and will most likely remain so. The average rent for a 1-bedroom in Miami, Fla is $2,639, up 15% year over year; in Manhattan, it's $4,501; and in Charlotte, NC, it's $1,700, also double-digit year over year increases. Overall, the pace of rent increases nationwide has moderated in the last several months, though not enough to salvage the savings of millennials.

Labor demands will continue to stay strong, and there could be an increased wave of strikes and stalled negotiations in an array of industries beginning with the service industry. Already we have seen the St. Vincent Hospital nurse's strike, as well as strikes at the Kellogg Company, John Deere, Cook County, and Hunts Point Produce Market^[2]. Workers at the plants in Burlington, Iowa, and Racine, Wisconsin, previously rejected a three-year deal that included 18.5% raises because of concerns that the proposed raises wouldn't cover soaring inflation and health insurance costs.. This is only the start of labor demands as the new labor movement tries to keep up with past and present inflationary pressures.

Grocery prices remain stubbornly high (double the overall inflation rate) at 11.8% year over year, according to data released Thursday by the Bureau of Labor Statistics. Though most in our industry haven't felt that pinch, much of America has. 

The country has a "structural labor shortage," which is a long-term phenomenon, Jerome Powell said last month. The Fed has explained (ad nauseam) that a smaller pool of workers makes it harder to rein in inflation because companies have to raise pay — and, most likely, prices — as they compete for workers.

Though many investors and RIAs believe that the Fed has achieved a "Mission Accomplished" moment, those who are re-entering the longer duration trade will be sadly disappointed. A world in which the labor force is still 3 million workers short of pre-COVID levels, with companies moving manufacturing closer to home to curb supply chain disruptions, and energy prices remaining volatile is not "Mission Accomplished." Labor's bargaining power is just now re-emerging.

Now, with a divided and highly fragmented Congress, avoiding default on our trillions of dollars of debt becomes less theoretical. We always assumed that debt ceiling and government shutdowns were kabuki theatre and would work out eventually - that the impact would be short-lived. We would have been right — in the past. But there are warning signs that this time could be different. We have been complacent about political risk and shouldn't be in 2023-4. Talk of “debt prioritization” (picking which bills to pay) will fail as a solution.

Having laid some background, here are some thoughts for 2023 that we believe could complicate the mainstream soft landing goldilocks outlook.

1. Both China and Russia will experience significant and increased domestic upheavals ignited by the suppression of civil rights, chaotic COVID policy, and unending war. Inflation in China accelerated in December and is expected to surge further in the months ahead as the economy revs up following Beijing's ending of its zero-tolerance measures to contain Covid-19. China's exports suffered the sharpest decline in almost three years in December, piling on further economic pressure. (Dentons Flashpoint Global Situation Report January 13, 2023)
2. The reshoring of U.S. manufacturing, such as Intel's $20bn semiconductor plant in Ohio (creating 10,000 jobs), will accelerate in 2023 and become a national priority. This will keep unemployment lower than expected and wages higher than expected.
3. U.S. Inflation may find a natural level (4% - 7%) that can be sustained for the next 36 months.
4. The 10-year treasury will reach 4.25%, below the historic average, and still below inflation levels, and the yield curve will become normalized as investors finally capitulate and realize that fighting inflation will take years, not months. The two or even three-percent Fed inflation target is unrealistic for the next few years.
5. The Dems and the GOP will find more middle-of-the-road and younger presidential candidates to back. A Trump-Biden contest will not happen. Trump will be thoroughly bogged down in unending lawsuits, and Biden's health, age, and recent document discoveries will keep him from running.
6. A gallon of gas will average above $4.00 as the war in Ukraine intensifies and Russia restricts any remaining energy exports to the West.
7. Global flooding will again set record levels as continued emissions of CO2 will increase glacier destruction/melting. 2023 will experience more hurricanes than usual despite Tropical Storm Risk (TSR), one of the industry's watched hurricane forecasting teams, saying that the 2023 Atlantic hurricane season could see activity levels around 15% below the 30-year norm.
   The world's oceans absorbed record amounts of heat from the atmosphere last year, which slowed the rise of temperatures over land but fueled powerful storms and weather systems that are damaging communities across the globe, per climate scientists. (Dentons Flashpoint Global Situation Report January 13, 2023)
8. There will be a continued, if not accelerated, population exit from the Northeast and California, with millennials as well as boomers continuing to seek lower housing costs, a warmer climate, or both.
9. The stock markets worldwide will stay manic-depressive with a continued and volatile adjustment down in the technology sector and will go through secular repricing despite 2022 being the worse year since 2008. Historically, significant down years like 2022 are followed (80% of the time) by up years. 2023 might be the exception. The Dow breaks under 30,000, S&P under 3300, and NASDAQ breaks 9750 as revaluations continue and the investor community realizes a low-interest rate environment will not be returning for years.
10. The Labor market will continue to be strong. 2022 was the year that workers took to the picket lines again, raising industrial disputes in the Western world to levels last seen in the 1980s and encouraging workers not formally unionized in the U.S. at Starbucks and, to a limited extent, Amazon to band together for increased rights. More industries will follow suit.
11. The de-globalization of the world will accelerate as the U.S. will lead the charge in bringing back manufacturing jobs and reducing dependence on China, Russia, Iran, and other rogue countries for goods and services. China and other major economies will follow suit. In short, protectionism is back stronger than ever.

At FolioBeyond, we continue to believe that a cautious, hedged approach is appropriate in 2023. This would mean continued portfolio diversification to include commodities, low-duration^[3] fixed income, and a slower allocation into equities, preferably a long/short equity fund that was positive last year and in 2021.

Footnotes:

[1]  The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. More information can be found at https://www.bls.gov/cpi/questions-and-answers.htm

[2]  The fund does not hold any of the aforementioned companies in its holdings. All holdings can be found at https://www.etfs.foliobeyond.com/risr

[3]  Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates.

Before investing you should carefully consider the Fund's investment objectives, risks, charges and expenses. This and other information is in the prospectus. A prospectus may be obtained by clicking here. Please read the prospectus carefully before you invest.

Investments involve risk. Principal loss is possible.

Fund Risks - The value of MBS IOs is more volatile than other types of mortgage related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate. The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund. Please see the prospectus for a complete description of principal risks.

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Investments involve risk. Principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The fund is new and has limited operating history to judge fund risks. The value of MBS IOs is more volatile than other types of mortgage related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate.

The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund. Please see the prospectus for a complete description of principal risks.

To view a full list of holdings, including the fund’s top 10 holdings, click here.

Diversification does not eliminate the risk of experiencing investment losses.

Index Definitions

Bloomberg Barclays US Aggregate Bond Index: A broad-based benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).          

US Treasury 7-10 Yr Bond Inversed Index:

ICE U.S. Treasury 7-10 Year Bond 1X Inverse Index is designed to provide the inverse of the daily return of the ICE U.S. Treasury 7-10 Year Bond Index (IDCOT7). ICE U.S. Treasury 7-10 Year Bond Index tracks the performance of US dollar denominated sovereign debt publicly issued by the US government in its domestic market. Qualifying securities of the underlying index must have greater than or equal to seven years and less than 10 years remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and an adjusted amount outstanding of at least $300 million.

S&P 500 Index:

The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.

IBOXHY Index:

iBoxx USD Liquid High Yield Total Return Index measures the USD denominated, sub-investment grade, corporate bond market. The index includes bonds with minimum 1 years to maturity, minimum amount outstanding of USD 400 mil. Bond type includes fixed-coupon, step-up, bonds with sinking funds, medium term notes, callable and putable bonds.

Definitions

Alpha: a return achieved above and beyond the return of a benchmark or proxy with a similar risk level.

Annualized Equivalent Yield: represents the annualized yield based on the most recent month of income distribution : (income distribution x 12 months)/price per share.

Basis Points (bps): Is a unit of measure used in quoting yields, changes in yields or differences between yields. One basis point is equal to 0.01%, or one one-hundredth of a percent of yield and 100 basis points equals 1%.          

Beta measures: the volatility of a security or portfolio relative to an index. Less than one means lower volatility than the index; more than one means greater volatility.

Coupon: is the annual interest rate paid on a bond, expressed as a percentage of the bond’s face value.

Correlation : a statistic that measures the degree to which two securities move in relation to each other.

Convexity: A measure of how the duration of a bond changes in correlation to an interest rate change. The greater the convexity of a bond the greater the exposure of interest rate risk to the portfolio.

CPI: Consumer Price Index

CUSIP : An identifier number that stands for the Committee on Uniform Securities Identification Procedures assigned to stocks and registered bonds in the United States and Canada.

Duration: measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.

GNMA: Government National Mortgage Association

FNMA: Federal National Mortgage Association

FHLMC: Federal Home Loan Mortgage Corporation

Short Investment (Shorting): is a position that has been sold with the expectation that it will decrease in value, the intention being to repurchase it later at a lower price.

YOY: Year-over-year

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