I started my career in the financial field 42 years ago. When I entered the business, inflation was raging, hitting a high of 14%. Oil prices went from $2.50 a barrel all the way up to $40. Gold went from $35 to $800 an ounce and silver skyrocketed from $0.50 to $50. It took Paul Volker, then Fed chairman, raising the fed funds rate to a high of 20% in 1980 to tame the inflation dragon. By late 1981, inflation had peaked and Volker had won the battle.
That was then and this is now. Here we are 40 years later—oil prices are over $100 a barrel and could be heading higher, gold recently hit $2,000 this year, and inflation is running at 8.5%. In my opinion, actual inflation is much higher but underreported.
The Fed Is Behind the Inflation Curve
During the last Fed rate raising cycle, it took the Federal Reserve five years to raise the fed funds rate to 2.50%. It took a 20% market correction in 2018 for the Fed to reverse course and keep rates at zero while printing an ocean of money as seen in the graph below.
Unfortunately, the Fed kept rates far too low for far too long and now we are dealing with the consequences. Both fiscal and monetary policy have been highly inflationary, and we are now living with the results: the highest inflation rate in the last four decades.
The consequences of inaction are that the Fed is behind the inflation curve. They waited far too long to raise rates, and the administration keeps pouring gasoline on the inflation fire by spending trillions of dollars on new spending programs, which is driving demand far above supply. As a result of the pandemic and ongoing lockdowns, we are dealing with supply chain issues that have been exasperated by environmental mandates. It is my belief that these supply chain issues will not go away any time soon. This is why you are seeing empty shelves at stores, shortages of certain items, and high prices across the board globally for most everything we use. I will have more to say about why I believe the longer-term inflation trend is going to be with us for the remainder of this decade but, in sum, inflation is not going away any time soon.
The Fed May Keep Interest Rates Low
The Fed’s policy of financial repression by keeping interest rates artificially suppressed drove bond yields down the last decade with ten-year treasuries falling below 0.40%. It was very difficult to find returns in the bond market with rates suppressed this low. It was the reason I started our Equity Income Fund, as dividend yields were far above interest rates in addition to being taxed at lower tax rates. I also saw how these forces were setting us up for an inflationary wave and a global energy crisis emerging this decade given the monumental impacts and reactions to Covid. I outlined both of these scenarios through a series of articles starting in early 2020 listed below:
- The End of Money (April 1, 2020)
- Zero-Bound: The Return of Inflation and the Loss of Income (April 15, 2020)
- From Supply Glut to Energy Shock (May 18, 2020)
What I wrote about and predicted are now upon us and may get much worse later on in this decade as the US dollar loses its appeal as a reserve currency along geopolitical lines and we move to a multi-currency global system.
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Riding Out the Storm
So how are we prepared to weather the coming storms? Our equity income portfolio is defensively positioned for both an inflationary environment and a heightened period of volatility. The main sectors I have invested in are as follows:
- Consumer staples
- Drug and healthcare
- Precious metals
Our consumer staple stocks are holding up well with several hitting new records in addition to raising dividends. The energy stocks are holding their ground and I expect to hold them as I believe a major energy crisis may be upon us mid-decade. The base metal stocks and energy companies got hit in the latest market selloff, but I am expecting much higher prices once the Fed likely pivots and starts printing money again by Q3. The energy stocks and base metal stocks are paying dividends that range from 5-11%, in addition to raising those dividends double digits each year. Base metals have doubled over the last two years and are likely heading higher due to the global green agenda, which requires large amounts of copper (now in short supply), nickel, lithium, and silver. The precious metals stocks are more volatile but essential hedges in a high inflationary environment as we have today.
Dividends Taxed at Lower Tax Rates
I trimmed our technology stocks last year and hope to add them back once this bear market plays out with dividend yields close to 5-6%. The equity income portfolio is designed to provide income much higher than bonds and, more importantly, those dividends tend to go up each year. So far, we have been averaging 9% annual dividend increases over the last two years which is keeping us above prevailing inflation rates as this portfolio was designed to do. The critical fact is dividends are taxed at much lower tax rates than ordinary interest on bonds. The tax rate on dividends ranges from 0% to a high of 20%, plus the Affordable Care Act surtax of 3.8% if your income is above $200,000 for single individuals and $250,000 for married couples.
We had substantial profits heading into the recent market turbulence because of the way we were positioned. A few of you have asked why I didn’t raise more cash and take profits in what we now own. The answer is simple: taxes. Capital gains taxes can run as high as 23.8% for federal taxes plus state taxes. In states like California and New York, which have tax rates as high as 13%, it would amount to a 37% tax which is the equivalent of a major bear market. The difference here is once you pay those taxes on gains you do not get that back versus a market dip which can come back. The other reason is that the dividends continue despite market turbulence with several of our companies already raising dividends in the high single digits this year. The main objective of this portfolio is to provide high income returns that go up each year and are taxed at a lower tax rate than cash or interest.
Finally, I expect the companies we own and the sectors we are invested in to be the top sectors for market performance this decade. In my opinion, we are entering a commodity supercycle given that commodities reached a 100-year valuation low relative to financial asset prices entering 2020. Governments are all going green but green does not work without commodities. EVs use four times the amount of copper as a gasoline engine. Batteries also require lithium and nickel besides other special commodities that are in short supply. The other factor is green does not work on two-thirds of the earth’s land mass where the wind doesn’t blow on a consistent or strong enough basis and the sun is also too intermittent. We will likely be using fossil fuels well into this century. Energy transitions take time if not multiple decades to unfold.
Why Inflation Will Persist and Not Go Away
“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” – John Maynard Keynes
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.” – Friedrich August von Hayek
I would now like to take the time to explain why we expect this to be an inflationary decade and why we are invested in the way we are in our equity income portfolio.
First of all, let’s begin with inflation. Inflation has and will always be a phenomenon of too much money chasing too few goods. Policymakers do not take responsibility and may not always suffer the direct consequences for their inflationary actions. Often, their spending or use of excessive stimulus may have short-term rewards through votes, asset bubbles, or kickbacks from the industries or groups that benefit most. Once it is clear that the costs have outstripped the benefits via cost-of-living inflationary spikes in food and energy, as we see today, the politician’s first recourse is typically to blame the market, speculators, or greedy corporations engaged in price gouging. They may also blame unions and workers demanding higher wages, wars, pandemics or, as we see today, all of the above. One thing is for certain, gas and energy prices were already climbing steadily upwards from their 2020 lows years before Putin invaded Ukraine. Though we did see an immediate spike in the days and weeks following, we cannot blame Putin for the many years of regulatory pressure and underinvestment into the fossil fuel industry that has led us into our current predicament.
When it comes to the longer-term trend underway on energy, food, and overall inflation, there are seven key reasons why I expect inflation to remain high throughout this decade.
- Fiscal/monetary policy remain highly stimulative
- Tight labor markets with wages rising and shortages of workers
- Reverse globalization and the building of domestic factories is geopolitically expedient but will also increase costs longer-term
- Persistent supply chain disruptions
- $150 oil is likely heading our way
- Shortages and lack of investment across the commodity complex
- Government regulations, particularly those aimed towards carbon reduction, will likely continue to raise costs
The Fed is talking tough hoping they can talk inflation down, but it will likely not work. By Q3, we expect the Fed to pivot back to easing as the real estate and the economy roll over as they are now doing. Mortgage rates have doubled over the last year. The cost of financing a $750,000 mortgage has gone from $3,155 to $4,475. Mortgage rates are now close to 6% and still rising which is slowing the real estate market. Falling real estate markets have always been associated with recessions so it is one indicator next to PMIs that we are watching closely to give us a heads up when the Fed will pivot and reverse back to easy money.
Debt Levels Far Too High for Aggressive Monetary Tightening
Another factor is the massive amount of debt in the economy at all levels from government, businesses to consumers. US government debt is over $30 trillion and expanding at a rate of $300-400 billion per month. The average rate the government pays on debt is slightly above 2%. With rates rising on ten-year notes and over $6 trillion in bonds rolling over this year, a deficit ranging from $1.5 - 2 trillion, there will be a large amount of debt that will need to be financed. The Fed will need to intervene eventually if they want to avoid a debt crisis. A rise in interest rates by 1% will cost the government $300 billion in additional interest.
Consider as well what is going on in the corporate debt markets. Over half of all investment grade bonds are rated BBB, just one notch above junk bond status. If the economy rolls over, many of these bonds will get downgraded and need to be sold, triggering a debt crisis. It is one reason the Fed bought corporate bonds in the February 2020 bear market to prevent a debt collapse. You can see the stress in the corporate bond and treasury markets in the graphs below.
The Treasury ETF (TLT) has lost 19% of its value this year while the high yield corporate bond market is showing signs of stress. The Fed needs to tread carefully or else the bond market will lock up as it did in 2018.
Fed Policy Is Accident Prone
In my four decades in the business, I have only witnessed one soft landing once a fed rate raising cycle began, which was 1994. They have a very poor track record of predicting inflation and engineering a soft landing in the economy. Almost 95% of the time, a rate raising cycle ends up putting the economy into a recession. The government just reported that GDP contracted by 1.4% in the first quarter. If the economy continues to contract, we may already be in the beginning stages of a recession, typically defined as two negative quarters of negative economic growth.
Given our current level of inflation officially at 8.5%, it would take a fed funds rate of 10% or more to stem inflation. With an economy this leveraged, there is no way the Fed will be able to get to such levels without triggering a massive deflationary collapse. There is simply too much debt. It took them five years to raise rates to 2.5% last time when inflation was moderate compared to today’s 8.5%.
US government debt is now growing at 3-4 times the rate of economic growth as we have added nearly $8 trillion in new debt in the last three years alone. Consumer and corporate debt have also grown substantially as shown in the graph below.
When it comes to the above trend, we must also keep in mind that most of government spending is on entitlements, which are untouchable, meaning deficits are now on automatic pilot and will keep growing well into this decade. This will require the Fed to keep buying government debt in order to keep interest rates suppressed. This is another reason we like stocks as inflation hedges and for income as I believe we have entered a multi-decade bear market for bonds. The 60/40 split between stocks and bonds that worked so well for decades has broken down. The split does not work when you are in prolonged inflationary periods.
This year is a harbinger of things to come with both stocks and bonds both down for the year. What we are more likely to see is multiple bull/bear markets with the pendulum swinging between upswings in stocks followed by bear markets every few years. The decade-long disinflationary bull markets are, I believe, a thing of the past. What we are more likely to experience is what we went through between 1966-1982 as shown in the graph below as inflation rises and recedes.
As I wrote in my Death of Money and Energy Shock series of articles early 2020, events are unfolding exactly as predicted. So, for now, I intend to ride out the storm as the stocks we own are the kind of stocks that will likely do well in this environment. These are large blue-chip companies with a long history of raising dividends in both bull and bear markets as they are leaders within their industry with strong balance sheets, generating large free cash flow returned to shareholders in the form of rising dividends, stock buybacks, and the paying down of debt. The markets may correct further but the Fed will end up pivoting by the second half of this year I believe as asset markets falter and the economy slows down and heads closer to a recession.
We are monitoring key economic indicators both here and abroad and keeping close tabs on the assumptions we have made and the positions we own. If there is a course correction needed, we will be vigilant and do what is necessary to protect capital and hedge against inflation.
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