Wall Street Playbill

Well the beat, or the “play” goes on as the opening portion of this Outlook suggests. But beating Wall Street is not quite as hard as beating a Vegas casino. The odds are much better because our Central Bank – the Fed – makes sure over time that an investor has a decent chance of beating 50/50 odds as it supplies needed liquidity at a favorable yield for borrowers. Not recently of course. The market is in a much-needed tightening cycle but tightening cycles are brief. Over the past 25 years, the cost of money for banks via the fed funds window has averaged nearly 1% less YOY than the CPI as our “finance based” economy has required greater and greater cheap money to grow credit at a rate necessary to keep nominal GDP growing at an acceptable, non-deflationary growth rate. That it has overdone it for the past five years (2.25% less) is a reflection not only of the Fed’s miscalculation of the power of fiscal deficits via congressional spending (mainly a $2 trillion annual deficit on average) but also I suggest, of the need to run larger and larger deficits. Keynes’ famous dictum to escape the Great Depression suggested the government should step in to heal the private sector by spending what businesses and consumers were unwilling to. Pretty simple it seems these days after nearly a century of doing just that, but in the 1930’s it was a rather foreign and outrageous concept. Before FDR, the theory advanced by Treasury Secretary Andrew Mellon was to “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate” in order to stabilize the economy. NOT!

But Keynes changed that as did an increasingly accommodative Fed, accelerating in 1971 as Nixon broke the gold standard and central banks worldwide learned to join their treasurys via easy money. Together, both supercharged fiscal and monetary policy has accelerated annual CPI increases over the past half century to 4.0%, from a rather benign 1.7% in the 50 years previous. Some may comment that these policy changes were a rather small price to pay for long-term real GDP growth of 3% and that may be true, but there are consequences much like global warming that can only be viewed over the long term. Our recent global “banking crisis” is but one of an increasingly frequent series of events such as the Great Recession, the dot-com crisis, and the stock market crash of 1987 that can be traced to too much money creation, too radical financial innovation (portfolio insurance in 1987) and too many fiscal deficit bailouts. The aftereffects and consequences of such bailouts are now necessitating not only their perpetuation but their acceleration. Near 0% interest rates from 2017 to 2022, quantitative easing and Covid bailouts of $2.5 trillion per year are the most recent examples.

And so? It will be extremely difficult to return to the Fed’s historic 2% inflationary target. The lesson to be learned from the paragraphs above is that higher than 2% inflation has been required to keep the U.S. and global economies growing, which in turn have been required to maintain healthy asset markets, which increasingly is the target for Fed policy despite Chairman Powell’s denials.

Investors should therefore invest with expectations for 3%-plus annual CPI gains. They should own TIPS versus nominal Treasuries. Own them in smaller size via ETFs such as STIP and VTIP. They should include commodities in a portion of their diversified portfolios. They should focus on companies with the capacity to raise prices and maintain margins in an inflationary environment (you tell me!) And also – well here’s a sidebar: Recall my beginning Wall St. playbill where I railed against banks for lending money that isn’t theirs and then being bailed out when things go wrong? Well I’ve always told myself and close friends that I wish I could start a bank. It’s a license to make money even when run conservatively. Some in recent months have hit the front pages when they weren’t so conservative – like Silicon Valley Bank which in turn produced a moderate financial crisis cratering the market prices of regional banks deemed susceptible to withdrawals of deposits. As a result many regionals are down 30%-40% since and it’s possible to own (or in effect) start a bank at 60%-70% of book value. Admittedly, regionals will have their cyclical problems if and when a recession occurs but my long-time wish to own a bank is now possible via public markets. Recent ROEs of 9%-10% at 60% of book provide an enticing long-term investment. Many smaller regionals may be gobbled up by larger counterparts at premium-to-market bids. I’ve become a banker by proxy. My purchases – not recommendations for legal purposes – include WAL, KRE (an ETF), SNV, and PACW.

Good luck to me! Best of luck to you. We both can finally join the cast of “Wall Street” – the play.