Self Inflicted Wounds

On Monday morning this week I had the opportunity to walk the National Mall in Washington DC.   An important stop on my walk was the National Archives – which has airport-like security protecting founding documents including the Declaration of Independence, the Constitution and Bill of Rights - all under subdued lighting to preserve the now almost 250-year-old documents from the effects of light and time…

Under those dim lights were the words of the 10th amendment:

The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.

In other words, unless explicitly stated in the constitution all rights were held by states or the sovereign people.  For the first time in history a country was founded on the idea that ordinary people – not kings, queens, churches, or institutions were in charge!  

Not more than a mile down the street from the National Archives is an institution known to us as the Federal Reserve.  It exerts control over the supply of money and by extension interest rates for anything from mortgages to certificates of deposit.  Its role has morphed since it’s founding in 1913 and since the fall of 2008 has included an implicit mandate to backstop financial markets.  

I acknowledge that nothing the Fed attempts to do seems nefarious.  It’s “dual mandate” is to maximize employment and stabilize prices – both important and admirable goals.  However, it is an unelected group of smart people who sit in a room and make decisions about the “price of money” – or interest rates.

As you’ve no doubt noticed – we live in unique times. Whether it be a global pandemic, inflation, a war in Ukraine or historic droughts we have a convergence of events that is unprecedented.   Financial markets – not just stocks but also bonds, crypto and now real estate have declined as a result.  

While some of the current messes are the consequences of “acts of God”, others are unequivocally “self-inflicted”.  A series of well-intentioned but poor decisions in both monetary (Fed Reserve driven) and fiscal policy (federal spending and taxes) are the source of a fair amount of blame for our current challenges.  It is not my intention to place that blame on any president or political party – there is plenty of blame for out of control government spending over multiple administrations to go around…

But one institution’s policies stand out:  In response to the economic collapse in 2008 the Federal Reserve began a new and unprecedented policy of buying up mortgage-backed bonds (Quantitative Easing or QE) to lower interest rates for mortgages as a means of strengthening a very weak US economy.    This in addition to interest rate cuts to near zero levels were intended to provide a backstop.  While some might argue that this made sense it is difficult to argue that keeping rates near zero and continuing to buy bonds for the next twelve years has not distorted markets.  

Part of the magic of capitalism is that markets have self-correcting mechanisms.  However, when the mechanisms for correction don’t work because of policy intervention – markets get highly distorted! Evidence for these severe distortions is the ever-increasing prices of growth stocks, real estate and “alternative assets” like crypto as well as VC and private equity markets for companies in the last decade.    

The term TINA or “There Is No Alternative” became part of the investing lexicon.  Who wants to have cash in the bank or bonds yielding near zero when you can purchase assets with an exploding amount of money available at very low rates?  To some academics and their acolytes, the good times could go on forever – with a credit card bill never coming due financing a lifestyle that without government largess the citizens could not afford.  The Federal Reserve could continue to print more money and as long as they kept rates on government debt service low it could go on for perpetuity. The only possible wrinkle to their ideal of ever-expanding cash to permanently finance more extravagant lifestyles was inflation.   Now that inflation is rampant, and the era of exceptionally low rates is forever behind us the consequences of bad policy are beginning to wreak havoc.  The chickens have come home to roost…

I believe the founders would be both shocked and saddened by the power wielded by federal government institutions which was not granted in the constitution.  In my opinion we need to let free markets be free.  We need to let states make choices in their best interests and most importantly we need to recognize that “we the people” are in charge.

I acknowledge that I don’t know how these financial challenges will play out.  I suspect that inflation has already become somewhat embedded and that the only thing which will decrease it will be significant additional raises of interest rates.  Rates are the cost of financing the national debt – so a rise from 1% to 4 % in interest rates mean a QUADRUPLING of the cost of financing that debt (read: raised taxes).   I don’t think that will go over well for either family finances or the economy…

The other scenario is that the Fed successfully crushes inflation by raising interest rates and selling their inventory of bonds (Quantitative Tightening or QT).   Whether the economy goes into a severe recession or not at this point a function of luck - and that alone…

How to invest?  Own cheap (value) companies with current earnings (not discounted by high rates into a far distant future).  Companies not dependent on future financing. They are not only cheap but will weather most economic scenarios better than the alternatives.