The United States reached the congressionally authorized debt ceiling on January 19^th 2023. The Federal Government, which needs to borrow almost four billion dollars every day to meet its budgetary obligations, no longer has the authorization to borrow new funds through the issuance of U.S. Treasury securities. The raising of the debt ceiling is usually a formality. It has been increased 78 times since 1960, and was increased 17 times with little fanfare during Ronald Reagan’s Presidency. The last time the debt ceiling became a major issue was in 2011, during Barack Obama’s time in office. Present circumstances mirror 2011, with the House of Representatives controlled by the Republican Party and the Senate and White House held by the Democratic Party. This portends another nasty standoff over raising the debt ceiling. 

Everyone knows that the impasse over the debt ceiling will be resolved eventually. The Federal Government currently runs a deficit of about 1.4 trillion dollars a year, and borrows to cover social security checks, Medicare payments to the U.S. medical system, as well as paychecks for millions of civilian and military personnel. There is broad political consensus to continue all these programs and payments. A failure to raise the debt ceiling could also lead to a default on U.S. debt, which would destabilize financial markets and economies worldwide. Given the stakes, it is surprising that the debt ceiling has become a political football again, but the showdown reflects the state of American politics.

The political reality is that neither party is likely to get much of anything they want passed in the next two years. The Democrats accomplished some of their legislative priorities last year when they had control of Congress and the White House. The Republicans lost a Senate seat in the 2022 elections, and won a bare majority in the House. They will be unable to pass anything of any consequence with the Senate and Biden blocking their path. About the only thing the Republican-controlled House can do is launch investigations and continue the search for Hunter Biden’s laptop. But some have bigger aspirations than that, and see the debt ceiling showdown as an opportunity to impress their constituents. The Democrats think raising the debt ceiling is an obligation of the government, and should be done without controversy, as was the case when Reagan, Bush, and Trump were in power. The Republicans see the debt ceiling as a lever, and the Democrats are in no mood to be leveraged by a party that barely controls one legislative body. 

It is difficult to see how the standoff over the debt ceiling will end, even though it will at some point. Until that time, it is much like a game of chicken with two cars speeding at each other head-on with little inclination to veer away. Kevin McCarthy, who became the Republican speaker of the House by one vote after 14 failed attempts, will anger some extremists in his party if he even allows a vote on the debt ceiling without major concessions from Democrats. If he angers even a few members of his caucus, they will likely call for a new vote for Speaker and McCarthy will be voted out. The Democrats do not want to negotiate over the debt ceiling at all, and particularly not with someone seen as hostage to the extreme right. It may be that a collision is inevitable, and that a resolution will only come after economic damage has been done. The public should be prepared for months of posturing, as both parties try to pre-emptively pin the blame for any economic damage on each other. 

Brinkmanship over the debt ceiling in 2011 contributed to a drop in the U.S. Dollar, a rise in precious metals, and a sizable decline in stock prices that took months to reverse. It did not lead to a drop in value for longer-term government bonds. While investors were concerned about receiving their money in a timely fashion on bonds coming due in the summer of 2011, at the height of the crisis, there was little concern that any default would extend to bonds coming due months or years from that date. We are not sure that history will repeat, but it could be a guide. 

Current Strategy

While the debt ceiling may become a major issue for investors by summer, it was rampant inflation that drove a historically bad year for investors in 2022. The S&P 500 declined by nearly 19%, while the technology-heavy Nasdaq Index collapsed by 33%. Investors fled riskier assets, with hundreds of high flying stocks favored during the pandemic losing 70% or more of their peak valuations. The most widely held cryptocurrencies plunged in value, and lesser-known crypto coins simply disappeared. The red-hot IPOs (initial public offerings) of 2021 turned ice-cold, with most selling for a small fraction of their previous highs. Yet the broadest financial pain was felt in a far more stolid investment: U.S. Treasury bonds. One index of medium-length government bonds declined by over 12% last year. For many who rely on the stability of bonds, this decline felt seismic. It amounted to the largest yearly decline in bonds across more than a century of reliable data. 

Against that ugly backdrop, there has been some unequivocally good news in recent months. Inflation peaked in late summer and moderated through the fall and winter. With bond yields having reset to more normal historic levels and inflation no longer demanding such a draconian response from the Federal Reserve, bonds again seemed a stable and attractive investment option. We continued buying Treasury bonds for clients in the later months of the year, and captured the highest yields in 15 years. 

Stocks have also begun to recover off the low set in October of last year. But stocks still have one very large hurdle to overcome before they can stage a full recovery. Much of the progress on inflation has come because of softening economic conditions. Weaker consumer spending has induced price reductions for various goods, and the housing market is beginning to cool in many parts of the country. While lower inflation caused by slower economic growth is good for bonds, it is not necessarily good for stocks. Slowing growth can compress margins, as firms find themselves overbuilt and overstaffed. Sliding into a recession is historically damaging for stock prices.

We see many signs that a recession may emerge in 2023, and have therefore been less inclined to assume that stocks have bottomed. In general stocks tend to reach bottom during a recession, not before one has started. Consumer spending declined over the last two months of the year and layoffs are spreading, particularly in the high-paying technology industry, but so far the economy is not in a recession. While there is debate about the likelihood of a recession, there is no doubt about the fragile state of the economy. Yet even after a year of declines, many stocks are not properly discounted for that fragility, in our view. That said, we remain alert to opportunities that may well emerge as the economic picture continues to develop.

After decades of loose monetary policy, the Federal Reserve Board has embarked on a mission to tighten credit by sharply raising interest rates. This change has been forced on the Fed by rampant price inflation in everyday goods and services. Many critics of the Fed argue that decades of easy monetary policy (artificially suppressed interest rates) have buoyed asset prices, leading to greater wealth inequality. The Fed has also engaged in quantitative easing, which enabled large government deficits. We agree with the Fed’s critics that such policies went on for far too long and unleashed some of the economic ills being felt today.

Federal Reserve Board policy has provided the fuel for asset bubbles. Long-time Fed chairman Alan Greenspan presided over the meltdown in 2000 brought on by the dot.com mania. Ben Bernanke was Fed chairman when the housing bubble burst in 2007-2008, leading to the financial crisis and Great Recession. And now Jerome Powell is grappling with a market collapse brought on by the highest inflation in 40 years. Only Janet Yellen (chairwoman from 2014-2018) escaped the fallout from loose monetary policy. Using the tool of low interest rates to tamp down every little fire in the stock market has simply resulted in more dry tinder and eventually larger fires.

When inflation in food, energy, airfare, rent, and just about everything that affects daily life started to accelerate in 2021, the Fed attributed the price changes to transitory forces. They said the changes were caused by special factors related to the pandemic and would wind down as bottlenecks in supply chains abated and people returned to the workforce. About one year ago the forecast from the Fed and the futures market was for interest rates of approximately ¼ of one percent by December 2022. Since the Fed controls shorter-term interest rates, it seemed likely that its forecast would become its policy. But we now know that did not happen. Interest rates are more than ten times higher than the forecast of a year ago. The Fed did not want to change its forecast or policy and admit that it had been engaged in wishful thinking. But it has been forced to radically alter policy by inflation that was not transitory, that did not fade away or burn itself out. Instead, inflation has spread more broadly and become hotter, turning into a true inflation conflagration that has burned investors and torched the budgets of lower-income consumers.

Monetary policy and demographics can be viewed as the fuel and dry conditions that made for a combustible economic situation. Add in swirling geopolitical winds and the combination of
forces became even more potent. The conditions for an inflation spike that would force the Fed to abandon its zero-interest rate policy have been present for some time. In retrospect it was the pandemic and policies enacted in response to the pandemic that sparked the inflationary fire. A long fuse was lit when Jerome Powell said in late spring 2020 that the government, through fiscal stimulus (lots of checks in every mailbox) and the Federal Reserve, through monetary stimulus, were going to err on the side of overfilling any economic holes left by the pandemic. We remember thinking at the time that there could be negative repercussions from such aggressive policies, but the only effect for the next 18 months was a robust stock market. The negative implications of filling the economic forest with dry tinder took two years to manifest.

Over the past few months, it has been shocking to see the bond market, usually a paradigm of careful analysis, be so out of step with the change in Fed policy. Bond market investors seem to be in denial about a major shift in Fed policy, and the stock market which now slavishly responds to every up or down tick in bond prices is also in denial. The Fed has clearly lost credibility with investors, because of its repeated pronouncements in 2021 that inflation was transitory, requiring no need to raise interest rates. Investors who once closely followed Fed forecasts now see the central bank as incompetent and unpredictable. Investors are starting to ignore the old Wall Street adage that warns investors to “not fight the Fed.” Fed chairman Powell and numerous Fed governors have felt it necessary to remind investors that the Fed is not kidding; interest rates will keep rising and will stay high until inflation is squelched. A familiar pattern is emerging, of a plunge in financial markets after the warnings, followed by a subsequent rally that does not hold. Bond and stock prices are being reluctantly, slowly, painfully reset to levels that conform to the new regime of higher interest rates.

Current Strategy

The bear market of 2022 has been long and drawn out, unlike the bear market of 2020, which was over just weeks after it began. The difference is that this time the Fed has not rescued the market with extremely low interest rates. Instead, almost every asset class is being pulled down by the gravity exerted by high and rising rates. Over the past thirty years when stocks fell into a correction or bear market, other asset classes such as bonds and gold would often gain value. That’s not happening now. There are few, if any, places to fully preserve capital other than cash. Even bonds bought a few weeks ago at yields of nearly four percent have lost a bit of value as inflation numbers remain elevated and interest rates keep climbing.

The pressure on asset prices will not go away until interest rates stop climbing. This reality has not stopped investors from trying to time a bottom in stock prices. A hallmark of bear markets is large, sharp rallies that fade quickly. So far in 2022 there have been 38 trading days where the broad market indices gained or lost more than two percent; in all of 2021 there were only 8 such days. Bear markets rallies can be seductive, offering a salve to wounded accounts. But unless one can tell whether the rally will last for mere hours, a day or two, or maybe several weeks, they can be an invitation for further losses rather than gains.

We have tried to preserve capital by taking profits on our biggest winners from the 2020-2021 period, exiting almost all consumer staples companies and utilities at near record highs, and taking some modest losses on stocks bought late in the bull market cycle. When compared to current prices these sales were generally well-timed and helped preserve client capital. Despite all these protective sales, the remaining, much smaller list of holdings has declined more than we anticipated. Which is another way of saying that we should have “cleared the decks” by selling even more holdings back in 2021 when prices were higher. With stock prices now at much lower levels, the advantage in selling more holdings becomes less. There is less downside to protect from and less money coming in from a sale. Our focus has shifted to finding new positions to lift the equity exposure level of accounts to a similar or higher level than at the start of 2022. It is strategically imperative to have more exposure to equities on the way up than one had on the way down.

For the first time in at least fifteen years the bond market has become dynamic, a daily drama full of risk and reward. The Fed can no longer suppress bond rates as it has done for decades, so the word “reward” can be used again in relation to bonds. There is much to ponder concerning the peak, or terminal, interest rate. Everyone is trying to guess that number: is it 4, 5, or maybe even 6 percent? The eventual bottom in stock and bond prices, gold prices, real estate, and foreign currencies all hinge on that terminal rate. The situation is further complicated by the probability that intermediate-term interest rates could start to fall even as the shortest-term rates rise a bit more. This is called an interest rate inversion and is a common occurrence prior to recessions.

Trying to guess all the different peaks for various bond maturities is impossible. Our goal for clients is to build a laddered portfolio of bonds that spans from 2 to about 6 years, with a bit of longer dated (7-10 year) paper for certain accounts. Rather than making one big guess about interest rates, the laddered bond strategy allows us to make a series of judgements about rates as economic data is reported.

When Covid-19 crippled the U.S. economy last spring, it elicited an overwhelming government response. Government leaders stated their intention to backfill any economic hole created by the pandemic. They have certainly done that, pouring money into the pockets of both individuals and corporations through stimulus checks, payroll protection grants, enhanced unemployment payments, and child credits. Hundreds of billions in support has also flowed to states, cities, colleges, and medical institutions. The total amount of government aid in the U.S. has been over $5 trillion dollars.

This money, combined with low interest rates, has led to an explosion in asset prices. Real estate has been hot in many regions, stock indices are reaching new highs, and crypto currencies have raced ahead of all other assets. The economic hole has been more than filled and the excess liquidity is flooding into nearly all assets. But the biggest recent gains are in crypto currencies. At least some of the money from stimulus checks, it seems, is finding its way into bitcoin, ethereum, dogecoin, or some of the other 7,500 digital tokens on the market.

The digital token (crypto) world is not something we have addressed in the past. It is an esoteric and lightly-regulated asset. John Oliver, host of “Last Week Tonight,” put it best when he said that cryptocurrency and blockchain are “everything you don’t understand about money, combined with everything you don’t understand about computers.” Today, blockchain technology is increasingly embedded in newfangled assets, and cryptocurrencies have swelled to a collective valuation of over $2 trillion. Inventors and promoters of cryptocurrencies and blockchain technology want to supplant the financial world as it exists today, the one where the Federal Government, banks, and intermediaries such as Visa, Mastercard, and Paypal are the ones who issue currency, offer credit, and record and verify all financial transactions.

The idea of an alternative financial system that is heavily encrypted, anonymous, yet totally verifiable (as to the proper allocation of every debit or credit from a transaction) has appeal to people on the left and right of the political spectrum. Such a system is a check on the power of government to control money supply, track transactions, and levy taxes. No wonder the first question on every individual tax form, right under one’s name and address, now says: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” Millions of Americans have made transactions in virtual currencies, but only a relative handful are responding with an honest answer to that question.

We are addressing the cryptocurrency craze now because it is the latest example of a speculative fever that has been sweeping the financial markets since last summer. A few months ago, all attention was on the meme stocks, such as Gamestop. As that fever subsided it was immediately replaced by dozens of cryptocurrencies that suddenly doubled or more in a matter of weeks. The biggest percentage gainer of all was something called Dogecoin, which was started as a joke back in 2013 by two computer software fellows who wanted to prove that foolish people would buy anything that purported to be a digital token. At the time there was a picture of a dog, a Shibu Inu breed, with a goofy look on its face that people found humorous and were exchanging with each other online. Dogecoin’s founders used that image as their mascot of sorts, hence the name Dogecoin. This digital “joke” coin sat for years at virtually no value, until the last few weeks when it shot to 45 cents per token, giving the 130 billion tokens a total value of $54 billion. This is truly speculation, and the greater fool theory in play at an extreme. It indicates how much money is floating around, and how impetuous people are willing to be in their speculation.

The sudden rise of cryptocurrencies, to a combined value of more than $2 trillion dollars, may in fact have dampened the rise in the stock market. Much of the wild speculation that used to occur in lower quality stocks near the end of bull markets has now moved over to the crypto markets, because the gains there can be lightning fast. The idea of investing in stocks, owning part of a company, and possibly benefitting from stock appreciation or dividends seems pedestrian compared to a double in a week (or a day) on a cryptocurrency. While the explosive public interest in cryptocurrencies may be a sign of a larger investment bubble about to pop, it could also mean that bubbles are occurring in different assets at different times, and are not intertwined with the broader investment universe.

Current Strategy

Excess liquidity has led to a series of rolling bubbles in various financial assets. While it is important to proceed with caution in such a pumped-up environment, there are still many companies with share prices that remain tethered to business fundamentals. The overall stock market has performed well in recent months, as investors rotated from elevated tech stocks to a broader list that included banks, industrial, retail, and consumer products companies. Watching investment bubbles expand and then pop can be fascinating, but should not distract investors from establishing worthwhile, long-term positions in companies that may be attractively valued. We have been active in this regard, capturing some of the dramatic gains made last year and redeploying those funds to companies that may benefit from a full economic reopening.

The bond market has begun to shift more significantly in 2021. As investors anticipate continued government spending, increased deficits, and potentially higher inflation, they have sold their longer-dated bonds. Short-term yields are still anchored in place by the policy and language of the Federal Reserve, but yields rose on 10- and 30-year bonds in recent months. We have begun buying corporate bonds for the first time in nearly a year, and will continue to add to our bond holdings if rates climb higher still.