Third Quarter 2024 Client Newsletter

Published 10/31/2024

Your Portfolio On Politics

Standard political disclaimer: This newsletter is distributed to clients and friends from Oregon to Florida, New Hampshire to Arizona, and nearly every state in between. Our evenhandedness isn't political; it's a necessity. If at any point you think I'm rooting for either party, you're mistaken – I hardly like either of them.

Okay, on to the coverage!

If you're still seeking out political analysis/commentary with less than a week to election day, congrats, you're a true civic champion. This short memo will review recent worst-case scenarios and how worrying about them could have been destructive to your investing health.

When we discuss the best/worst potential election outcomes with clients, we're typically quick to note that divided government is the least bad and also the highest probability outcome. In most cases, it's an unsatisfactory position, but it makes good sense.

Businesses need to know the rules of the road to be successful. It's like if we had to deal with a speed limit constantly fluctuating between 95 and 15 mph. Drive the Ferrari or the Schwinn on the wrong day, and you'll have serious consequences! 

So, flipping from one unified government (one party controlling the Presidency and both houses of Congress) to another is the scariest outcome. Imagine for a moment that next week, the "Other Party" is going to capture complete power in 2025! Nightmare fuel.

But before we sell everything and hide for the next four years, let's see how the last two nightmares played out; after all, it is Halloween.

Way back in November of 2016, roughly half of our readership watched in horror as a political outsider rose to power alongside his congressional colleagues. Trump won the Presidency, and Republicans retained the Senate and House with 2 and 47-seat majorities, respectively. Chaos would soon roil markets, right?

Nope.

Tax cuts and the promise of deregulation drove markets higher in an instant. Tariffs and an arguably resultant manufacturing recession then stymied markets for two years before a pandemic and record stimulus drove markets to new all-time highs. By the end of Trump's first term, markets had notched an impressive pace higher.

In November of 2020, I presume the half of our readership that cheered the market's success under Trump was despondent as they watched Biden win the Presidency. Once the news came that Democrats had knotted the Senate in a 50-50 tie (Dem. VP acting as a tiebreaker) and retained the House, the horror show was on. Chaos would soon roil markets, right?

Nope

Fiscal stimulus continued, which enabled U.S. Consumers to enjoy a purchasing binge for the ages, and markets surged. Direct fiscal stimulus, government backstops/lending programs for businesses, and supply chain faults eventually led to a generational inflation surge. Global central banks increased interest rates dramatically, chilling markets for almost two years. But by the end of Biden's first term, markets had notched an impressive pace higher.

Two potentially horrific political scenarios produced two positive outcomes. Either could have been a lethal drug for portfolios. So, if you're finding hyperbolic election/market storylines, check the author's pieces from November 2016/2020; see if they've done a copy-paste.

Please remember that this exercise is not intended to argue that this election will turn out great either way and that the markets will be higher 4 years from now. If you know our style, you know that we don't espouse a 'cross your fingers and hope' methodology. We'll work with the investing environment we're faced with and manage what we can manage.

No matter what happens in the coming weeks, I hope we can give each other some grace and realize we're all on the same team. Though, I know that makes me wildly unrealistic.

The Right Rate

Central banks around the world have begun cutting interest rates. But what does that mean? And how will it impact different participants in the economy? Our goal in this section is to give some background on why rates for various groups currently are where they are. Along the way, we'll suppose where the right rate might be.

Since the surge in interest rates was directly related to inflation, we should begin our interest rate review with the path of consumer inflation in the United States. The annual headline inflation rate has fallen to just 2.4%, within spitting distance of the Federal Reserve's objective of 2.0%.

We can quibble that core inflation is stuck in the 3% range. Or we could mention that the Fed prefers an inflation measure derived from Bureau of Economic Analysis data. But no matter how you slice the data, inflation is coming down, which means the Fed can end its campaign against prices and begin cutting rates.

But how much will they cut?

We like to contrast the Fed's projections (dot plot), with futures markets. Both are subject to change; the Fed revises their projections quarterly, and markets are live every minute of every day. Here's how they stand.

The actual federal funds rate (green line) is how the Fed implements policy: higher in times of undesired inflation and lower in times of economic stress. They cut rates by 0.50% at their meeting in September. Throughout history, there have been very few times that they began cutting without finally taking rates down dramatically. You'll note that the last two cutting cycles (2007 and 2020) were a reaction to economic crises – they took rates to 0% in each case. This time looks different, for now. 

The markets (red line) expect rates to be cut to about 3.5%-3.7% by 2027, a full 0.50%-0.75% higher than the Fed's projection (blue line). Markets and the Fed's projection tend to deviate more the farther out you look. As you'd expect, markets tend to be melodramatic about the pace of economic growth and inflation. Just one week ago, the two datasets aligned almost perfectly.

Despite the divergent and often volatile data, there is some signal – the Fed will likely adjust rates lower by another 1.00%-1.50% over the next year. That would make their policy rate slightly more restrictive than the pre-pandemic norm of around 2.5%. At that point, policy would be what central bankers call neutral – rates neither stimulative nor detrimental to the economy.

The policy rate is the shortest-term benchmark. As investors, we use fed funds to gauge how much we can earn on cash or overnight funds. I don't know about you, but I never borrow money for a term of one day. So, let's zoom out and look at the maturity lengths we typically interact with as borrowers.

The chart below shows the interest rate the U.S. Treasury pays to borrow for different periods. For instance, if you find '10Y' on the x-axis and follow that vertical line up to where it intersects the bold red line, you'll see that the U.S. currently pays about 4.30% per year when they borrow for a 10-year term.

The current shape of the yield curve is relatively flat, with the leftmost dot corresponding to the Fed's policy rate (4.75%) and the far right dot representing a 30-year term (4.50%). The shortest maturities are the domain of the central bank, while market forces almost entirely control the longest maturities.

The treasury curve is effectively bedrock – the lowest rate anybody pays and the benchmark for calculating all other economic interest rates. Compared to 2019, rates are substantially higher across the curve.

Whether it's higher due to fears of the increasingly untenable borrowing needs of the U.S. government, expectations of higher inflation, or the outlook for economic growth, a higher long end of the curve is a problem.

That's because important things, like mortgages, are priced off of long-term treasuries. The relationship has been relatively stable over the years: take the 10-year treasury yield (red line below) at any given time, add 1.8%, and on average, that's what you'll pay for your 30-year fixed rate mortgage (green line below).

You'll notice that the spread between the two (blue) is about the highest it has ever been. Only the chaotic, non-functioning mortgage market of 2008 was more severe. Less demand for mortgage-backed securities and a lack of new originations are among the problems ailing the secondary mortgage market and, by extension, your ability to get a typical spread on your new mortgage.

If the premium reverts to the long-term average, a new 30-year fixed mortgage would drop from 7.2% to around 6%. And if the Fed is as accommodative as is currently expected (discussed above), we could expect another 1.00% decline in mortgages. That'd get you into the 5% range – a far cry from the 3% mortgages of the recent past, but far more workable.

High rates are also becoming a problem for businesses and the government. The chart below shows the impact of debt on three different cohorts – Corporations, Small Businesses (sole proprietors and partnerships), and the U.S Treasury. We've standardized the data by showing each as a % of nominal GDP. A rising line indicates a worsening burden to service debts relative to economic growth.

Entities that must constantly reissue new debts to pay old debts (U.S. Treasury, sigh) or companies with floating rate debt (loans) that adjusts higher with market rates are having an increasingly difficult time. Historically, you'll note that the red and green lines are still well-contained to historical norms, but the longer rates stay high, the worse things will get.

Corporations, on the other hand, strategically issued fixed-rate debts at historic lows. Their debt burden relative to their financial position has actually improved since the pandemic. Other than the wealthy, who don't need to borrow, corporate borrowers are the 'haves' of this credit cycle.

All That Glitters

Gold as an investment vehicle is a bit of a funny concept. It pays no interest nor any dividend. It owns no factories and sells no services. All it does is sit there. Detractors call it an unproductive asset, a barbarous relic, and a pet rock. Gold bugs, who nearly worship the shiny mineral, think it's the cure to all that ails mankind.

We're far from ideologues on the matter. If it adds beneficial characteristics to our portfolio, we're a fan; if not, we're just as happy to watch from afar.

The fundamentals for gold are as simple as how much is being dug up versus how much is purchased for jewelry (46% of the market), physical coinage/bars (22%), central banks (16%), liquid investments (8%), and technology/industrial (7%).

Jewelry, physical coinage/bars, and technology/industrial are historically stable end markets. Liquid investments and central banks are much more variable, and despite only making up 24% of demand, they're the marginal drivers of demand. That's where we'll focus this analysis.

Exchange-traded funds and mutual funds that offer investors exposure to the price of gold must physically hold the metal in a warehouse in an amount equal to the value invested in the fund. When investors buy shares of the fund, the company must buy more of the metal. For example, you can see every bar of bullion the GLD ETF owns here (https://www.spdrgoldshares.com/usa/gold-bar-list/).

As you'd expect, the holdings of these funds tend to be positively correlated to the price of gold. However, that's not the case right now. Check out the total tons held by investors worldwide, compared to price.

Prices are up dramatically, but holdings in the investable funds peaked almost four years ago – during the height of pandemic uncertainty. Very odd.

Central banks used to be among the only owners of gold. In the 1930s, it became illegal for U.S. citizens to own gold in any form other than jewelry or collectible coinage. And when the U.S. abandoned the gold standard in 1971, thirty-five dollars could be exchanged for one ounce of gold. But times have changed.

Currencies now free float against each other, relying exclusively on a government's ability to manage expectations through interest rates and confidence. Monetary theory has come a long way since 1971. However, sovereign authorities still choose to maintain a portion of their reserves in gold to bolster confidence in their currency and establish a rainy-day fund that isn't beholden to outside influences.

Throughout the mid-2010s, the world was relatively calm, and central banks and governments didn't have much appetite for gold. But that changed when Russia invaded Ukraine in the spring of 2022.

The U.S. and Europe responded to the invasion by completely cutting Russia out of the international financial system. The sanctions were punitive towards them, but the most significant consequence was that the rest of the world was put on notice; if you mess with the U.S. or Europe, you'll have a hard time using dollars or euros.

The resulting wave of buying by central banks was driven by China, Russia, and other countries seeking to diversify.

The demand surge by central banks explains the divergence between investable gold and the price. But other forces must be at work to sustain a move like we've seen in price. That's where the technicals come in. 

If the fundamental drivers of gold are as precise as the weight of a bar of bullion, the technicals are as squishy as the soft metal. While technicals always involve some emotion, gold is the purest technical play on emotion.

Anxiety about political instability, large-scale wars, currency crises, and a vague sense of uncertainty/fear are textbook pitches for buying gold. They're collectively 'you know it when you see them' indicators, making them challenging to chart or measure. We'll skip trying to present them here, as you likely don't need our help discerning the state of the world. 

I prefer to look at the price of the shiny stuff versus its principal investing competitors – stocks and bonds. To dramatically oversimplify the terms: In recessions, corporate earnings fall, and stocks do poorly. In rate-cutting cycles, bonds become less attractive versus assets with no yield. And when the price of a security breaks out over a prior high, investors can get excited (FOMO) and bid an asset up in a somewhat irresponsible way.

On the especially annotated long-term chart below, you'll find the start of recessions marked with red verticals, and the start of cutting cycles are black verticals. The black horizontals mark periodic price highs, with each breakout's appreciation directly above the upward-facing arrow. It's a lot to look at; take a few moments. 

The breakout periods speak for themselves – when gold works, it can work exceptionally well. It has tended to work best or, at the very least, inflect higher in periods of economic stress and the beginning of easing cycles.

Also, make sure to note the easing cycles that began in 1980/1989 and the recessions that started in 1981/1990 – the price didn't do anything; it just sat there like a lump for almost two decades!

As always, history is a guide. It helps us put behavior in context and sets us up to understand what could come next. I've admitted to many clients, maybe you included, that I generally think gold is pretty silly. While it can bring tremendous value, it can also be a proverbial deadweight to portfolios. But by keeping a balanced perspective and a willingness to imagine, we'll remain immune to the allure of gold buggery.