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Something Doesn't Feel Right

We'll Go Forward Cautiously

*  Inflation is increasing but interest rates seem to stay artificially low.

*  If rates increase as they should the debt service on our enormous national debt will go through the roof.

*  Confidence in our national government and many local governments is rock bottom.

*  Keep an eye on Japan.


Interest Rates and Economics 101


You remember what we learned in Economics 101 about interest rates.  The natural level for long term rates is 200 basis points over the inflationary expectation.  With an inflation rate around 6% that makes for an 8% long bond rate.  That’s why, as inflation has crept up, everyone in government wanted to believe inflation was “transitory”.  Remember that?  Fed Chairman Powell recently abandoned that “transitory” verbiage but still no one wants to believe inflation is long term.  Why?  Lots of reasons but for those senior administration officials I think it’s all about debt service on that $30 trillion in national debt.  Just think what happens if the long bond rate goes to 8% from the current 2.1%.  With increases like that all along the yield curve it’s okay to go ahead and double your blood pressure meds.


Politicizing the Fed


I sense a growing synergy between Chairman Powell and Treasury Secretary Yellen.  Most are expecting three or more Fed rate increases in 2022 starting in March.  That’s what you would expect because half of the Fed’s dual mandate is to control inflation.  The other part of the mandate is to control unemployment.  Unemployment is not likely to be a problem any time soon.  In fact, the high employment rate is an inflationary pressure.  Because of the impact of increasing rates on the national debt I’m skeptical about the central bank raising rates.  In recent years it almost seems like the Fed now has at least three mandates, the third being to maintain stable asset values and the fed has done that by making funds and credit so readily available.  I don’t know what happens to other markets including equities if the Fed artificially represses rate increases to accommodate the Treasury and the Administration.  What happens if Yellen and the Administration prevail on Powell not to increase rates even in the face of increasing inflation because the federal budget cannot sustain the additional cost associated with mounting debt service?


Japan’s Economic Challenges


As bad as the national debt is in this country it’s worse in Japan, the world’s third largest economy after the US and China.  Japan’s debt relative to her GDP is about twice that of the US.  If the US has gradually migrated to the modern monetary theory believing that debt does not matter, then the Japanese are modern monetary theorists squared.  Like the US, Japan’s inflation rate is increasing but Japanese bond rates are still relatively low but moving up.  My bet is that whatever is the sequel to modern monetary theory will happen first in Japan.  At some point, Japanese rates should increase to reflect accelerating inflation rates which will drive up public debt service putting a squeeze on the availability of funds for government services in Japan.  Then what happens? 


When the national debt service crisis hits Japan I think I know what happens initially in the US.  Many around the world will panic and do what the world has done for a very long time now and that is buy a ticket on the Flight to Safety and that means investing in the US and particularly American equities.  So, I think we can expect an initial pop in the US stock market.  That is until the world realizes that the US suffers from the same public debt disease as Japan.  What matters then is what the US does.  Do we hope for the best and keep digging the debt hole deeper or do we adopt some form of Paul Volker economic reform?


Our Investment Perspective


I don’t have many long-term answers but I think I see the way the process will unfold. I think our US equity investments are relatively safe through at least the early phase of the Japanese economic collapse.  Then it all depends on whether a latter-day Volker appears on the scene.  But with increasing inflation, increasing national debt, and increasing bond rates the outcome can’t be good long term.  If the Fed accedes to what I think will be Administration pressure not to raise rates the long-term outcome likely will be worse.  With our enormous national debt, increasing inflation, and low rates we are heading into unchartered waters.  It may be good for US equity for the short term but the longer-term effects on asset values can’t be good absent a major course correction by our national government.


What are we doing?  We continue to measure our success by our increasing income and not the value of our ownership.  We have no control over markets, but we can control our income.  We invest only in dividend champions (DCs), those businesses that have increased their dividends for at least 25 years.  We buy DCs by selling out-of-the-money puts on days when a particular DC declines a lot.  For example, if a DC declines 5% on a particular day we sell puts with a strike price about 10% lower.  We limit our options sales to the cash we have available.  That’s a change for us. We usually are comfortable incurring some debt.  So, when a major market correction comes, we believe we will be less affected because our DC businesses tend to have the kind of endurance earned over earlier market declines.  That minimum of twenty-five years of increasing dividends is a wide and deep moat around the DC class of businesses.

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