April 28, 2022
Dear Partners,
The unraveling we’ve been anticipating is in full swing. The first quarter proved challenging; if you’re just looking at a chart of the S&P 500, you would never know we’re in a bear market, but if you look at the average hedge fund or individual investor’s portfolio, it’s a blood bath. Supposedly safe bonds are down 9.5%, revealing that they offered only return-free risk. The Fed has signaled its displeasure with persistent and rising inflation expectations by suggesting that one or more 50 BP interest rate increases are imminent. Their policy path stands in contrast to countries like Euroland, Japan or China, whose struggling economies require monetary support, and so are not following the Fed’s path higher. As monetary policies diverge, the release valve must be currency, and the U.S. dollar has surged vs. all major currencies.
Few investors can predict inflection points. Hundreds of small, seemingly innocuous, corrosive decisions accumulate over the years, and barely pierce our collective subconscious. Then a match is lit and:
- Poof! – The post-cold war is over, and the world has returned to its pre-World War II state in which the strong take advantage of the weak.
- Poof! – Authoritarians everywhere are on the march.
- Poof! – A global food shortage portends unrest.
- Poof! – the end of deflation and beginning of inflation.
Geopolitics are a mess; a lot of bad news happened in a short period of time. Russian soldiers’ humanity is on display, and the world is sickened and heartbroken by the obliteration of Ukrainian cities and the massacre of their helpless residents. Aside from the obvious humanitarian concerns, why does this matter to investors? Two reasons: a downgrade in one’s quality of life is bad for animal spirits, and anything that stymies the global free flow of goods, services, capital, and labor erodes global wealth.
The end of the declining interest rates era of 1982 to 2022 likely represents an inflection point between high investment returns and low investment returns. Falling interest rates and abundant liquidity made ordinary investors in stocks, bonds, real estate, private equity, venture capital and hedge funds look brilliant. Buying an asset when interest rates are 6% and selling it when they fall to 2% is not skill; it’s called being there. The present value math only discounted those investment cashflows at a lower rate. The recent past has been atypical; people who created nothing got rich. In normal times, the only thing harder than making money on your investments is keeping the money you’ve made. Capital built over long periods tends to be depleted by profligate spending, bad investments, investor psychology, inflation, careless heirs, wars, revolutions, and taxes. Of the eight, at least five are in play today; that makes for tough sledding.
This turmoil is the worst possible scenario for central banks. Either the Fed raises rates a lot and slows growth, or they don’t raise enough, and inflation destroys the value of the dollar, erodes real wages, and leads to a recession. In the meantime, the Fed has stopped buying bonds, and is about to engage in quantitative tightening by shrinking its $9 trillion securities portfolio. Shrinking the Fed’s portfolio is an enormously risky adventure with minuscule odds of avoiding a financial calamity. Either way liquidity is coming out of the system, and like a deflating balloon, the air is seeping out of the asset price bubble. There will be no more big government spending programs, and no new fiscal stimulus. GDP will slow in Q2 and may decline into recession in 2023; it could be sooner. Keynesianism has been thoroughly discredited; the supply side finally matters again.
For the markets this is all bad news. The result is a lower stock market for quite a while as a greater share of national income will flow to labor and a lesser share to capital. If you were not over-allocated to equities the past three years, you missed it, maybe for a long time. It’s over; don’t chase it. Being in cash is not great, but it’s better than being in a falling stock and bond market. It would not surprise me if the equity market dipped below its long-term forward PE of 16. When war in Ukraine ends, the market will rally, but inflation will not end because, even though the demand factors will likely dissipate, the supply constraints will persist. The labor shortage has been brewing for years; it is global in nature, and the fix is a generation away. Frontier economies have spent the last 30 years migrating a few billion rural subsistence farmers earning $2.00 a day to the cities where they earn many multiples of that. The migration trade is done. The positive economic benefit of offshoring is past, and it is reversing. Since the 1980’s, there has never been enough domestic labor to manufacture what we consume in the U.S. Yet today, for national security reasons, specific industries and technology must begin onshoring. This will require enormous amounts of capital and labor; labor prices are not coming down in your lifetime. Be long robotics companies. Natural resources also face pressure; politicized energy policies have placed boundless demands on metals, commodities and a variety of materials. It is elemental; there are not enough copper and nickel molecules in the known universe to feed the green energy machine. Few policy makers even contemplate the concept of energy density. Conditions precedent to supply constraints will spread across other sectors in the economy.
As discussed last quarter, this environment favors real-return assets like natural resources, value-oriented stocks with positive cash flow, high-velocity real estate where rents can be easily adjusted to beat inflation, and short-term loans backed by hard assets. Quality, cashflow, interest income and dividends are good defense until the market turns around, which will happen when interest rates are once again permitted to reach market equilibrium and financial assets are repriced accordingly.
Jim Kauffmann
Founding Partner
Contact
Bay Point Advisors
Jim Kauffmann
Chairman & Founding Partner
moc.srosivdatniopyab@nnamffuakmij
About Bay Point Advisors
Established in 2012, Bay Point Advisors LLC is a privately held firm based in Atlanta, Georgia specializing in customized, secured lending solutions across real estate and other industries, including entertainment, aviation, and natural resources. Since its inception, Bay Point Advisors has originated over $1 billion of privately negotiated loans.
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