In recent weeks we have seen an increase in market volatility due to higher inflation, rising rates, and the Russian invasion of Ukraine. The conflict creates geopolitical and economic uncertainty both of which are headwinds for the markets. Ukraine has vast amounts of natural resources including Europe’s second-largest natural-gas reserves, the sixth-largest iron-ore reserve and the tenth-largest reserve of titanium in the world. Additionally, Ukraine is rich in lithium and other critical rare earth minerals, many of which are utilized in EVs (Electric Vehicles). The Russian advance has been met with formidable resistance by the Ukrainian people and world governments have placed significant economic sanctions on Russia while also providing military aid to Ukraine. Many fortune 500 companies have announced plans to cease operations in Russia including the export of goods into Russia. As a result of the conflict, bond yields have reached their recent highs, while inflation continues moving higher. Let us all hope that a diplomatic solution is found quickly.
We believe two major themes will be crucial in shaping the global macro environment this year, 1) the fading COVID-19 pandemic and 2) the normalizing of central bank policies (i.e. rising interest rates). There has been continued optimism as cases from the Omicron variant continue to dissipate and the global pandemic appears to be fading. This has prompted a notable shift in domestic public health policy, with restrictions being lifted across the country. There is pent-up demand by the consumers as savings rates reached record levels during the pandemic and additional mobility should be positive for economic activity in the marketplace. Supply-chain issues will continue to be a headwind and will take time to normalize but demand is expected to be strong.
The other key theme will be how the Federal Reserve and other global central banks start on their long road towards normalizing monetary policy. Investors have ridden a wave of ultra-accommodative liquidity, in the form of both monetary policies (central banks) and fiscal policies (government spending) that had pushed asset valuations to record levels during 2021. The central banks around the world are about to take away the punchbowl as their economies strengthen and inflation becomes more persistent. The Federal Reserve is expected to make the first of several interest rates hikes over the course of 2022, with the first coming this month. In just the past few years, the Fed has battled one crisis after another. Since the start of 2020, it has had to navigate the COVID-19 pandemic, global supply-chain bottlenecks, an unexpected surge in inflation, and now a war that has recently driven the price of crude oil above the $100 per barrel mark. According to the Federal Reserve Bank of Chicago, the goal of the Fed is “to foster economic conditions that achieve both stable prices and maximum sustainable employment.” Keep in mind that even though the unemployment rate stood at 4.0% in January 2022, the U.S. had 10.93 million job openings in December 2021, according to the Bureau of Labor Statistics. There is still a lot of work to be done on these two fronts, stable prices, and full employment.
The end of the “easy money” era is just starting to unfold and the period of negative-yielding bonds is ending. Even with the recent rise in bond yields, the shape of the yield curve, and the level of bond yields are inconsistent with what will be needed to contain inflation. We expect higher volatility and lower net returns as bond market losses accumulate. Our plan of riding the curve will offset the bond market changes.
The question has been, will inflation be transitory, and will our economy return to a period of sluggish growth? The bond markets, with assistance from the Federal Reserve, have reluctantly given way recently by increasing the yields on bonds and interest rates in general. The bond market has been responding reluctantly to inflation and increasing energy prices. But the markets have not capitulated to higher inflation. Inflation is running at a 7.5%+ annual rate and the interest rate on the U.S. 10-yr. Treasury is roughly 2%. The overall level of inflation is being exasperated by supply chain constraints and price levels are expected to decline as more of the global supply chain continues to be repaired. However, there will be less of a decline in the rate of inflation because of the high price of oil as well as other commodities.
Riding the Curve
The yield curve is a graphic illustration of the level of interest in each year from today until 30 years from now. A normal yield curve is one where short-term interest rates are lower in year one, gradually rising each through year 30.
You may have noticed that we have been buying short-term Treasury notes in bond only accounts and balanced accounts. This money has been in cash and T-bills, remaining safe and receiving nominal interest, but better than bank CD’s and money market accounts offer. Short-term interest rates have been increasing recently anticipating the Fed raising interest rates. The banks are not increasing the rates they offer on short-term deposits. Wells Fargo recently offered a retail branch CD (Certificate of Deposit) for 3 years at 0.25%. The 3-yr. Treasury Note is above 1.50% and it is state income tax free whereas the CD is not! Short-term interest rates are rising, and we are taking advantage of rise in yields. Currently we are moving money out on the yield curve, purchasing treasury and municipal bonds with maturities of no longer than approximately five years. As the longer-term interest rates rise, we will move our maturities farther out on the yield curve to capture higher yields. Currently, we are laddering the maturities from 1 year to 5 years, and as rates rise, we will move the maturities out on the curve. For example, when the 1-year bond matures, we will reinvest those funds into 5- or 6-year bonds, increasing the income.
We will ride the yield curve to higher income as the yields rise reflecting higher inflation and a strengthening economy coming out of the pandemic. There is comfort knowing that we are earning something on our cash, and we have little market risk on our fixed income portfolios in a rising inflation and interest rate world.
According to the Department of Energy, in 2021, the United States imported 245 million barrels of crude oil and related petroleum products from Russia. This equates to nearly 672,000 barrels per day, an increase of 79% increase from just four years ago.
The Biden administration recently announced a ban on the import of Russian oil into the US. Additionally, the administration has urged OPEC+ (Organization of The Petroleum Exporting Countries) which includes Saudi Arabia, UAE, and Venezuela, to increase oil production and sell it to America to replace the supplies lost by the Russian ban. Despite the change in policy there was little call from the administration to increase the domestic production of energy despite the US’s ability to produce oil and liquid natural gas (LNG) cleaner than that of most other major energy producers. This doesn’t make sense from a policy perspective as increased US energy production would benefit American workers, the economy and allow our allies to be less dependent on Russia or other foreign countries for its energy.
Mutual Funds – Buying a Tax Problem!
Not only are mutual funds very expensive to buy and own, they also often bring a tax problem with them for taxable accounts. Successful mutual funds have gained in value. Those gains over many years are reflected in the current share price. When you buy a mutual fund, you are buying the unrealized gains and the unrealized tax on those gains from earlier years. Some funds have unrealized gains that are over 50% of the price of a share of the mutual fund! The result is you end up paying the tax on someone else’s gain! It’s complicated and it is not fair, that is why no one tells you about it. Contact us if you or your family has taxable mutual funds.