THE DELICATE BALANCE BETWEEN INFLATION AND LOW UNEMPLOYMENT

February 16, 2023

In Warren Buffet's 1986 Chairman's letter, he gave a unique insight into a piece of his strategy when it comes to entering and exiting his stock trades. Interestingly enough, it has nothing to do with timing or predicting market direction. 

 

This is what he wrote about not having any stocks that meet his investing criteria. 

 

"This statement in no way translates into a stock market prediction: we have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future. What we do know, however, is that occasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community. The timing of these epidemics will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both as to duration and degree. Therefore, we never try to anticipate the arrival or departure of either disease. Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." [1]

 

Reread the final sentence because it's worth reviewing. 

 

His modest goal: simply be fearful when others are greedy and be greedy only when others are fearful. 

 

If this is the case, now would be the time to think contrarian to the market because it's operating in a place of greed. According to CNN's Fear and Greed Index, the market sentiment has been in an area of extreme greed for most of February. [2]

 

Their fear and greed index have five different points of measuring the market sentiment: extreme fear, fear, neutral, greed, and extreme greed. As of this writing, the index is currently in the "greed zone". 

 

At this point, you should be asking yourself: why?

 

Why is the market sentiment teetering between greed and extreme greed? 

 

The Law of Cause and Effect

We don't believe that it's possible to know the exact reason but we do think there is enough evidence to come to a conclusion with conviction because we're all familiar with the universal law of cause and effect. The law states that every single effect within our world has an original starting point. 

 

Let's assess a few things:

  1. 2022 was a difficult year for portfolio returns that left many investors afraid and grasping for hope as a recession seemed inevitable.
  2. Markets have sustained a positive rally since October 2022 with many people suggesting that the bottom of the bear market has taken place. 
  3. Inflation has slowed and come down from the high of 9.1% in June which suggests that the Fed's aggressive increasing of interest rates is working. 
  4. The January unemployment numbers were below the Fed's 4%-5% target for unemployment and suggests that the labor market is strong. 

 

These are a few of the primary factors that are leading people to believe that the economy is fine and the Federal Reserve will change its stance on aggressively increasing rates. 

 

This narrative is music to the ears of all the investors who are eager to see gains in their portfolio after a year where stocks and bonds both took a beating. 

 

But we have to ask ourselves: does this position make sense? Is it realistic for inflation to get under control if the Fed pivots on increasing rates…especially in a low unemployment environment?

 

The Challenge of Low Unemployment

When the economy is operating at low unemployment, it typically means that there is high demand for labor, and therefore, high demand for goods and services. This high demand can lead to higher prices for goods and services, which in turn can contribute to inflation.

 

In addition, when unemployment is low, employers may have to pay higher wages to attract and retain workers. These higher wages can lead to higher costs of production, which can also contribute to higher prices and inflation.

 

Another factor that contributes to inflation is the level of government spending. When the government spends more money than it collects in taxes, it may need to borrow money by issuing bonds. This can increase the money supply, which can lead to higher inflation if the economy is already operating at or near full capacity.

 

In this scenario, raising interest rates may not be enough to bring down inflation if the economy is already operating with low unemployment, high demand for goods and services, and rising costs of production. 

 

Therefore, the Fed shifting its stance on rising interest rates could encourage more consumer spending which naturally leads to an increase in the prices of goods and services. 

 

We just don't see that happening because consumers are already struggling to keep pace at the current levels of inflation. In the final three months of 2022, we saw credit card debt hit an all-time high and delinquencies among borrowers accelerate. 

 

Wilbert van der Klaauw, an economic research advisor at the New York Fed, said, “Although historically low unemployment has kept consumer's financial footing generally strong, stubbornly high prices and climbing interest rates may be testing some borrowers' ability to repay their debts," [3]

 

On top of these concerns, many of the largest companies in the US have lowered their earnings projections since the beginning of the year. Among the S&P 500, 288 companies have had their consensus 2023 EPS lowered since the end of 2022. 

 

That's 58% of the largest companies with negative revisions compared to 52% of the S&P 500 companies having positive earnings revisions this time last year. [4]

 

Our Modest Goal

In our opinion, there is wisdom in holding tightly to Warren Buffet's advice of being fearful when others are greedy. Our goal for Directional Portfolios is multi-faceted: 1.) We want to position the portfolio to be properly aligned with the overall economic cycle and 2.) We want to be on the right side of the market swings that take place inside that economic cycle. 

 

Our modest goal is to build upon this proactive approach in order to be more agile for our clients in changing markets. 

 

Links to sources:

  1. https://www.berkshirehathaway.com/letters/1986.html"
  2. https://www.cnn.com/markets/fear-and-greed
  3. https://finance.yahoo.com/news/troubling-signs-emerge-as-credit-card-debt-hits-record-high-160607906.html
  4. https://www.morningstar.com/news/marketwatch/20230214250/these-20-companies-are-bucking-a-mostly-negative-earnings-trend-heres-what-that-means-for-their-stocks

EXPLORING CENTRAL BANK DIGITAL CURRENCY (CBDC): THE FUTURE OF MONEY

By Tom Hermann (Chief Investment Officer) • July 14, 2023
The financial landscape is evolving rapidly, and central banks worldwide are embracing the concept of Central Bank Digital Currency (CBDC) as a means to modernize their monetary systems. CBDCs are digital currencies issued by central banks with their value linked to the issuing country’s official currency. The idea of CBDCs is gaining traction globally, with 87 countries actively exploring their implementation [1] . These 87 countries represent over 90 percent of global GDP. In this week's update we will delve deeper into how CBDCs will work, their benefits, and the unnerving risks they present to privacy and freedom. How Will CBDCs Work? In theory, CBDCs have the potential to digitize and replace physical currency. They are digital representations of a country's official currency, and will be issued and regulated by that country's central bank. The main goal for digitizing traditional money is to make it more accessible, efficient, and secure. The emergence of cryptocurrencies like Bitcoin and the growing importance of digital payments have propelled the exploration of CBDCs as a modern financial tool. CBDCs have the potential to revolutionize financial transactions by streamlining processes and reducing costs. In the current financial system, each bank operates its own payment tracking system, resulting in delays and inefficiencies when multiple banks are involved in a transaction [2] . However, since CBDCs would be handled by the central bank it would allow for all the transactions to be consolidated onto a single ledger, enabling instant clearing of payments and universal acceptance, regardless of the payment method or platform used [2] . Ultimately, if this idea comes to fruition, it will eliminate the need for banks that are not the central bank. Benefits of CBDCs CBDCs would require a complete overhaul of the financial system. Therefore, CBDCs must offer several significant advantages to justify that type of overhaul. Here are the some of the most prominent benefits for CBDCs: Reduced Costs - One key benefit is the potential for reduced costs. By shifting focus from physical infrastructure to digital finance, financial-service providers could save an estimated $400 billion annually in direct costs [3] . Increase speed - CBDCs have the capacity to enhance the speed and efficiency of electronic payment systems, benefiting both individuals and businesses. Appeal to the unbanked - CBDCs offer a solution for people who do not have access to a bank account. According to a survey from 2016, 1.6 billion people around the world did not have a bank account. Another statistic shows that less than 5% of adults do not have a bank account [3] . CBDCs have the potential to increase financial inclusion, empowering those without bank accounts, but adoption isn’t a guarantee as many underbanked people may favor the total anonymity that comes with using cash. Heightened Security - This is a byproduct of the speed and single bank ledger. Private key cryptography could be implemented for users to "sign off" on transactions digitally, and they would become finalized and unalterable in a short period of time [3] . Risks and Concerns While CBDCs offer numerous benefits, they also come with risks and concerns that must be carefully addressed. One major concern is the potential for increased governmental control. Although no central bank currently plans to restrict CBDC usage, the hypothetical possibility of the government deciding which purchases are permissible raises privacy and individual freedom concerns. Additionally, the traceability of digital currency may lead to increased taxation, as every transaction becomes easily traceable. Technological stability is another challenge, as evidenced by the temporary shutdown of the digital version of Eastern Caribbean DCash due to technical issues [4] . Let's take a moment to go more in depth on the potential for governmental control. The following is a quote from professor Eswar Prasad. Prasad is a professor at Cornell University and the author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. Prasad made this statement while speaking at the World Economic Forum's annual meeting of the new champions. “You could have, as I argue in my book, potentially better and some people might see a darker world, where the government decides that unit, so central bank money can be used to purchase some things but not other things that are deemed less desirable, like, say, ammunition or drugs or pornography or something of the sort. And that is very powerful in terms of the use of a CBDC and I think also extremely dangerous for central banks” [5] Prasad noted that he was only speaking hypothetically and said, “No central bank is contemplating any such uses for its CBDC but, as an academic, it is important for me to point out all the possibilities and potential—both good and bad—of a world in which all payments are digital and anonymity might be limited (relative to the use of cash).” [5] This is possible because CBDCs are programmable. For example, a CBDC could be programmable where it can only be used for certain items or even have an expiration date – which would ultimately force spending. This allows for CBDCs to make it much easier for a centralized authority to dictate and control human behavior because they can restrict the flow and opportunities if you are not behaving in a manner that they're requesting. This is very evident in China's social credit system. Use Cases for CBDCs It's important to balance the potential benefits of CBDCs with concerns related to individual privacy and governmental control. This is highlighted by China's social credit system. The China social credit system is a broad regulatory framework intended to report on the ‘trustworthiness’ of individuals, corporations, and governmental entities across China [6] . China’s “Social Credit System” rates its citizens based on their behaviors, and those who score well get privileges; those who score poorly do not. A citizen with a high score is likely to enjoy various privileges—high-speed internet, the ability to travel freely, access to the best restaurants, golf courses and nightclubs—that fellow citizens do not [7] . There are many ways to lose points and lower one’s social credit score, depending on the city where the offense takes place. Some of the more trivial score-lowering actions include: not visiting their parents on a frequent basis, jaywalking, walking a dog without putting it on a leash, smoking in a non-smoking zone, and cheating in online videogames [6] . A citizen with a poor social credit may experience one of these forms of punishment [6] : Travel bans Reports in 2019 indicated that 23 million people have been blacklisted from traveling by plane or train due to low social credit ratings maintained through China’s National Public Credit Information Center [6] . School bans The social credit score may prevent students from attending certain universities or schools if their parents have a poor social credit rating. For example, in 2018 a student was denied entry to University due to their father’s presence on a debtor blacklist [6] . Reduced employment prospects Employers will be able to consult blacklists when making their employment decisions. In addition, it is possible that some positions, such as government jobs, will be restricted to individuals who meet a certain social credit rating [6] . Increased scrutiny Businesses with poor scores may be subject to more audits or government inspections [6] . Public shaming In many cases, regulators have encouraged the ‘naming and shaming’ of individuals presented on blacklists. In addition, flow-on effects may make it difficult for businesses with low scores to build relationships with local partners who can be negatively impacted by their partnership [6] . CBDCs can also allow the government to be more targeted in their efforts to manage economic growth. One such case is the ability to combat inflation effectively. With the flexibility of CBDCs, central banks can implement different interest rates on specific balances or accounts, allowing for more precise monetary policy implementation. CBDCs also have the potential to support targeted stimulus efforts by directing funds to designated sectors or implementing expiration dates to encourage spending [8] . Implementation Timelines The timeline for CBDC implementation varies by country. In the United States, the Federal Reserve is already taking steps to address transaction inefficiencies by launching the FedNow digital payments system by the end of July 2023. This system aims to provide low-cost bill payments, money transfers, paychecks, government disbursements, and other consumer activities [9] . Time will tell when this will be fully implemented in the United States, but many see the implementation of FedNow as the first step toward a CBDC. Globally, a recent survey suggests that by 2030, approximately 24 central banks will have implemented digital currencies. This projection highlights the increasing global adoption and recognition of CBDCs as a fundamental part of future financial systems [10] . It is not a foregone conclusion that CBDCs will be implemented as there is plenty of opposition to the idea. Senator Cruz from Texas and Governor DeSantis from Florida have both introduced legislation to prohibit the Fed from establishing a CBDC [11][12] . If CBDCs take over the financial system, it appears there will be minimal options for those who do not want to participate in the system. Some of those options may include: using bitcoin that is established on a decentralized platform with options for privacy and anonymity, using physical precious metals like gold and silver, and/or exchanging value for value like in an archaic bartering system. Conclusion Central Bank Digital Currencies have the potential to revolutionize the way we transact and interact with financial systems. By leveraging digital technologies, CBDCs can offer reduced costs, increased speed, improved financial inclusion, and heightened security. However, careful consideration must be given to the risks associated with potential governmental control, privacy concerns, and technological stability. As countries progress toward a digital economy, CBDCs will play a pivotal role in shaping the future of money, transforming financial systems and enhancing economic efficiency on a global scale. The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situati on. Sources: https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-central-bank-digital-currency-cbdc https://www.forbes.com/advisor/investing/digital-dollar/ https://www.mckinsey.com/featured-insights/mckinsey-explainers/what-is-central-bank-digital-currency-cbdc https://www.bloomberg.com/news/articles/2022-02-21/eastern-caribbean-dcash-outage-is-test-for-central-bank-digital-currencies?sref=YMVUXTCK https://apnews.com/article/fact-check-world-economic-forum-cashless-society-false-cbdc-592718364311 https://nhglobalpartners.com/china-social-credit-system-explained/ https://fee.org/articles/china-s-social-credit-system-sounds-pretty-dystopian-but-are-we-far-behind/ https://financialpost.com/fp-finance/cryptocurrency/central-bank-digital-currency-inflation-fighters-best-friend https://www.forbes.com/advisor/investing/digital-dollar/ https://www.reuters.com/markets/currencies/twenty-four-central-banks-will-have-digital-currencies-by-2030-bis-survey-2023-07-10/ https://www.cruz.senate.gov/newsroom/press-releases/sen-cruz-introduces-legislation-to-prohibit-the-fed-from-establishing-a-central-bank-digital-currency https://www.flgov.com/2023/03/20/governor-ron-desantis-announces-legislation-to-protect-floridians-from-a-federally-controlled-central-bank-digital-currency-and-surveillance-state/

THE WARNING SIRENS: RISING INTEREST RATES AND SLOWING BUSINESS PERFORMANCE ARE HARBINGERS OF ECONOMIC CHALLENGES

By Tom Hermann (Chief Investment Officer) • July 7, 2023
The global economy is facing increasing pressures, and there are growing concerns about a potential recession on the horizon. Two significant indicators that have historically foreshadowed economic downturns are an inverted yield curve and Purchasing Managers' Index (PMI) readings below 50. Over the past couple of months these two indicators have continued to point in the direction of an impending recession. In this week’s update, we will explore the historical context and significance of these indicators and analyze their current implications for the economy. Understanding the Inverted Yield Curve: An inverted yield curve occurs when short-term interest rates exceed long-term rates, typically reflected in the inversion of the two-year and 10-year Treasury yields. An inverted yield curve is often viewed as an indicator of a troubled economy because it deviates from the normal yield curve shape, where longer-term interest rates are typically higher than shorter-term rates. In an inverted yield curve scenario, short-term interest rates exceed long-term rates, implying that investors have lower expectations for future economic growth and inflation. This phenomenon has been a reliable recession predictor in the past, and suggests that the global economy is headed toward a recession despite the stock market trading near all-time highs 1 . The Fed chose to pause rate hikes during their June meeting, but many expect the rate hikes to continue in the future 2 . Persistently raising short-term rates in an inverted yield curve environment can increase the risk of an economic slowdown or recession. The inversion of the yield curve itself is often seen as a reliable predictor of economic downturns. By continuing to tighten monetary policy in this scenario, the Fed may unintentionally contribute to a deeper and more prolonged recessionary environment. PMIs Indicating Economic Contraction: PMIs, or Purchasing Managers' Indexes, are widely used economic indicators that provide valuable insights into the health and performance of various sectors within an economy. They are based on surveys conducted among purchasing managers in manufacturing, services, construction, or other sectors. The purpose of PMIs is to gauge the prevailing business conditions, sentiment, and trends within a specific sector or the overall economy. When a PMI reading falls below 50, it indicates economic contraction. The US manufacturing sector's recent contraction, raises concerns about the overall economic health and suggests a challenging road ahead 3 . The ISM Manufacturing PMI came in at 46 in June, down from 46.9 in May. This is the lowest reading since July 2020 3 . The manufacturing sector is followed closely due to it strong linkages with other sectors of the economy. Changes in manufacturing activity can impact supply chains, employment levels, and the performance of related industries. Manufacturing job losses can have a cascading effect on the economy, impacting consumer spending and business investment, and further contributing to the likelihood of a recession. Analysis of Current Economic Indicators:

RESILIENCE AND VULNERABILITIES: DECODING THE GLOBAL ECONOMY'S STORY

By Tom Hermann (Chief Investment Officer) • June 30, 2023
Amidst upwardly revised GDP growth and declining jobless claims, underlying risks such as banks prioritizing financial stability and a decline in global manufacturing cast a shadow of uncertainty. In this week's update, we delve into crucial economic factors that are currently shaping the global landscape. By examining manufacturing PMI, banks' defensive stance, and the resilience observed in the US economy, we aim to provide valuable insights into the current state of affairs. Manufacturing PMI and Recession Signals The S&P Global Flash US Manufacturing PMI™ is a widely recognized economic indicator that measures the performance of the manufacturing sector. In June 2023, the PMI dropped to 46.9 [1] , raising concerns about a potential recession. The PMI measures the performance of the manufacturing sector based on surveys conducted among purchasing managers. It provides an overview of various aspects, including new orders, production levels, employment, supplier deliveries, and inventories. A reading above 50 indicates expansion, while a reading below 50 suggests contraction. This decline from 51.0 in May marks the lowest reading since February 2020. The contraction in the manufacturing sector is primarily driven by a slowdown in new orders and production [1] . Manufacturing PMI is an important indicator as it reflects the overall economic health of a country. The slowdown in new orders and production can be influenced by various factors such as changes in consumer demand, supply chain disruptions, labor shortages, trade policies, and global economic conditions. However, in this instance, the largest contributors are a drop in consumer demand and global economic conditions. Historically, there is a correlation between manufacturing PMI contractions and economic recessions. For instance, during the global financial crisis of 2008-2009, the PMI readings dropped significantly, signaling an economic downturn. Similarly, the PMI contraction in 2020 preceded the economic recession triggered by the COVID-19 pandemic. This makes it an important signal for investors and businesses to monitor [1] . Defensive Posture of Banks Worldwide Banks worldwide have been adopting a defensive posture, which further signals potential trouble ahead [2] . A defensive posture means that banks are taking measures to mitigate potential risks and ensure financial stability. Specific actions can include increasing capital reserves, tightening lending standards, reducing exposure to high-risk assets, enhancing risk management practices, and diversifying their portfolios to minimize vulnerabilities. The cautious approach of banks reflects their awareness of potential risks in the economy. By adopting a defensive posture, banks aim to protect themselves from financial shocks, economic downturns, and uncertainties. This cautious approach contributes to overall economic stability by reducing the likelihood of systemic risks and enhancing the resilience of the financial system. When banks take this defensive posture, it becomes a greater priority to be fiscally stable than make loans - which are the main revenue source for banks. In my opinion, this is something to watch as many commerical real estate loans come due in the next 12-18 months. As interest rates have significantly increased over the past 12 months, it will be challenging for businesses to renew those loans which will negatively impact the banks and their revenue [3] . Signs of Resilience in the US Economy Despite concerns highlighted by manufacturing PMI numbers and the defensive posture of banks, positive news emerges from the US economy. First-quarter GDP growth has been revised up to 2.0% from 1.3% [4] , indicating ongoing economic expansion. The revision of first-quarter GDP growth from 1.3% to 2.0% indicates that the US economy is expanding at a slightly faster pace than previously estimated. This upward revision suggests stronger economic performance and reflects positive momentum. Additionally, weekly jobless claims in the United States fell to their lowest level since October 2021 [4] . The decline in jobless claims to their lowest level since October 2021 signifies a that the labor market is showing signs of resilience. In previous weeks we've discussed the impact of labor hoarding and how it could be affecting these weekly numbers. The revised GDP growth and the decline in jobless claims reflect the resilience of the US economy. However, it is important to note that the economy is growing at a slower pace compared to previous quarters [4] . The Federal Reserve's efforts to combat inflation may influence future economic growth. While positive indicators exist, rising inflation and external factors such as the war in Ukraine could impact the possibility of a future recession [4] . Conclusion In summary, considering the manufacturing PMI numbers, the defensive stance of banks, and the positive indicators in the US economy, the outlook for the next 6-12 months remains uncertain as we are getting mixed signals across the global economy. There are some encouraging signs for the US economy as the labor market appears to be resilient. However, there's an undertone of vulnerability that warns of potential risks that could lead to a sharper downturn if not carefully managed. Our Directional Portfolios aim to build a portfolio that will adjust with the business cycle. If you'd like to learn more, you can call or text at 678.884.8841 or email us at connect@findabundance.com . The opinions expressed in this commentary are those of the author and may not necessarily reflect those held by Kestra Investment Services, LLC or Kestra Advisory Services, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situati on. Sources: https://www.pmi.spglobal.com/Public/Home/PressRelease/6e8efbfbddde43f29eb12c5193939625 https://www.ecb.europa.eu/press/key/date/2023/html/ecb.sp230302~41273ad467.en.html https://fortune.com/2023/06/26/commercial-real-estate-office-downturn-outlook-goldman-sachs-morgan-stanley-ubs-pwc-bofa/ https://www.reuters.com/markets/us/us-weekly-jobless-claims-fall-first-quarter-gdp-revised-higher-2023-06-29/
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