In the immediate aftermath of the financial crisis and housing downturn, Alan Greenspan, the former Federal Reserve Chairman, was dragged in front of Congress to explain what he and the Fed did wrong in the lead up to the crash. When one Congressman mentioned that a few people had mentioned prior to the collapse in the housing market, that low rates were fueling a hosuing bubble that was bound to pop, Greenspan responded with “A lot of people say a lot of things.”

Indeed, that is the feeling one may have lately as the doom and gloom brought on by the Fed’s rate rises grip the US and world economies. I have read treatises about how inflation may not be dictated by the central banks this time around but rather by governments on a war footing. I have read about how a new era of stagflation may be taking hold, with rapid rate rises tanking the economy and governments hoarding commodities and labor, fueling inflation in other countries. And I have read about how the simultaneous interest rate rises around the world could be ushering in a new call for a modern gold standard as battling rate rises seek to pass off inflation onto the next country rather than experience it at home.

While some of these takes may be interesting, worrying or downright terrifying, rather than cowering in fear, I find it’s often more useful to weigh the likelihood of different outcomes and plan accordingly and as always, look for the silver lining.

The Pain

First is to assess the damage and where things stand in the investing world right now. This post is called nowhere to run because we are going through an almost unprecedented economic era when both bonds and stocks are falling in value.

Those who study economic history or are old enough to have been investing before the beginning of the 40 year bull market in bonds which just came to an end, have been conscious of the risk to bonds for what seems like decades now.

Interest rates and bond prices are inversely correlated so higher yields mean lower prices. In addition, investors are looking for returns above inflation. Inflation surprises hurt bond holders as they send prices tumbling in order to adjust to have yields more closely reflect inflation.

The “transitory” talk, in which the Fed expected inflation to be high for a short period and then subside, proved false. When the Fed pivoted and admitted its mistake, the inflation surprise coupled with rate rises sent bond prices falling like we haven’t seen in a generation.

When inflation was low or predictable, bonds could act as a counterweight to falling stock prices. Usually the Fed would cut rates when the economy slowed and stocks fell, lowering bond yields and raising bond prices. This price rise acted as a counterweight to falling stock prices which lessened the blow for those who held a diversified portfolio consisting of both stocks and bonds. One of the most popular of these has always been the 60/40 portfolio consisting of 40% bonds and 60% stocks.

Yet the prospect of higher rates, stubbornly high inflation and a darkening geopolitical and economic outlook, has sent share prices and bond tumbling at the same time this year. The normally reliable 60/40 bonds and equities portfolio has lost over 20%% this year which is one of the worst on record.

The Fear

Yet this isn’t even the worst part. As I mentioned in the beginning, the bears have another gloomy cloud to send our way. Right now markets are pricing in a brief bit of inflation, say a year or two, and then a return to a more normal environment with low inflation. We know this because rates are peaking in the 4-5 year treasury market, then falling off after. The 10 year yield is at 3.88% compared to a 5 year yield of 4.1%. This “return to normalcy” may well turn out to be true. In such a scenario, we may see a short term recession this year into next, which will quell inflation and then rate cuts will push up both bond prices and stock prices and the happy times will return.

But the bears have an even more dastardly vision. Some of them are imagining a scenario where energy prices and structural labor shortages keep inflation high in the long term. In this scenario the US enters a recession this year or next yet continues to experience inflation well above the 2% target. At that time the gloves come off and inflation expectations for the long term may take off. 10 and 30 year treasuries could plummet in value. This will wallop corporate borrowers who issue long term debt and will slam the housing market, where rates usually trade off a spread to 10 year treasuries. If homebuyers fear 6% rates, imagine having to contend with 10% rates when inflation expectation decouple from the past. House prices are similar to bond prices in the sense that higher rates would drag values downward as they increase the carrying cost to own a home through a mortgage.

Silver Lining

Yet in all of this, there is still good news, and that good news is that savvy investors can be prepared for both the bull scenario with inflation being tamed in the near term, or the bear scenario where inflation becomes more entrenched.

First let’s look at the optimist’s scenario. This will likely follow a familiar path for investors used to the traditional cycles of the past 20-30 years. Overall, inflation will peak some time in 2022 or early 2023. The Fed will pause rates and wait to see that inflation will not return. The US will likely enter a recession but after a quarter or two where inflation remains weak and unemployment starts to rise, the Fed will cautiously cut rates, maybe in late 2023.

In this outcome, stocks may bottom this year or early next year (depending on how inflation appears in the subsequent quarters). In a reverse to what has played out this year, investors will experience a rally in both stocks and bonds of all duration with holders of short term debt seeing strong price gains. The dollar could reverse some of its gains of the past year, potentially even producing gains in developed market bonds and shares.

This scenario would return us to a more familiar place with low rates, rising share prices and bonds at high prices. The housing market, likely entering a downturn, would continue to be soft for a few years but eventually would see things turn and start to see price gains again. The home buyers of 2022 to 2024 may turn out to be winners.

The Bear Case

I briefly touched on the bear case previously. This is a scenario where rate increases don’t offset structural shifts in production, producing a scarcity in both goods and services. In this scenario, rate increase still send the economy into recession but inflation remains high.

In such a scenario, there will be little place to hide on the long side. The few bright spots in equities may be in defensive sectors like healthcare, defense, and consumer staples. Medium and long term bonds would get crushed. Corporate borrowing costs would skyrocket leading to further layoffs. It wouldn’t hurt to purchase long term treasury puts to hedge for an outcome like this.

Here, the macro factors may start to play an important role as well. As I discussed in a recent post, oil companies that can tap large natural gas resources may be the winners of an energy crisis in Europe. Even with slackening demand at home, the gas demand in Europe isn’t going to change overnight with a switch to other sources. Oil companies like Occidental and Chevron can export this gas for a hefty profit, which they will have room to do since most of their sales are domestic currently.

After the initial fall in prices, bonds of all durations may actually start to look attractive again. Even if they don’t beat inflation, it’s better to earn 5% or 6% and lose 2% when inflation is 8% rather than get trapped in a falling stock market with inflation high, with falling prices coupled with inflation compounding your losses.

Yet there is silver lining for higher rates of all durations: conservative savers will finally be rewarded again. Bank deposits will pay more as will money market funds and short term bonds. Short term bonds especially will start to closely try to track inflation to at least return par.

The situation could end up looking a lot like the 1973-1974 bear market in the US. This period saw both stocks and bonds fall in value but in the subsequent years, stocks turned out to be a complete disaster, having falling 44% from peak to trough. Bond investors lost money but it was still a better place to be than stocks.

In addition to the few places to be long, as distasteful as it is to some, gains could be had in buying puts in particularly vulnerable companies. This could be the next trade from any gains had from profitable puts on long dated treasuries. Those companies with fixed income assets, like say, companies that have a lot of fixed rate leases on their books, could see huge losses. In addition, a prolonged downturn would mean they see less demand to replace those assets with higher fixed rate debt. This is one reason I am short firms like Affirm, which specialize in buy now pay later, which are stocked full of fixed rate short term assets.

For long term investors, stocks may finally start to look cheap. This will only be for those that can endure multiple years of losses, but tenacity and grit has always proved to be an asset for such an investor.

Conclusion

In summary, there are 2 main scenarios investors can plan for when it comes to rates and inflation. In the bull case:

⁃ Long domestic bonds, both short and long term

⁃ Long domestic stocks

⁃ Long foreign stocks, I really like Japan for this outcome as cheap exports boost their economy

⁃ Occidental Petroleum for greater gas and carbon capture demand

And for the bear case:

⁃ Long dated Treasury puts

⁃ Consumer Staples, Healthcare and Defense stocks

⁃ Short term treasuries

⁃ Short or puts on leasing companies

⁃ Occidental Petroleum (again)

One additional individual stock call I am willing to make in the bear scenario is the trade finance firm Bladex. This is a bank to facilitate trade in Latin America. It is collectively owned by the region’s central banks so benefits from sovereign preference. Its short dated dollar assets and willingness for riskier emerging markets give it a pricing edge in a chaotic world, and Latin America is adept at moving in a chaotic and risky environment. It’s also a small cap stock with a market cap of $500 million currently, this allows it to yield 6-7% while flying under the radar of large funds looking for a stable yield pick up.

Investors willing to look past the headlines and hype will be able to spot opportunities amidst either scenario. As always, keeping core positions in stocks and bonds is key and will position investors to benefit from these long term, no matter what the next few years may bring.

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