Author: Robert Kahl

Independent Investment Advisor | Investment Portfolio Management | 401(k) and 403(b) Advisor | Nonprofits | Families
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The Fed’s New Rationale

The Fed’s New Rationale

Federal Reserve Chairman Jerome Powell gave a speech at Jackson Hole, Wyoming to outline the Fed’s new rationale for monetary policy.  The purpose of the speech was to outline a new framework for the Fed’s monetary policy.

Chairman Powell said the review of monetary policy was motivated by “our evolving understanding of four key economic developments.”  The four economic developments that he listed are:

  1. Assessments of the potential, or longer-run, growth rate of the economy have declined. For example, since January 2012, the median estimate of potential growth from FOMC participants has fallen from 2.5 percent to 1.8 percent.
  2. The general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate.
  3. The record-long expansion that ended earlier this year led to the best labor market we had seen in some time. The unemployment rate hovered near 50-year lows for roughly 2 years, well below most estimates of its sustainable level.
  4. The historically strong labor market did not trigger a significant rise in inflation. Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realized on a sustainable basis.

The revised statement of longer-run goals and monetary policy was approved unanimously by the Federal Reserve Open Market Committee.  While some aspects of the Fed’s policy remain in place, Chairman Powell highlighted some changes.

  1. The Fed expressly acknowledges that interest rates at the “lower bound” of its policy range reduces their scope to support the economy in the future by cutting interest rates.
  2. Maximum employment is a broad-based and inclusive goal. They appreciate the benefits of a strong labor market, particularly for many in low- and moderate-income communities.
  3. Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks.
  4. Their actions to achieve both sides of their dual mandate (stable prices and maximum sustainable employment) will be most effective if longer-term inflation expectations remain well-anchored at 2 percent.

In a curious comment that seems designed to give the Fed more leeway, Chairman Powell said that they would not be tying themselves to a “particular mathematical formula” that defines average inflation.  Their approach “could be viewed as a flexible form of average inflation targeting.”

While the economic developments that Chairman Powell listed are accurate, some commentators believe the Fed needed a new rationale to justify the huge volume of purchases of US Treasury securities and, to a lesser extent, mortgage-backed securities.  Since September 4, 2019 (one year ago), the Fed has added $2,276 billion of US Treasury securities and $460 billion of mortgage-backed securities to their balance sheet.

The Congressional Budget Office is now projecting a federal budget deficit of $3.3 trillion for the fiscal year ending September 30, 2020.  This requires US Treasury debt issuance that far exceeds demand from the private sector, so the Fed buys much of the new debt.  The increase in the monetary base to accommodate federal deficit spending and US Treasury debt issuance is likely to lead to inflation that exceeds 2%, along with further declines in the US currency.

Note to Clients

Earlier this year, I asked clients for approval via e-mail or phone conversation to temporarily increase the maximum limit on the precious metals allocation from 15% to 30%.   I now expect the reasons for having a significant precious metals allocation to remain in place for some time.

During the next two weeks, I will be sending out revised investment guidelines to show a potential allocation range of 0 – 30% for precious metals.  In the past, I committed the maximum of 30% of portfolios to precious metals bullion.  This proved to be timely and the precious metals allocation in most accounts now exceeds the initial allocation of 30% because gold and silver have increased in price more than most securities.  I would also like some provision in the investment guidelines to acknowledge that the upper limit on the allocation may be exceeded due to better relative performance.  I am not necessarily a perma-bull on precious metals, but I believe it will continue to be an attractive asset class until the US and other governments take a rigorous stance against deficit spending and the creation of more fiat currencies.

If you have any questions, please contact me.

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Financial Markets Commentary – July 4, 2020

Time to Re-open the Economy?

As the economy began to re-open, the Center for Disease Control (CDC) began to report an increase in COVID-19 cases.  In response, state and local governments began to shut down or restrict business and social activities again.

According to the CDC, one month ago, the number of daily new cases for COVID-19 was in the 15,000 to 25,000 range.  During the last week, the number of daily new cases was in the 35,000 to 55,000 range.  However, the number of weekly total deaths from all causes in the US has fallen by over 20,000 from its peak that occurred during the week ending April 11.  The dichotomy is most likely due to the increase in testing and the nature of testing for COVID-19.  Since testing has increased, more people are receiving results that indicate they have/had the virus.

There are now more than 30 different test kit providers for COVID-19.  There are two basic types of tests.  Some tests are designed to test for antigens – a specific virus, bacteria or other foreign substance that results in an immune response.  Antigen tests indicate a current infection.  Serology (or antibody) tests are designed to detect antibodies in blood serum which are proteins that can fight off infections.  Serology tests indicate that there has been an immune response in the past but the virus itself may be absent.  Some doctors have been critical of the CDC testing data that conflates the two types of tests and treats them equally.

The CDC is currently conducting surveillance of US serology testing by commercial laboratories.  The surveillance should allow the CDC to develop a better understanding of 1) how much of the US population has been infected with COVID-19; 2) how it has been changing over time; and 3) how many people experienced mild illness or were asymptomatic.  At the present time, the CDC is unable to predict to what extent the presence of antibodies will provide immunity to prevent future illness from the virus.

Given the increased testing and nature of the serology tests, the potential for illness is not as scary as some of the media reports would indicate.  However, the policy response of various government entities has been to assume the worst interpretation of the data.

 

Investors Are Fed Dependent

While the global economy is struggling to recover from the impact of COVID-19 and recent social strife, the financial markets have reacted to the negative developments with aplomb.  Corporations will start reporting financial results for the second calendar quarter soon and there will likely be some negative surprises.

On Thursday, Ray Dalio, founder of Bridgewater Associates, had an interview with Bloomberg.  While his comments reflect the thinking of many professional investors, Dalio speaks his mind a little more freely than most.  Some of his comments:

  • “The capital markets are not free markets allocating resources in the traditional ways.”
  • “The economy and the markets are driven by the central banks in coordination with the central government.”
  • Unlike the 2008 financial crisis, now “the whole economy is systemically important. If they don’t go out and lend to companies… we would lose large parts of the economy.”
  • Regarding stock market valuation levels: “Multiples shouldn’t be used in the traditional way of a frame of reference.”
  • “You are going to see central banks’ balance sheets explode.”
  • If a compelling alternative to the dollar emerges, “it would be probably the biggest disruptor not only to the markets but to the whole world geopolitical system.”

Nick Panigirtzoglou is an analyst at JP Morgan who writes their “Flows and Liquidity Report.”  He estimates that the US Treasury will have net issuance of $4.1 trillion in new debt this year and the Federal Reserve will purchase $2.5 trillion of this new debt.  That would leave $1.6 trillion of debt to be purchased by the public.  The problem is that the purchase of this much debt by the public would require higher interest rates as an inducement to sell other assets (like stocks or certificates of deposit) to use them as a source of funds for the purchases.

Panigirtzoglou believes that the financial markets are already signaling the need for further monetary and/or fiscal policy stimulus.  The writers at ZeroHedge opined: “Unless the Fed wants another market meltdown on its hands, it better pre-emptively stimulate and do so to the tune of trillions.”  Indeed, that appears to be the path of least resistance for the Fed.

 

Precious Metals Update

COVID-19 has had an impact on mine production worldwide.  The two countries with the largest silver mine production in the world are Mexico and Peru.  Due to COVID-19 related mine closures, their combined production declined from 822 metric tons in February to 386 metric tons in April.  Information for gold mining production was unavailable.

Craig Hemke, analyst with Sprott Inc., has written about the increased physical demand on the COMEX for both gold and silver.  In the past, most COMEX contracts were closed prior to the contract’s expiration and there was no physical delivery of metal.  In past years, an average delivery month for COMEX gold had 6,000 – 10,000 contracts (100 ounces each) that resulted in delivery of physical gold.  In June 2020, there were 55,102 contracts (equal to 5,510,200 ounces or about 171 metric tonnes) that required delivery.  Hemke writes, “the physical delivery crisis continues unabated and it appears that COMEX will be under delivery distress for the foreseeable future.”

According to Hemke, the story is very similar for COMEX silver.  In the past, a typical delivery month had about 3,000 – 4,000 contracts (5,000 ounces per contract) that required delivery.  May and June 2020 had 9,044 and 16,834 contracts, respectively, that required delivery.  The amount of deliveries for the July contract on the first day of the month was 11,458, so there will likely be a new record amount requiring delivery for the month.  Hemke writes, “The weight of all this delivery demand may eventually lead to a force majeure-style failure, but that’s very likely not coming this month or next.”  He believes that the CME, LBMA, and bullion banks will work to protect the pricing scheme as long as they can.  Given the reduced mining supply and higher level of demand for physical delivery of gold and silver, I expect higher prices during the remainder of the year.

If you have any questions or comments, please contact me.  Happy 4th of July!

Robert G. Kahl
CFA, CPA, MBA

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Financial Market Commentary 5/1/2020

Aftermath of COVID-19

The Labor Department announced yesterday that another 3.8 million people filed claims for jobless benefits last week. A total of 30.3 million have applied for unemployment in the past six weeks since the COVID-19 economic shutdown started.

In mid-March, I thought the economic shutdown would be shorter in duration and the economic rebound would be quick.  Based on a variety of reports, it now appears that the economic recovery will take much longer.  While some companies have access to Federal Reserve loans and other sources, many companies will have difficulty finding sources of financing while their businesses recover.  Many businesses are adjusting their cost structures to adjust to revenue levels that are expected to be lower than before COVID-19.  Consumers will also give more consideration to how they spend money.

The federal government, state and local governments, many businesses and households have increased their debt levels during this period of economic shutdown.  As the economy restarts, a higher portion of their cash flow will likely be used to service debt and reduce debt outstanding.  Higher debt levels will act like a dragging boat anchor for the economy.

There have been numerous announcements of dividend cuts or suspensions.  Among the companies that have suspended dividends altogether are Marriott International, General Motors, Ford, Boeing, Delta Air Lines, Darden Restaurants, and TJX Companies.

 


CBO Projections and Other Economic Indicators

The Congressional Budget Office (CBO) is forecasting that the unemployment rate will average 15% during the second and third calendar quarters and will subside to 10% by the end of 2021.  The CBO projects a decline in real GDP in Q2 (2nd quarter) compared to Q1 of -11.8%.  For the full calendar year of 2020, they expect a decline in GDP of -5.6%.

Based upon current tax laws, the CBO projects that the federal budget deficit will be roughly $3.7 trillion in fiscal year (ending September 30) 2020 and $2.1 trillion in fiscal year 2021.  They also project that interest rates will remain at current levels.

The US Composite PMI (purchasing managers index), a key leading economic indicator, slumped to 27.4 in April.  A level of 50 represents an economy that is at a steady state.

The household savings rate increased to 13.1% of personal disposable income.  This represents a 40-year high.  Bank of America’s chief investment strategist, Michael Hartnett, argues that consumers have the ability to finance recovery but their willingness to do so is in doubt.  Positive consumer sentiment would be helpful.  The University of Michigan consumer sentiment index was at 71.8 for April, the lowest level since December 2011.

Despite the dismal economic reports, the S&P 500 index increased by 30% from its year-to-date low on March 23 to the end of April.  Based upon the last twelve (trailing) months, the S&P 500 Index is priced at 20.9X earnings, with a 2.05% dividend yield.  However, second quarter earnings are expected to be fully impacted by the COVID-19 shutdowns and more dividends will be suspended or cut by companies.

 


Corporate Debt Markets

Boeing (BA) is one of the companies that has benefited from Congressional and Federal Reserve largesse.  BA raised $25 billion in a bond offering yesterday.  The company originally planned to sell $10 to $15 billion but decided to increase the debt issuance to $25 billion in response to $75 billion worth of offers.  Maturities ranged from 2023 to 2060.  The 10-year bond was priced at a yield of 5.15%, 450 basis points above the US Treasury 10-year bond.  Last July, BA sold a 10-year bond priced at a 90 basis point premium to US Treasury bonds.

BA’s debt was recently downgraded to BBB-, the lowest rating that is still in the investment-grade category.  For the first quarter ending March 31, 2020, BA reported a net loss of $628 million and negative shareholders’ equity of $ -9.4 billion.  The BBB- credit rating makes BA eligible for purchase by the Fed.  But the Fed also reserves the right to purchase “fallen angel” bonds that fall into the speculative category.  Thus, Boeing indirectly benefitted from the backstop provided by the Fed’s commitment to purchase corporate debt.

Much of the corporate debt that has credit ratings in the speculative category does not currently qualify for purchase by the Fed.  Many of these companies with lower credit ratings will have to restructure financially or close and liquidate.  A financial restructuring in Bankruptcy Court often involves a conversion of debt to equity on terms that are highly dilutive for the existing common shareholders.

 


Mining Supply

Anna Golubova of Kitco News analyzed a recent report on mine production from GlobalData and writes that “as of April 27, an equivalent of 65.8% of yearly global silver production is still on hold.”  By comparison, only 13% of copper and 9% of gold mine production is shut down.

The ratio of the price of gold/silver is now at 112.  Relative to gold, silver has never been cheaper during the last 5,000 years.  The price of silver has potential.

 


Outlook

The strong rebound in equity markets during the last five weeks appears overdone.  I expect to see better buying opportunities for stocks in the coming months despite the record high $4.7 trillion that is now parked in money market funds.  In this type of market with large short-term swings, I believe it makes sense to trade more actively.

Fixed income with high credit quality should be stable during the next few months.  We will see more credit downgrades and eventually some defaults of many debt securities.

Gold and silver bullion prices should do well in this financial environment, although the timing is certainly difficult to predict.

If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA