Author: Robert Kahl

Independent Investment Advisor | Investment Portfolio Management | 401(k) and 403(b) Advisor | Nonprofits | Families
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The Inflation Inflection Point

There was a positive reaction by the financial markets to Federal Reserve Chairman Powell’s comments on Wednesday this week.  He said, “The time for moderating the pace of rate increases may come as soon as the December meeting.” The last four rate hikes to the fed funds rate have been 75 basis points (0.75%), so he is indicating a rate hike of 50 or 25 basis points at the conclusion of the Federal Open Market Committee meeting on December 14.  The current fed funds rate target is 3.75-4.0%.

The financial markets paid less attention to Chairman Powell’s other remarks, which reflect the Federal Reserve’s concern of reducing inflation.  After his comment about the December rate hike, he said, “History cautions strongly against prematurely loosening policy.  We will stay the course until the job is done.”

Goldman Sachs strategists are forecasting a peak federal funds rate of 5.25% in May following a 50 basis point hike on December 14 and three more 25 basis point hikes next year.  Most economists expect inflation to trend lower as interest rates peak and supply constraints ease.

Rob Arnott, Partner and Chair of Research Affiliates and his partner, Omid Shakernia, recently published an article, “History Lessons: How ‘Transitory’ Is Inflation?”  The full article is located here: https://www.researchaffiliates.com/publications/articles/965-history-lessons.  Their conclusion is contrary to the consensus.  They cite a meta-analysis of 67 published studies on global inflation and monetary policy by Havranek and Ruskan (2013) which found that across 198 instances of policy rate hikes of 1% or more in developed economies, the average lag until a 1% decrease in inflation was achieved was roughly 2 to 4 years.

Arnott and Shakernia conducted their own study and examined all cases where inflation surged above 4% in 14 OECD developed economy countries from January 1970 through September 2022.  Their study focused on the level and trend of inflation.  Their conclusion had the following key points:

  • The US Federal Reserve Bank’s expectations for the speed of reverting to 2% inflation levels remains dangerously optimistic.

  • An inflation jump to 4% is often temporary, but when inflation crosses 8%, it proceeds to higher levels over 70% of the time.

  • If inflation is cresting, inflation levels of 4 or 6% revert by half in about a year. If inflation is accelerating, 6% inflation reverts to 3% in a median of about seven years, threatening an extended period of high inflation.

  • Reverting to 3% inflation, which we view as the upper bound for benign sustained inflation, is easy from 4%, hard from 6%, and very hard from 8% or more. Above 8%, reverting to 3% usually takes 6 to 20 years, with a median of over 10 years.

Arnott and Shakernia believe that the consensus view that a short “transitory” period of high inflation will soon pass places too high a probability on the best case and ignores economic history.

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

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Next Moves for the Fed and BRICS+

The Federal Reserve’s Open Market Committee (FOMC) meets Tuesday and Wednesday of this week.  The FOMC meets approximately every 6 weeks and releases their policy statement at the end of their two-day meetings.  The consensus expectation is that the FOMC will announce an increase in the fed funds target rate of 75 basis points this week.

When Chairman Jerome Powell gave testimony to Congress on June 23, he noted that inflation remained “well above our longer-run goal of 2 percent” while the “labor market has remained extremely tight.”  Not much has changed during the last four months regarding both inflation and employment.  The rationale for higher interest rates remains in place for now.  Interest rates remain far below the level of inflation as measured by the government.  However, in the future, there are limits to how much the Fed can raise rates.

As of September 30, 2022, the US Treasury has $30.9 trillion of debt outstanding, reflecting a debt/GDP ratio of 123%.  In December 1980, when Fed Chairman Paul Volcker raised the fed funds rate as high as 22%, the US Government had $908 billion in debt, which represented 32% of GDP.  Since the US debt to GDP ratio has nearly quadrupled during the last 42 years, the Fed will eventually have to consider the impact of higher interest rates on the interest expense of the US Government, as well as businesses and households.  Higher interest rates raise the risk of debt defaults.  It remains to be seen where the tipping point of financial pain is due to higher interest rates.

Meanwhile, in the rest of the world, the dynamics of international relations are changing rapidly and the United States is losing its leadership role.  ZeroHedge described the recent protests in Europe:

Tens of thousands of people have marched across metro areas in France, Belgium, the Czech Republic, Hungary, and Germany – many of them are fed up with sanctions on Russia that have sparked economic ruin for many households and businesses – but also very surprising, support for NATO’s involvement in Ukraine is waning.

There has been increasing awareness and dissent among Europeans about their countries’ leaders prioritizing NATO’s ambitions in Ukraine over their own citizens.  The prioritization has been in the form of sanctions against Moscow, sparking energy hyperinflation and supplying weapons to Ukraine, which has made Moscow displeased with any country that does so.  Some Europeans are now demanding NATO negotiate with Moscow to end the war so that economic turmoil can abate.

There is also increased interest by many countries in joining BRICS+ (an economic alliance started by Brazil, Russia, India, China, and South Africa).  The original five BRICS countries seek to expand their influence by establishing principles of “inclusive and equal cooperation” for international trade and financial regulation.  Among the countries being considered for admission to BRICS+ are Argentina, Egypt, Indonesia, Iran, Kazakhstan, Kenya, Mexico, Nigeria, Saudi Arabia, Senegal, Tajikistan, Thailand, Turkey, and United Arab Emirates.

Saudi Arabia’s intention to join BRICS+ is significant.  Mohammed al-Hamed, President of the Saudi Elite Group in Riyadh, told Newsweek: “China’s invitation to the Kingdom of Saudi Arabia to join the BRICS confirms that the Kingdom has a major role in building the new world and became an important and essential player in global trade and economics.  Saudi Arabia’s Vision 2030 is moving forward at a confident and global pace in all fields and sectors.”  Thus, Saudi Arabia’s snubs of President Biden are no surprise as the country realigns its economic and geopolitical interests.

As Saudi Arabia is the largest exporter of oil in the world, there is serious doubt about the longevity of the “petrodollar” (use of the dollar for payment of oil deliveries).  Fed Chairman Jerome Powell acknowledged this in June when he said, “rapid changes are taking place in the global monetary system that may affect the international role of the dollar.”

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

Sincerely,
Robert G. Kahl
CFA, CPA, MBA

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Europe’s Pending Energy Crisis

On Wednesday, August 30, Russia halted all natural gas deliveries via the Nord Stream 1 pipeline.  Supposedly, this was a planned maintenance that will last 3 days.  Russia had been operating Nord Stream 1 at 20% of capacity, while waiting for the delivery of a repaired turbine from Canada.

One year ago, the Dutch TTF gas futures contract for October 2022 delivery was priced at 28.80 euros per 1 megawatt day.  On August 26, the contract hit a record high of 346.52 euros.  As of the August 31 close, the price stood at 239.91 euros, a drop of 30.8% in 5 days.  German and French electric futures prices have also hit all-time records.

German economic minister, Robert Habeck, said that companies have worked hard to reduce gas consumption in recent months by switching to alternative fuels like oil, making processes more efficient, and reducing output.  But some companies have “stopped production altogether” with businesses that have a large energy component being the most susceptible.  The Budel zinc smelter in the Netherlands will be placed on care and maintenance from September 1 “until further notice.”  Norsk Hydro also announced plans to shutter an aluminum smelter in Slovakia at the end of September.

The dire situation of European energy is now reflected in consumer confidence surveys.  German consumer confidence is at an all-time low of -36.5, whereas the normal range had been between 0 and 10 prior to 2020.  German producer prices increased 37.2% in July 2022 from a year earlier.  Excluding energy, German producer prices, increased 14.6% from the prior year.

Apparently, Russia and Ukraine were prepared to negotiate a peaceful settlement in April.  Prime Minister of the United Kingdom, Boris Johnson, went to Kiev that month.  According to Ukrainska Pravda, Johnson had two messages for President Zelensky:

    • Putin is a war criminal and should be pressured, not negotiated with, and
    • Even if Ukraine is ready to sign some agreements with Putin, the UK and US are not.

And so, the war in Ukraine continues.

China has increased its imports of Russian natural gas substantially this year.  During the first six months of 2022, China increased liquified natural gas (LNG) volumes by 28.7% compared to the prior year.  China also imports natural gas from Russia via the Power of Siberia pipeline and the volumes imported via the pipeline increased 63.4% during the first half of the year.  There are several reports of Chinese (formerly Russian) LNG cargoes being sold to Europe.  So, Europe is willing to buy Russian natural gas from China, transporting it on ships with LNG capabilities.  This is an expensive alternative to Nord Stream pipeline deliveries, but it does get around the economic sanctions imposed on Russia.

The profits from acting as an intermediary natural gas deliveries are very attractive.  News sources indicate that Sinopec has sold 45 cargoes of LNG to Europe year-to-date.  Profit estimates from reselling Russian LNG to Europe using China as an intermediary range from tens of millions of US$ to over $100 million for a single LNG cargo shipment.  ZeroHedge writes that the embargo on Russian energy has failed spectacularly, and: “Worse, while Europe could buy Russian LNG for price X, it instead has to pay 2X, 3X or more, just to virtue signal to the world that it won’t fund Putin’s regime, when in reality it is paying extra to both Xi and to Putin, who is collecting a premium price thanks to the overall market scarcity.”

Unless there is a break in the geopolitical situation, this coming winter in Europe will experience inadequate heat and food for its residents, as well as a dramatic decline in economic production.  There are likely to be many European business failures and bank insolvencies as well.  The repercussions are likely to be global in nature.

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

Sincerely,
Robert G. Kahl
CFA, CPA, MBA