Higher for longer

Markets roared after yesterday’s “low” inflation reading ahead of the Fed’s next interest rate decision (which should be out by the time you are reading this).

The Consumer Price Index print for May came in at +4% year-over-year, but “Core Consumer Price Index” - or CPI minus fuel, food, taxes, duties, financial investments and a few other “volatile” components, still remains at +5.3% year-over-year and +0.4% month-over-month.

Ironically, yesterday’s divergence in the standard CPI print vs. the “Core CPI” puts the Fed in a very awkward position. Inflation is proving hard to defeat, and there are structural issues driving inflation higher at the core of the U.S. economy.

Why "Sticky" inflation isn't going away

Let’s highlight 3 reasons why inflation in the U.S. is likely to remain sticky - and could rise in the months to come.

1. Wage Pressure

As of May this year, average hourly earnings for U.S. workers are up +4.3% year over year, and wage growth is up +5.3% year-over-year. If labour costs are still increasing, this will lead to companies continuing to increase their prices to pass the cost through to the consumers. While wage growth figures are down from +9.3% year-over-year earlier in 2023, it is still well above the Fed’s 2-3% inflation target.?

Another factor adding pressure on wages is the tightness in the U.S. labour market. While the unemployment rate ticked to 3.5% in May, it is still near historical lows.?

The tightness is also underpinned by a renaissance of manufacturing-related construction.

The U.S. is undergoing a bit of a construction boom as it prepares to on-shore a lot of manufacturing - perfect example of “deglobalization” in effect.

This construction boom is leading to wage pressure, and the subsequent staff required to man the factories will continue to be a tailwind for the next few years.

2. Rent Pressure

This one is simple, the median sales price for a house in the U.S. is 33% higher now than it was pre-pandemic.

Prices move to go up (and down), before rents. This is reflected in the Price to Rent ratio for the U.S. market below:

As you can see, leading up to the pandemic, the price-to-rent ratio was hovering around 110 - meaning, rents were 110X the price - at a median price of $329,000 pre-pandemic, this works out to an approximate rent of ~$2,990/month.?

If we assume that the price to rent ratio is going to normalize north of 110 - at say 125X, that means that at a median sales price of $436,800, we’re looking at approximately ~$3,494 in rent.? When it’s all said and done, average rent should be about ~17% higher than before the pandemic. We still have ways to go.

There are 2 ways for the price to rent ratio to come down - lower home prices or? higher rents. We’ll most likely get a combination of the two.

Because so many savvy Americans are locked into low-single-digits 30-year mortgages during the pandemic lows (good for them!), I expect we’ll see more of a correction upwards in rents than downwards in home prices.

3. Wealth Effect

Most portfolios in the U.S. include some form of real estate (likely residential), some basket of stocks, and potentially some short-term or long-term bonds.?

Real estate is in great shape, all things considered. After the Fed went vertical on interest rates, the median home price in the U.S. is only down ~9% from their peak. Keep in mind that’s after a historic +45% rally since 2020.?

The U.S. stock market is roaring. The 3 major indexes, the S&P 500, the Nasdaq, and the Dow Jones, are all within ~10% of their all-time highs.?

What about the bonds? While you may be down bad on your longer-term bonds (which you can hold to maturity instead of crystallizing the loss), your short-term bonds are pumping cash.?

This results in people feeling rich. And when people feel rich, they spend. When they spend, they drive prices higher and keep people employed.

So, what can the Fed do?

I don’t envy the Fed. Neither of their options are great at this point. Here’s a few scenarios (that could already be playing out as you read this):

Option 1 - “Nuke it, Jerome”: The Fed could raise rates to shock and cool down markets. If they do that, they’ll break something? eventually. It could be the already fragile regional banks (or something else). Upon the breakage, the Fed will be forced to bail out or print, whether implicitly or explicitly. This is exactly what happened when the regional banks went bankrupt earlier this year.

Increasing interest rates will put tremendous pressure in an economy where dollar liquidity is constrained due to the refilling of Yanet Yellen’s checking account (the Treasury General Account).?

Quick TLDR here is that she ran out of money and needs to issue bonds to “refill” her coffers. The U.S. dollars to purchase her bonds will have to come from somewhere else. This will “drain” dollars out of the economy/markets.

Outcome from Option 1:?

Sequence of events:

Fed Raises -> Markets drop -> Something breaks?? -> Fed prints -> Asset prices rise

Long-term results:

Asset Prices: High

Fed Interest rate: High

Option 2 - “Grind higher”: Another alternative is not to raise rates, and allow the market to run its course. The S&P 500 is nearly ~13% higher year-to-date thanks, almost exclusively, to 6 stocks related to AI (plus Tesla), which have carried the weight of the S&P 500 index gains year-to-date.

By not raising interest rates, the Fed will fuel the idea of a “smooth landing”, which will entice investors back into the markets because FOMO. Equity markets, real estate and risk assets could catch a more sustained bid - fuelling the wealth effect, which - combined with rent and wage pressures would result in higher inflation for longer. Persistently high inflation readings would cause the Fed to keep rates high - or potentially even force them to raise rates later on.?

Outcome from Option 2:

Sequence of events:

Fed holds rate steady -> Asset prices rise -> Inflation persists

Long-term outcome:

Asset Prices: High

Fed Interest rate: High

Whether Jerome decides to “nuke it” or “hold it steady”, we will arrive at higher asset prices with higher interest rates for longer eventually.

What can you do as an investor to manage your portfolio in this environment?

1. Protect against high interest rates/inflation: Be cognizant of the cost of your capital. If you have cash that’s earning nothing when interest rates are at 5%, you are effectively paying 5% a year to hold that cash. You can consider yield bearing products like Ledn’s Savings Accounts, Prime Loans (now available in USD to qualified clients) - which pay 9% APY, or even short-term government bonds.
2. Be smart with the timing of your investment allocations: Everyone’s portfolio and personal preferences are different. The key takeaway here is that in the event of a “choppy patch” scenario, investors could get attractive entry points for assets like Bitcoin and certain stocks if and when the market drops. Take this into account as you’re managing your portfolio over the summer.
3. Volatility can be your friend: There are products that can allow you to benefit from market volatility to earn great yield for certain assets in your portfolio, like stablecoins and bitcoin. There’s something new coming this summer from Ledn! More details soon!

If not now, when?

All of this will take time to unfold. In terms of key dates, some of the top analysts in the world point to the month of September as a historically eventful and volatile month. The reasons referenced range from the timing of the U.S. harvesting season, and the quarterly expirations of financial products like options and futures products - which expire at the end of October.?

Regardless of the reason, several experts believe that the high interest environment could claim its next victim by September of this year. If and when this happens, the inevitable bailout should drive asset prices higher.?

HODL.