Good morning. I hope everyone had a great weekend. Looks like summertime is here, which typically means less volatility in the marketplace.
There are a lot of earning events this week so stay updated in the Telegram group if you are a Grit Alpha Pro member. I will be talking about earnings in there and then sending out more formal writeups on companies I follow.
Today I went on a rant about higher interest rates and if/when the Fed will cut. It is an interesting dynamic happening in the economy. Things will be forever changed.
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I’ve been spending a lot of time thinking about the rising rate environment and what will happen to asset prices. In general, as rates move upward asset prices rerate lower from investors increasing their discount rate. For those who are not trained in corporate finance here is a simple way to think about rising rates.
When interest rates were zero investors bought speculative assets to realize their internal rate of return needed to undergo a project or invest. This is because there is no “risk-free” alternative for investors to get an acceptable rate of return.
When interest rates moved up, investors were finally able to achieve a “risk-free” return in instruments like U.S. Treasuries. Currently, risk-free treasuries are yielding something like 5.50%. Thus, investors now need at least a 5.50% annualized return before even considering making an investment.
When investors model out tech companies that don’t generate free cash flow until year ten in their models, these cash flows become more worthless as investors can get that 5.50% rate of return now.
Value stocks that generate cash day one, don’t fall as much in a rising rate environment, as investors can get an acceptable rate of return, that likely yields more than 5.50%, because cash flows are generated day one.
That is a long-winded way to say that when interest rates increase assets prices move downward because discount rates increase.
We all know that interest rates are up, and asset values are down. So now the million-dollar question is: when will interest rates come back down?
Investors want to know when interest rates will come down, because if you can time the move in interest rates you can make a ton of money. And a lot of investors think the Fed will cut rates sooner rather than later. This is because it is inefficient and impractical to run the government with higher rates, given the absolute level of debt in the system.
Said another way, the Fed will be forced to lower interest rates because something bad will occur in the economy, like bank failures. When this happens, discount rates will re-rate lower and risky assets will outperform. And it appeared the market movement seen late last week indicated the Fed is closer to lowering rates.
But there are a few things to consider before you go “all-in” on a Fed decision:
The Fed will probably not lower interest rates immediately after raising them aggressively all year. They would look pretty silly and will likely maintain rates for the time being.
Should this theory of the Fed not lowering rates immediately hold true, then the only reason why the Fed will lower rates is due to something bad occurring in the economy.
Directionally, I think something badly needs to occur in the economy for the Fed to reverse course on rates. Based on the recent Fed meetings, it appears that we won’t see any incremental increase in rates. But I don’t think we are going to see a decrease anytime soon. A decrease in rates will likely come from one of the following:
Large unemployment numbers
A collapse in a major financial institution
Stock market collapse – something like 40% drawdown in valuations with multiple halts
In my opinion, the only way we see lower rates is from a large systematic event occurring that changes the economic landscape. We will need to see a massive number of layoffs, an actual financial institution going under (not these Ponzi scheme California banks) and an actual collapse in stock market valuations. Without a major negative event, I think higher rates are here to stay, along with higher discount rates.
Higher rates will bring layoffs.
Higher rates will force over-levered companies to restructure.
Higher rates will blow up bank business models as bond prices collapse and loan portfolios deteriorate.
Eventually higher rates will lead to lower rates and continued money printing. Own real assets and position yourself for a potential hyperinflationary environment. The system is unsustainable with the level of debt. Own something that will outperform on a tail-end event.
I think you left one out. If the inflation rate falls below the Fed Rate, then I believe they will lower rates. However, I think they have a long way to go. I don't believe the published inflation rates, as they continue to change the way inflation is measured. They are between a rock and a hard place. If they continue to raise rates to control inflation, they will destroy the banking system. If they don't increase rates or lower rates, inflation will continue unabated, which leads to hyperinflation. If you want to know more about hyperinflation, read "When Money Destroys Nations", which is about the hyperinflation in Zimbabwe from 1998 to 2008. I think I would rather see the destruction of the banking system.