In July, I said it would be hard to do worse in the past hundred years than Q2. It turns out that it was also hard to do better. Q3 was one to forget, ending about where it began. This year’s asset selloff is not due to a global pandemic or a critical collapse in the banking system, it is all about the Fed.

After many years of insisting that inflation was "transitory" and would wane without intervention, the fickle Federal Reserve Open Markets Committee (FOMC) transformed themselves into ardent inflation fighters. Despite signs that inflation might already be abating, they embarked on their all-time fastest increase in short-term rates and committed to continuing until the growth in the consumer price index (CPI) drops to 2%. This creates a challenge for investment markets because the byproduct of this approach is a significant destruction in consumption and declines in asset prices. One major driver of costs is energy, which has already dropped precipitously. However, the shelter and wage components of inflation remain sticky.

America has under constructed housing relative to the population for decades now. This is partially because almost 3/4^ths of the nation’s wealth is tied up in housing and scarce housing drives up this broad asset’s value—which pleases voters and ironically creates an inflation hedge for property owners. In terms of wages there are not enough humans to fill the jobs available today. After working through a very stressful pandemic, laborers now want to be paid. Accordingly, we have seen increased unionization, which pushes paychecks higher. These factors have sparked wage-push inflation especially in the service economy, which is 80% of the labor force in the United States. The Fed cannot build multi-family housing or add working age people to the US economy. The only tool they have—short term interest rates—is extremely imprecise and there is a high risk of overtightening which could cause a real estate bust or expose imbalances in the asset management or banking businesses.

Looking forward, how are we to think about investing against this backdrop? For bonds, there is a silver lining to rising rates. Imagine if we could engineer a portfolio that generated a solid almost guaranteed return of 5%/annum. This portfolio would earn income for the next 10 years no matter what happened to stocks. We can turn this fantasy into a reality because the interest rate now paid by corporate bonds is a contractual 4-6%/annum. Just before the Covid-19 crisis, Amazon issued bonds yielding a paltry 0.25%/annum. Now we can buy these bonds and earn 4% or more. If the Fed locks inflation down to 2%, which the futures market is foreshadowing, then that bond will yield a +2% real return with little risk—the yield will fail if and only if Amazon files for bankruptcy! So why not just put everything in bonds?

Because for long-term investors stocks offer more potential. It is not a question of if, but when, will stocks reclaim their January highs. Although stocks offer more upside, it requires “intestinal fortitude” to get there. It is easy to get emotional facing extreme volatility. Gains made since 2020 feel like endowments and losses on even a portion of those wins imparts a sense of doom and fear. Of course, these are paper losses that we can reclaim but investing on impulse can lead to some short-term comfort but in the long-term, they are costly decisions.

Because the balanced portfolio—which includes both stocks and bonds—gives investors the highest risk adjusted return. It is also the most potent portfolio in the face of inflation. Especially since we employ alternatives in the form of energy, (conventional and alternative), precious and industrial metals, and agriculture. Lastly, it makes your portfolio “antifragile,” shielding it against the “unknown unknowns.” Situations that could disrupt markets might stem from this year’s amazing rally in the US Dollar. High interest rates lead to a strong currency, which protects U.S. citizens from a dire winter fate when it comes to their energy bills. Putting this in perspective, for most Europeans who must buy energy priced in U.S. Dollars with weakened Euros, energy bills will increase by 20x. For example, if their electricity bill was $101.15 last year, it’s expected to be $2023 next year! This phenomenon in a colder climate produces a tremendous amount of social and political risk and, of course, it tilts the climate initiatives in a new direction. How good is our electrification? How resilient are electrical systems are run on natural gas? This quarter, the state of California encouraged citizens to reduce reliance on the electrical system. The financial system exposes areas that we still need to address and which we are monitoring for risks and opportunities.

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