The Beginning of the Beginning

By Thomas A. Martin, CFA, Senior Portfolio Manager

The central banks are “putting on the finishing touches?” The cake has largely been baked and the base layer of frosting has been applied. Is it ready to serve or does it need a few decorative flowers and a smiley face? The chefs are talking it over. The Fed’s dot plot suggests one more hike of 25 basis points is on the table, but they could always change their collective mind. The waiting diners are saying they think they’ll get their cake as it is now. Either way, the thought is that we are at (or near) the end of the hiking cycle.

Inflation fighting bona fides versus consequences of high rates at high levels of debt. But the cycle is about much more than the peak level of rates or how long they stay there or even when they start to go down again. The really important thing is what happens to all the ingredients of the economy now that we are here. Is this enough to vanquish inflation? Will it prove too much for the banks or for the various real estate markets? Will it prove too much for consumers? It’s one thing to get a little breakage here and there, but quite another if lots of things break all at once. That’s one way that a bad thing (inflation) abruptly turns into something worse (deflation).

The trouble is that nobody really knows. The lags that are supposed to kick in haven’t obviously, unequivocally, kicked in yet, and it is unclear if there are structural changes mitigating against that. But now is about when they would. The change in the level of rates is what we tend to think of as kicking things off, but today it may be the level that can do the damage. It’s not that we haven’t lived with rates at this level before, but we haven’t with as high a level of debt as governments and consumers are currently carrying. People are figuring out that they are going to have to manage this, but it will get harder, not easier, as time goes on and stresses build. The participants all seem to agree that lower rates would be better. And sooner would be better.

They will get there, but will they get there because we engineer them to get there or because a force of nature takes them there?

The Fed is in the engineering business. They want to talk about the things that they are supposed to engineer, which is inflation and unemployment. They will not talk about the force of nature until (if) they absolutely have to. But it does enter their calculus whether they name it or not. As far as the consequences of our rate and debt journey go, we are at the beginning of the beginning.

Who will control long term interest rates? We are hoping it is our cake bakers. While the central banks are able to maintain their credibility that they’ve got this, business decision makers and consumers will continue to operate with some degree of confidence and optimism. But if those same decision makers look around and decide they are not being adequately compensated for their risks, they will adjust prices downward by refusing to pay the current prices. Then nature will have control.

Asset allocation positioning, liquidity and preparation continue to be critical.  As strategic asset allocators, we constantly evaluate the status, relationships and potential outcomes of the macroeconomic variables and our investment options. We believe the weight of the evidence remains biased toward the positive for now, but we lean towards high liquidity and quality.

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