The current debate on Wall Street centers on the potential for a recession. Many pundits are claiming we are already in a recession. Many more are predicting a severe recession before year end. Holding this belief enforces their thinking that inflation is going to fall back to a 2% level. With inflation this low, the thinking proceeds, interest rates are not going higher and will begin falling by year end. In a two-word response we describe this logic as “highly doubtful”. Wall Street is not Main Street. There is no question Wall Street is in a recession. Perhaps a severe recession. Markets are sharply lower. Bonuses are down, investment banking fees are non-existent. Assets under management are falling. Summer Rentals in the Hamptons are off sharply. The prognosticators working in this environment tend to assume their personal experiences must be what is going on all over the country. The New York media often follows this crowd. Current reporting on the economy is tilted.

Facts on the economy show employment is strong. Job creation is strong. Wages are moving higher. There is pent up demand for autos, travel, computer chips and services. Recent durable goods orders show strength across the board. The June ISM services index showed growth in all 18 categories. Manufacturing indexes recently released are showing growth. These are not the signs of a recession.

The outlook for inflation to fall back to the 2% level is based upon the mistaken Keynesian theory of a recession lowering commodity prices. It fails to address the recent 43% growth in the M-2 money supply. This money printing is the root cause of inflation. Until the Federal Reserve Bank removes much the excess reserves created over the last 24 months, we doubt inflation will make an exit.

Interest rates are a function of inflation. To deal with higher inflation the Fed must drain reserves. If inflation stays elevated, the Fed will be forced to “raise” interest rates higher than current expectations. We strongly disagree with any theory the Fed will be “lowering” interest rates by year end, or early next year. Keynesian belief that 2.25% interest rates will discourage 8.5% inflation is suspect. Labor inflation and housing inflation are beginning to work their way into the CPI. We don’t see this changing anytime soon.

The bond market follows interest rates. Higher rates, lower bond prices. The first half of 2022 is the worst bond market performance in over a hundred years. This is with interest rates at only 3% on a ten-year government bond. A move higher in the rate will continue the bond market rout. Better to keep fixed income maturities short to avoid further pain and suffering.

Our outlook for a strong economy doesn’t flow through to a good stock market. History shows several diversions between the two. Higher costs of doing business will hamper corporate profits. Businesses face higher labor costs, higher transportation costs, higher energy costs and especially higher costs of capital. We are cognizant of the profit benefit over the last ten years of companies re-financing debt at lower and lower levels. Stocks sell at a multiple of earnings and cash flows. Flat to lower earnings with higher interest rates leads us to believe prices stock prices will continue to fall.

While our current (and past 18 month) outlook for stock and bond prices is bearish, we see excellent buying opportunities occurring later this year, or early next year, when prices are lower. Wall Street will overcompensate to the downside when their predictions of recession etc. fail to materialize.

Markets are much changed since our last letter. There are many issues behind the moves. The main issues are inflation, the Russian invasion of the Ukraine, falling covid cases, the outlook for interest rates and the outlook for the world economy.

Covid cases are falling sharply in most of the world. Many countries are slowly dropping travel restrictions while simultaneously re-opening their economy to pre-covid levels. We expect this trend to continue and result in strong economic growth around the world. While inflation is a threat to this increased consumer spending, we believe recent geopolitical events will increase this trend. Consumers are showing a propensity to spend. They lived through the threat of covid. Now they are confronted with a dictator in Russia potentially destroying world peace. Both events are creating a reason for consumers to examine their “bucket list” with the goal of crossing off a few entries. This may be travel, buying a new vehicle or a new house, adding a pool or extension to their existing house, buying different clothes, attending sporting events etc. A recent survey of Europeans revealed many people saying they always wanted to visit the United States. They now pledge they are going to do the same. Good for the U.S. economy.

The Russian invasion of the Ukraine is tragic in the suffering and deaths it will cause before it is over. The economic results are not as certain. A world-wide recession that some predict is not a certainty. Higher prices for certain commodities are more of a guarantee. While difficult to deal with the prices, it is not a precursor to ruining the world economy. We hope that a negotiated end to the invasion can come soon.

Before the invasion, inflation was moving significantly higher. This was sure to bring about an increase in interest rates in the U.S. and elsewhere. There is nothing that changes our opinion about inflation. If anything, the war will cause inflation to be even higher than pre-war. Interest rates will need to go higher than previous expectations. Central Bankers including our Federal Reserve may go much slower in raising interest rates due to concerns about the Russia/Ukraine tragedy. This will only assure that inflation and interest rates are headed higher.

We expect bond prices to trade much lower between now and year end regardless of what happens overseas. Only keeping durations as short as possible will prevent fixed income losses. The stock market will trend lower over the year marked by intermediate periods of rallies, only to later make new lows. Buying the dips will not work. Commodity stocks are performing well and will be a small area of the stock market that will perform. Commodity prices from beans, corn, wheat, oil, natural gas, copper, gold etc. will be volatile, but are not going back down to levels of a few years ago. The Nasdaq YTD is down 17%, the S&P is down 11.4%. Energy stocks are, on average, up 35%. Global metals and mining are up 11%. Commodity related stocks are, on average, up 20%.

Our managed portfolios are showing slight gains YTD. Our positions for the last 18 months have avoided high flying Nasdaq issues with little investment merit, while concentrating on good cash flow generating companies with positive exposure to inflation.

We view a strong world economy. However, we believe the best investment approach is one of selection and caution.

The first quarter economic data of 2021 continues to point towards a major economic recovery around the world. By design, your portfolio is invested in many issues tied directly to the recovering economy. Last year saw investors go overboard on high-tech glamour issues - companies making little if any money and generating no positive cash flow. This year the markets are rewarding investments in companies with real profits, cash flow and dividends. We continue to like bank stocks, energy, gold mining, fertilizer, and pharmaceutical issues among others.

This year, interest rates and inflation are also on their way back up. Most fixed income investments are down sharply for 2021. The negative returns are close to double digits depending upon duration. We believe bonds will continue to be a “bubble” market in 2021. Traditional fixed income investments have the potential to drop by as much as 15% to 20% by year end. You may notice your fixed income holdings are almost all “floating rate” issues avoiding this risk. We also have large money market balances at quarter end. This is not a permanent home but more of a safe port in the storm.

Higher inflation and runaway government spending are currently our biggest worries. We are monitoring the same and will act when necessary.

A special thank you for your understanding of the past year. The pandemic brought unprecedented downward moves in economic growth and, for a while, investment prices. Interest rates also plunged to 0%. We managed portfolios throughout the last twelve months with discipline while also taking advantage of markets underpricing value stocks. This approach is the reason your portfolio(s) have fully recovered and are now at “new high-water marks”.

Prices for stocks and some bonds are now attractive. The sell off in banks, energy, airlines and basic industries such as chemicals is overdone. Markets are as “illiquid” as any time in history. Price movements are now driven by loans to hedge funds and others being called by banks. It becomes forced selling.

This started with many, us included, underestimating the ability of the world public to panic over the corona virus. The damage to the world economy is real. The damage is also self-inflicted. We believe in the next 4/6 weeks the panic will end and we will slowly return to business as usual. This return to normal has incurred in China and South Korea. This tells us the world recession will probably be shallow and short-lived.

We are waiting, trying to determine when the “forced selling” and panic selling is over, or close to over. At that time, we will be increasing our equity positions from approximately 35% to 50/55%. Dividend yields far exceed yields on bonds. The Fed will most likely keep rates at the current unprecedented low levels even after the crisis is over. Stock dividend yields are attractive.

There are some that believe the panic over the virus will continue for the balance of 2020 and well into 2021. We disagree. They see the world going into a severe recession or near depression. We disagree. The world dealt successfully with Asian flu, Hong Kong flu, swine flu and others. It will handle the Corona virus.

President Smoot (AKA Trump), tweeted this morning that the problem is not the trade war with China and others. His contention is that the FED is keeping interest rates too high. They need to lower them immediately and aggressively is his advice.

This is absurd. The ten-year U.S. Treasury is 1.70%. The cost of money is NOT keeping people from buying cars and homes. The ability to borrow money at all time low interest rates is NOT keeping corporations from borrowing to expand plant and equipment. For both business and consumers, loans are readily available at historical low interest rates. Does the President believe if the cost of loans was just lower, it would create a major spending boom by business and consumers?

The problem is indeed tariffs. This is a major cost increase that discourages both Chinese citizens from buying and U.S. citizens from buying. It destroys business confidence on both sides. It stops business activity. The U.S. and China represent approximately 45% of the world economy. The other 55% are beginning to see sales to both China and the U.S. slow.

Hopefully the President’s comments are just political posturing. It worries us that he may actually believe what he tweeted this morning.

10 Reasons Why Terril & Co. Is Reducing Your Portfolio’s Exposure To Stocks And Long Duration Bonds

In no particular order …

1. The market doesn’t seem to care that the budget deficit is now running at more than $1 trillion per year, an all-time high. Pundits say the deficit doesn’t matter anymore. We disagree.
2. Cover stories in mainstream business media proclaim the “death” of inflation. It is buried forever, the experts say. Again, we disagree.
3. Investors seem to trust that no matter the real world shocks dealt to the international economy and investment markets, central bankers will simply cut interest rates and save them from losses. We believe that could be a very costly assumption.
4. In 25% of the industrialized world, the interest rate on newly issued debt is negative. Yes, banks are PAYING the buyer to warehouse their money. This is not normal. This is the type of extreme condition often seen at market tops.
   Markets seem complacently certain that interest rates worldwide will remain at current or lower levels forever. We remember the days when an interest rate of 5% was considered low.
5. Investors are taking on more risk every day in an attempt to boost returns. Abandoning risk guidelines to chase momentum stocks is commonplace – and is seldom a smart long-term investment strategy.
6. A larger than once imaginable segment of current presidential contenders are extolling the merits of socialism. Amazingly, they are finding a following.
7. The IPO market is again red-hot with offerings of companies that have little, if any, chance of ever generating positive cash flows. Enamored with rosy sales growth projections and swelling customer counts, IPO investors are ignoring seriously flawed business models that cannot generate profits.
8. Bitcoin and other cyber currencies continue to have a following even as the sector deals with scandal after scandal. The notion that central banks will stand by idly and lose control of their currencies is ridiculous. A core function of government is to control the means of financial exchange and the creation of same.
9. Market volatility is unprecedented. Liquidity is poor in major moves up and down – a sign that many of today’s investors are short-term speculators, not long term holders.
10. Computer algorithms rule today’s trading floor. Typically, algorithms base buy-sell decisions on price momentum, not investment fundamentals.

Investment markets in late 2018 decided it was likely that the world economy was approaching a recession. The prevailing thought was that banks would end up with billions in bad loans and interest rates would return to zero. We didn’t agree with this reasoning in December, and we continue to be skeptical of it today. Consumers in the U.S. and most other industrialized countries are in their best financial position in 50 years. Central bankers around the world continue to provide ample liquidity and are acting to keep interest rates at historic lows. The movement toward more economic freedom and away from socialism is alive and continuing to progress, albeit slowly.

We believe the world economy will continue to grow in 2019. It may be at a slower pace than in 2018, but it will be growth nonetheless. Also, interest rates are likely to rise slightly in the coming year.

The stock market developed a love affair with growth stocks about 6 or 7 years ago. Buy growth at any price was the mantra. We believe this love affair is now on the rocks (witness Apple, Netflix and Tesla). We see value stocks – the laggards of the last 6 years – beginning to get some affection. Steady earnings, increasing dividends, stock buy-backs and good balance sheets do matter. A dominant position in an industry also helps. Last year, banks, energy, pharmaceuticals, basic materials and computer chips were laggards. While the fundamentals of these businesses were good, their stock prices were down. This dichotomy will change in 2019.

The political atmosphere stinks. Partisanship is worse than ever. After nearly one month, the U.S. government remains shut down. Brexit issues overhang Britain. China’s trade dispute with the U.S., Canada and Europe remains front and center. Budget deficits are obscene. It is easy to get depressed.

However, political events like the above are not likely to cause a major world recession. We continue to believe in the economic potency of creative entrepreneurs, the world citizens that produce and trade with each other. Their determination to create a better life for themselves tends to overcome the incompetence of their governments.

We remain constructively positive on the outlook for the world economy and investment markets.

Inflation and interest rates are both moving higher. We see this trend continuing through year end. Fixed income markets, year to date 2018, are DOWN 4% to 9% depending on the duration of the bonds held. We believe this trend will continue with the over-all losses widening. Our portfolios avoided this down activity by keeping, on average, our maturities less than a year. We are benefitting as we own an abundance of floating rate issues. The rate re-sets every 90 days. A year ago, the rates were close to 1.5%. Today they are paying 3.5%. By next summer we expect 5%. The Federal Reserve Bank is committed, over the next two years, to shrinking the size of their massive balance sheet. The Fed is reducing the size of their reserves at the exact same time they will need to keep inflation from accelerating. This will result in higher interest rates.

To date, the stock market has ignored all issues that could be considered negative. The amount of speculation in stocks with no earnings, no cash flow, and increasing debt, is high. The complacency of investors willing to believe stocks can never go down is growing daily. Investors fearful they are missing out on performance, so they are “now” willing to put all their portfolio into aggressive stocks at all-time high prices, is also increasing daily. Their ability to consider potential risk is minimal.

Historically, all the above actions have spelled a top in stock prices. We believe this time is no different. Add in the coming major increase in interest rates and we see little reason to hold major stock positions.

We "are" holding our financial stocks. The growing cash dividends will continue. The higher interest rates are not a negative for the financials. Issues that benefit from higher commodity prices are also attractive.

The investment climate has changed in the last few months. No longer is the world economy, inflation, interest rates and corporate profits front and center. The issue now is world trade. The current administration is attempting to use severe tariffs (a tax on imported goods) to force other countries to change their policies on world trade. The response so far is retaliatory. Other countries are imposing tariffs. Said plainly, when two parties both increase the cost of doing business, the result is less business. If the “trade war” escalates there is a high probability that the world economy slows dramatically. At days end, there are no winners in a trade war.

For decades, individual nations have protected the business entities in their country. This includes the U.S. Subsidies to farmers and the agriculture industry are just one example of U.S. protectionist policies. Major tax credits and incentives for the high-tech industry are another. In recent years, by mutual agreements with participating members, including the U.S., the world trade organization has granted advantages to certain countries. From time to time the need to make changes in the world system are negotiated. It appears this methodology is now to be abandoned in favor of instituting severe tariffs to force trading partners to “do as we say.” If the trade situation worsens it will be a major impediment to investments. We hope calmer approaches will prevail.

For perspective, we offer these observations.

1. Running a $25 billion trade deficit with country X doesn’t mean the U.S. lost $25 billion. We received $25 billion of goods and services we wanted. It was a value for value trade. Country X gave us one type of asset and we gave Country X another.
2. It is impossible for us to run a balanced trade account with poorer countries. The U.S. is 40 times as rich as Mexico. How can they possibly buy as much from us as we buy from them? A big part of this deficit is tourists traveling to Mexico. Are we to hurt U.S.-based airlines because Mexico’s citizens aren’t coming in equal numbers to tour New York, Chicago or Nashville?
3. Where is the evidence of the problem? We have run trade deficits with the balance of the world for over 30 years. Yet the standard of living in the U.S. is the highest in history. Unemployment is historically low at 4%. The economy is growing nicely and even gaining momentum. Interest rates and inflation are low. The U.S. dollar is strong.
4. We run trade surpluses with most countries in services such as banking, insurance, hi-tech consulting etc. Those surpluses are not reflected in typical trade deficit calculations
5. The xenophobic rhetoric we now hear about China is a repeat of what was said in the late 1980’s and early 1990’s about Japan. What happened to the economic takeover of the U.S. by Japan because of our huge trade deficits?
6. What IS a problem? Our ballooning BUDGET deficits! Countries that perhaps would buy more U.S. goods and services end up buying our Treasury bonds instead. We voluntarily give them an incentive to buy our bonds rather than our products.

If the trade war worsens, we will turn bearish on stocks and bullish on high quality fixed income. If the trade war is averted, our outlook is the opposite.

Year to date the U.S. stock market is unchanged. The bond market (fixed income) is down approximately 3%. Our belief is that by the end of 2018 stocks will be 3 to 5% lower and bond funds will be 10% lower. The main reason for this outlook is the probability that interest rates are going higher in the U.S. The budget deficit for the U.S. is moving up to the ONE TRILLION dollars per year level. With this new money demand, plus rolling over maturing debt, the markets will demand a higher interest rate to buy the debt. Couple this with inflation moving higher and the Fed’s intention to decrease the size of their balance sheet and it points to higher interest rates.

We remain positive on energy issues as the demand world-wide for oil continues to increase. Banks should also do well in an increasing interest rate environment. Major pharmaceutical stocks are also reasonably priced for investment. What is grossly over-priced is big technology companies. Particularly the ones losing money and burning cash such as Tesla and Netflix. Amazon generates cash and owns a profitable cloud computing division. The balance of the company, including home delivery, burns cash. The price of the stock is much too high. Bonds and other fixed income investments are a potential disaster. From such current low- low -low levels of interest rates, there will be major reductions in principal values as rates move up. In Europe, interest rates reflect a market controlled by the European Central Bank. When the Central Bank steps aside of the market price discovery will return. The level of interest rates the market will demand is much higher than current level. Two-year Greek bonds, (yes, the same Greece that was and is on the verge of bankruptcy), currently yield less than similar U.S. issues. Does anyone believe the credit of Greece is better than the credit of Uncle Sam? German credit is excellent. However; their ten-year bonds trades will a yield of only 5/8 of 1 %. Historically it trades more in line with U.S. debt currently 3.08%. There is a major price revision waiting when the market begins to set the rates.

Our floating rate bonds are performing well. We continue to expect movement towards this structure. We also favor gold mining stocks of major producers. The spread between the cost of production and the cash price of gold is at historic levels. Thus, gross profit is high.

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