Market Bearings with W. Allen Wallace, Chief Investment Officer

What do today’s market signals—on inflation, recession risk, and the U.S. dollar—mean for your investment strategy? This 5-minute read from Basepoint's Chief Investment Officer explains how today’s headlines may impact your portfolio.

“May you live in interesting times.”

While the above quote is often mistakenly referred to as “The Chinese Curse”, the sentiment remains the same. Interesting times can be hard times. Unexpected things happen, things change quickly, and chaos keeps our attention. As we survey the playing field, our conclusion is that we are not living in dull times.

Welcome to the inaugural edition of Market Bearings. This communication is part of our strategy of keeping you updated on what we think is important, and what we think should be left alone. Our goal is to let you know what we see, what we are doing about it, and what you should expect. While the format will adapt over time, our initial plan is to give you a brief market update, highlight an interesting chart, tell you what our eyes are on, share how we are positioning, provide an insight into our principles and philosophy, and get you back to life in 15 minutes or less... all while keeping it interesting.

Market Weather:

The current forecast calls for clouds, but we do not yet have enough information to confirm rain. Of course, clouds are a metaphor for uncertainty, and rain for recession. There is much bickering about interest rate cuts, Federal Reserve balance sheet expansion, and loosening fiscal policy, but on the other side of the coin is inflation, and we are not yet convinced that inflation has been tamed.

As we survey the available investments, we see elevated stock prices and historically excessive concentration (roughly 40% of the S&P 500 in 10 stocks), a wide divergence between valuations in U.S. stocks and foreign stocks, very tight credit spreads, sticky long-term interest rates, ballooning commodity prices, and quiet but concerning signs coming from private equity and private credit. Meanwhile, defaults have begun to rise, mortgage and credit card delinquencies have increased, and GDP growth is highly dependent on declining imports and health care services.

Given the above, it seems that securities are priced for sunshine. When perfection is demanded, we are often left disappointed. This does not mean we sit idle, but it does require us to be tactical in how we deploy your capital.

Chart of the Month:

Consumer Price Index (CPI)

The above chart illustrates the percentage of cells in the Consumer Price Index (CPI) calculation that are either “imputed” or that use “alternate estimation”. The CPI is a massive spreadsheet representing almost 100,000 prices. Historically, visits to stores and physical checks of prices have determined the contents of those cells. Over the past year, the number of those cells that are “estimated” has grown from 10% to over 40%. While we are not accusing the U.S. Bureau of Labor Statistics of making things up, it does appear that CPI is subject to significant interpolation.

What We’re Watching:

Our eyes are firmly focused on three major things: the potential for inflation to reignite, recessionary signals that have been all smoke and no fire, and the health of the United States Dollar.

Inflation spiked considerably after fiscal stimulus in the form of direct payments during the Covid pandemic. Inflation peaked at 9.1% in June 2022 and has since declined to 2.7% in the most recent reading. Keep in mind that this disinflation does not return prices to their previous level. Inflation is an annual metric, and it is cumulative. Only deflation, which in some ways can be worse than inflation, returns prices to their former level. Inflation eats away at your purchasing power and causes your income to buy less than it used to. When you are living on assets required to generate income, this can have a devastating impact over time. We need to keep inflation top of mind to be certain that we maintain your real purchasing power, not just the nominal dollar amount. This may cause you to bristle at holding cash. Keep in mind that a small real loss is superior to a larger nominal loss. Cash gives us options on future prices, but we need to use it with caution.

Recessions normally leave a trail of breadcrumbs. The yield curve inverts, the yield curve normalizes, jobs decline, and then we are in recession. We are in stage three now, and GDP remains positive. It is important to note that because GDP = C+I+G+(X-M)¹, with ‘M’ being imports, a decline in imports registers as a positive for GDP calculations. Tariffs have caused imports to decline, and this is factoring into GDP growth. In addition, spending on healthcare services is also accelerating. We will keep our eyes on recessionary conditions because it may cause equity declines, long-term rates to fall, and commodities prices (oil, gold, and silver) to decline.

After years of Dollar dominance, we have recently encountered turbulence. While a U.S. consumer living solely on dollar incomes may notice little other than the price of imports increasing, having a truly global portfolio allows us to position ourselves to take advantage of dollar weakness by owning international stocks and bonds, gold, silver, and oil. Even though fluctuations in currency can be temporary, having exposure to non-dollar-denominated assets can allow us to smooth returns, and to be positioned in case of a calamity like de-dollarization, or loss in reserve currency status. In addition, these assets allow us to take advantage of potentially higher interest rates, better valuations on foreign equities, and global growth as opposed to just domestic growth.

We will continue to monitor these key metrics and keep you posted as things change in future communications.

Portfolio Positioning:

Allocations have been updated to reflect changing times. We have added a few new asset classes that we have not used for a long time, or that are new to our allocations.

Domestic Regulated Utilities: Utilities have historically functioned like an equity/fixed income hybrid. They pay decent dividends, and they have caps on their return on equity as mandated by regulators. Because the amount of power generation has been insufficient to support the combination of electric vehicles, artificial intelligence, and bitcoin mining, new infrastructure will need to be built to satisfy demand. To attract capital into power generation markets, it may be necessary to reduce regulatory requirements, loosen return caps, or stimulate investments through tax incentives. The current federal administration has already shown a bias toward deregulation. While we are not certain that any of these things will be changed, we have asymmetric upside in the form of higher returns on equity, and our downside is reduced by steady long-term income and dividends.

Catastrophe Bonds: More affectionately called cat bonds. These function in the reinsurance market, and they care little about the direction of interest rates. They care about hurricanes, floods, and wildfires. Any one of these bonds on their own could be disastrous. Recently a Jamaican cat bond was wiped out by a drop in barometric pressure. So, the risk of ruin is too high when you only own a single bond. But insurance is that rare bird that grows ever more resilient with diversification. We get a fair yield, we own hundreds of different exposures to fire, hurricane, and flood events, spread out by geography and trigger types, and near zero correlation to equity markets, credit spreads, and interest rates.

International Bonds: International bonds have been absent from our portfolios for over a decade. They are denominated in foreign currency, so when the dollar drops their conversion value increases in dollars, which is what we care about. They can have higher yields than U.S. treasuries, and they can benefit from growing foreign economies. They are not without risk. The Dollar very well could increase, which would lower our returns. Right now, the yield spread is high enough to cushion the downside, and in the event of a severe decline in the Dollar, we have protection to maintain purchasing power.

Other changes: We have shifted more focus on mid and small cap companies, reduced precious metal exposure, very slightly reduced oil with the addition of utilities, restructured our bond portfolios to accommodate International Bonds, and have very slightly reduced cash due to declining short-term interest rates.

Principles and Philosophy:

Our portfolios are stoic by nature. We do not respond emotionally to volatility, and we focus firmly on what we can control. It is our own temperament that normally causes damage in financial markets. Panic is not profitable, and we have the courage of our convictions when everyone else is running for the exits. This does not give us permission to buy everything indiscriminately just because prices have declined. We do the work in advance to ensure that we are being adequately compensated for the risks that we take. We think about potential losses before we count returns. We continuously update our perspective and our models to be sure that we are acting on the most current reality. Finally, we remain humble and know that there are things that are unquantifiable, and we try very hard to avoid those things.  

Closing:

Markets have always been volatile, and they will continue to be volatile, but volatility is another word for cheaper prices. The most important thing is that we earn the return you need to reach your goals. There will be years when we earn double-digit returns, and there will be years when we have negative returns. Navigating these markers isn’t about being tough, it’s about being wise. Short of extreme calamity, our portfolios are built intentionally to be resilient and produce returns that are based on significant analysis, not popularity, or flows, or vibes. We thank you for trusting us to help you reach your goals. The hare may win the race, but the tortoise can last hundreds of years.  

1.       GDP= Gross Domestic Product (The total value of all goods and services produced within a country over a specific period)

·         C= Consumption (Spending by households on goods and services)

·         I= Investment (Business spending on equipment, structures, inventory, and residential construction)

·         G= Government (Government spending on goods and services at the federal, state, and local levels)

·         X= Exports (Goods and services produced domestically and sold to foreign buyers)

·         M= Imports (Goods and services produced abroad and purchased by domestic buyers)

Basepoint Wealth LLC is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Past performance is not indicative of future performance.  Therefore, no current or prospective client should assume that future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended by Basepoint Wealth), or product referenced directly or indirectly in this presentation, will be profitable.  Different types of investments involve varying degrees of risk, & there can be no assurance that any specific investment or investment strategy will be suitable for a client’s or prospective client’s investment portfolio. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.