Market Bearings with W. Allen Wallace, Chief Investment Officer

This month’s Market Bearings explores the growing tension between rising inflation, higher interest rates, and the impact of massive AI infrastructure spending on markets and asset prices. W. Allen Wallace breaks down what recent economic data may be signaling, why cash flow matters more than price fluctuations, and how Basepoint is positioning portfolios amid increasing uncertainty.

"Inflation is the one form of taxation that can be imposed without legislation."

-Milton Friedman

  "Interest rates are to asset prices what gravity is to the apple."

-Warren Buffett

Economic data is the rearview mirror of finance. We evaluate the present by looking at the past to make decisions about the future. We should not react impulsively to economic data prints, but we do need to evaluate them closely to see what story about actual economic activity is being written. Our main interests in evaluating economic data are determining the likelihood of dangers from inflation, rising interest rates, and potential economic contraction.

Data is an abstraction. Korzybski taught us that “the map is not the territory,” and we also need to understand that the same rules apply to data. Aggregation deletes structure. Collection methodologies shape conclusions. Timing and reporting shift narratives. Each data point is telling a single story about an intricate machine. Magnitude, acceleration, direction, and correlation all need to be integrated to make sound financial decisions.

In addition to our normal ruminating about data, it is important to note that the Federal Reserve will soon be under new management. Kevin Warsh has been approved as Fed Chair and will be sworn in on May 22, 2026. By the time this is published, it will likely be done. We will withhold all predictions and assumptions until the new Chair has had a chance to organize his desk.

Lead Thesis:

The most recent inflation numbers have begun to rise. A single print does not make a trend, but many times there is inertia in financial systems, and it is slope and motion that matter, not the current position. If inflation continues to rise, intelligent investors will require higher yields as compensation. If demanded yields rise, the prices of assets will need to fall unless cash flow increases dramatically.

Market Weather:

The first sound of thunder has been heard. We are still comfortable with our positioning and continue to rebalance portfolios into our newest allocations.

• Domestic equity prices remain elevated, indexes remain concentrated, breadth is beginning to deteriorate, and many equities are off all-time highs while the market remains near highs.

• Credit spreads remain tight. Bond defaults are still low, but high-yield defaults have begun to rise. Recovery given defaults are declining (the percentage of assets a lender recovers during a default event).

• Long-term rates have risen significantly.

• The dollar remains strong.

• Private market liquidity has continued to deteriorate, and private credit defaults have risen. Most defaults have been mitigated by reorganization or “payments in kind”.

• Inflation has increased meaningfully in the most recent report, mostly due to energy.

• Gold and Silver remain relatively stable given the inflationary environment.
  

Long-term bond prices have been negative due to rising yields. Equity prices are diverging, with AI stocks rising and most other stocks facing headwinds.

Charts That Matter:

Big tech has been on a spending spree.

Free cash flow (FCF) is the lifeblood of a business. It is calculated by subtracting capital expenditures from operating cash flow. It is the money left over after paying all the bills and investing in the future. FCF can be used to pay down debt, buy back shares, or pay dividends to common shareholders. In some cases, it is just held as cash for a rainy day.

The large AI companies pictured in this month’s chart have begun directing almost all their FCF to infrastructure spending. This means they will not be able to fund additional infrastructure growth from operations and will need to start tapping capital markets in the form of debt issuance.

Interest rates reflect how much capital is demanded. Without additional money printing, borrowers compete for funds from the available capital in the market. If trillions of dollars in infrastructure spending need to be funded by constrained capital markets, the only pressure release valve is higher interest rates. If this trend continues, we expect long-term interest rates to continue rising.

A further consideration is the maintenance required to provide upkeep for newly built infrastructure. It is estimated that every dollar spent on AI infrastructure requires around $.25 of annual maintenance. If you spend $1 trillion on data centers, you now have $250 billion in annual maintenance expenses to keep the property running. I have seen very few projections accounting for the cost to maintain these new facilities.

The relationship between 10-year yields and inflation is out of line with history.

Source: FRED

Historically, there has been a very consistent relationship between bond yields and inflation. We typically expect the 10-year bond yield to be above the inflation rate, because investors expect to be compensated for inflation. Recent yields have returned to levels above inflation, meaning that real yields have shifted from negative to positive. If inflation continues to rise, we expect bond yields to continue their ascent. If inflation cools, we may see a softening of long-term rates.

What We’re Watching:

Inflation has begun to rise; we will see if the trend continues. Recession risk is still looming, although the impact of inflation on long-term interest rates has begun to dominate our time. Oil and Gas have barged into the discussion. The Dollar is being overshadowed by the other factors, and we will leave it out of the conversation this month.

Inflation recently printed hot with the Consumer Price Index (CPI) at 3.8% and the Producer Price Index (PPI) at 6.0%. Both readings were well ahead of expectations. Core Inflation (minus food and energy) is slightly cooler at 2.8%, but still well ahead of the Fed’s target of 2.0%. Since inflation is being driven by energy, there is a risk that future inflation will continue to rise since energy is a component in almost everything we use. Until the Strait of Hormuz reopens, this may continue to be a problem. We will have a new Chair at the Federal Reserve, so policy direction may soon change.

Long-term U.S. interest rates have risen significantly. The 30-year US Treasury Bond is currently at 5.18% and the 10-year at 4.67%. Higher long-term rates impact the economy by causing higher mortgage rates, auto loans, and putting pressure on business lending. Much of this rise is caused by increasing inflation expectations, but some of the increase is due to deficit spending, and we may see the beginning effects of an increased demand for capital to build infrastructure. The AI Hyperscalers have run out of free cash flow, and they are starting to tap capital markets for debt financing. This may continue to pressure interest rates even if inflation subsides.

Recession risk is still underpriced. The current GDP growth rate is 2.0%. It is important to note that the current inflation number is almost double the growth in GDP. Our main activities on the recession front are continuing to monitor jobs and keeping an eye on interest rates. The recent jobs report (Establishment Survey) was positive, with 115,000 new jobs, but it is important to note that the number of people working part-time for economic reasons increased by 445,000. Layoff announcements continue to accelerate in information technology, and new jobs are focused on health care, transportation, and warehousing. It is also important to note that the Household Survey shows 4 consecutive months of job losses, and a decline in the labor force.

Oil prices have risen to $105 for Crude and $111 for Brent. We continue to hold oil and gas exposure, which is focused on the large integrated oil companies (Exxon, Chevron) and we also have exposure to Midstream (pipelines) and non-US oil companies (Shell, Total). A portfolio of oil stocks is not just a bet on oil prices. Exploration & production, transportation, refining, and services all respond differently to rising prices. The allocation to each of these components is an important consideration when dealing with energy volatility. We are using an actively managed fund to gain energy exposure, so the allocation can be flexible in response to changes in energy market dynamics.

Portfolio Positioning:

We have continued to rebalance accounts into our most recent allocation:

• We have updated our individual stock sleeve to reflect current valuations. We have begun to harvest some gains from securities that are overvalued. The proceeds are building cash.

• Catastrophe bonds provide returns driven by physical events like hurricanes, earthquakes, and fires, not financial events. These securities should have very low correlation to fluctuations in economic and financial data. This gives us the potential for good returns that are not impacted by securities markets.

• Utilities provide stable income with the potential for a softening regulatory environment. A large merger was recently announced between NextEra and Dominion. It remains to be seen if this merger will be approved by regulatory agencies. These are both large holdings in our utilities fund.

• International bonds provide exposure to multiple economies and provide diversification away from the US Dollar. Returns have been stable given the rising dollar.

• We have also reduced asset classes that are priced for perfection by reducing metals and domestic fixed income. We have slightly raised cash by selling some equities that are overvalued.
  

Principles and Philosophy:

The majority of financial activity revolves around predicting the prices of assets. Modern portfolio theory evaluates price fluctuations, the correlation between price fluctuations, and the expected deviations in price fluctuations from average. The missing variable in all these calculations is durable cash flow from underlying assets. Prices are a derivative of cash flow, translated by a discount rate. Cash flows are primary and are the fundamental particle of finance. By focusing on cash flow we can manage long-term returns instead of obsessing over short-term volatility.

If you own a company that generates $1,000,000 in annual cash flow, and cash flow grows to $2,000,000 per year, are you really worse off if the price remains the same? Too much emphasis is placed on temporary changes in prices. Recently, attention has been given to the wide divergence between Warren Buffett-led Berkshire Hathaway’s (BRK) stock price performance compared to the S&P 500. People are claiming that Buffett may have lost his touch. A careful analysis shows that BRK’s operating earnings have grown twice as fast as the underlying earnings of the S&P 500, with a lower gain in price, meaning much of the outperformance is due to people paying more for the same dollar of earnings. So, we ask ourselves: at today’s price, which is a better investment for the future?

Closing:

All of this discussion is meant to point to a single important fact: when interest rates rise, the prices of assets respond. Assets are simply claims on temporal cash flows. The price of an asset converts the expected cash flow that you own into a single settlement price, given a required discount rate. The structure of assets determines how those cash flows are translated.

Most bonds are contractual cash flows. You earn periodic interest, and at maturity you are returned your principal. Certain bond structures have variable cash flows, but they are still contractual in nature. You can earn interest that is adjusted for either interest rates or inflation directly, and you can own bonds of varying credit risk that are subject to potential default. The common thread is that bonds are loans, not participation in operating businesses (other than convertibles, but we will leave that for now). Long periods of inflation are destructive to most bonds. Since interest payments are fixed, principal can be eaten away by rising prices. As rates rise to compensate new bondholders for expected inflation, the principal of existing bonds declines. We must be careful about yields, maturities, structure, and credit quality.

Stocks are claims on residual cash flows. This is what is left over once all the bondholders, vendors, and employees have been paid. Because equity owners are compensated last, they own the first losses. The advantage of equity ownership is that the cash flows are derived not from contractual obligations, but from an operating business. Depending on the business that you own, you may be protected from inflation by the ability of management to increase prices. A very good business can consider their cash flow to be protected from inflation. It is important to note that inflation protection does not necessarily apply directly to share prices. During periods of inflation, discount rates may change significantly, even if cash flow rises. Companies that are capitalized based on estimates of high earnings far into the future typically suffer more than companies with high current income. When inflation is high, earning cash now trumps the hope of earning cash in the future.

The fact remains that higher interest rates require either lower prices or higher cash flows to compensate investors for the opportunity cost of available alternatives in both bonds and stocks. When inflation rises, interest rates normally follow suit. If interest rates rise, asset prices normally fall. We mitigate this by focusing on solid underlying cash flows, not price fluctuations.

We continue to evaluate the cash flows available in bonds, stocks, alternatives, and the yields available on cash (which is an option on future asset purchases). As long as our cash flows remain stable, the current pricing of those cash flows is a secondary concern. As asset prices fall, the yields on stable cash flows rise, and we will shift to higher-yielding assets as opportunities evolve.

Thank you for the trust you have given us. We never take it for granted.

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.