Summer Commentary – 2022
By Contessa Archuleta on August 28, 2022
*Transcript of our client tea – held on July 21, 2022*
Access PDF here.
Kyle: Thank you, everyone, for joining us. We are going to start our talk today on cryptocurrencies, and then go down a list of questions which clients have provided to us.
Rob: The main purpose of cryptocurrency was to act as a hedge against inflation that was a result of currency debasement- which happens when governments print money indiscriminately. The central basis of cryptocurrency is that there is a limited supply of it, like gold, and therefore it’s not supposed to be subject to devaluation. It remains to be seen if this is true. What we’ve actually seen over the last year is that it has tracked the stock market, and in fact, it has been more volatile than the S&P 500 stock index. We’re still in the very early stages of dealing with electronic currency. In India, they’ve banned the use of cash and gone exclusively with electronic payments. India was primarily a barter system and a cash system because most people didn’t have access to the credit or cyber services. The government gained control over the black market and barter by doing away with the use of cash in the Indian economy. Cryptocurrencies are advertised as not being traceable and not being able to be stolen – both of which statements are apparently not true!
Kyle: The overall goal is to have a currency that is not influenced by governments and government policies. That would include inflationary actions such as printing money. As the governments print money, it creates the inflation. The idea that you have one central government controlling your currency is what cryptocurrencies are trying to get around, or at least Bitcoin primarily.
Rob: There are many forms of competing cryptocurrencies. I met a Bitcoin miner over this past July 4th weekend who actually was buying machines and saying that they were going to mine it with renewable energy, which is one of the concerns about Bitcoin is its total dependence on constant use of large amounts of electricity. It’s certainly still a speculative investment.
Kyle: In price range of $12,000 to $18,000, there is a point where it becomes too inefficient or too costly to mine. That doesn’t necessarily set a bottom price for Bitcoin because Bitcoin can still transact and still can trade at lower levels regardless of whether or not people are mining.
The key point about Bitcoin is that it had been touted as something which is an inflationary hedge and as something that’s uncorrelated to the markets. What we have seen this year with cryptocurrencies is that as people backed away from speculation, they’ve also backed away from cryptocurrencies. When we saw inflation and turmoil between Russia and Ukraine, you would have expected Bitcoin to rise in value. The opposite has occurred. As speculation has shifted in the markets, and investors have moved away from non-profitable tech companies or biotech, Bitcoin has also pulled back. There were new cryptocurrencies out there being driven up and there were multiple ways in which people were making money off these cryptocurrencies. Much of it was really just sort of a scheme for people to make money quickly while other people got caught holding the bag. Cryptocurrency may be around for a long time, and there’s going to be winners and losers.
Rob: Why don’t we take the Bitcoin discussion a bit further and talk about inflation in general? Everyone’s aware of how quickly home prices went up and some of that’s ascribed to COVID and the change in demographics and decreased desirability of high-density urban centers. The place that everyone was fleeing, Manhattan, has reignited and prices are as high as ever for apartments there. Real estate is still being seen as an inflation hedge as crypto was supposed to have been. The general consumer price index is up 10%. In many places across the country the housing market has priced out young people, so it is very difficult to buy unless you already own a home or have some other assets. The Federal Reserve (“The Fed”) has stepped in to combat inflation and has raised interest rates which has also raised the price of servicing the government debt. I was shocked at the rates on the short-term U.S. Treasury bills, the most liquid and high-quality investment in the world. The three-month U.S. Treasury bill is paying 2.5%. A year ago, it was paying under 0.2% and you couldn’t earn 2.5% in a ten-year, AAA, corporate bond.
Kyle: On a low rated junk bond, you would have been lucky to get 2.5% on a five-year basis.
Rob: If the government’s long-term goal is to not have to pay more interest, they have got to crush people’s expectations that inflation will continue. The Fed does have the ability to raise certain kinds of interest rates, but they and the government do not have the ability to control inflation. That’s an important distinction. The central bank can do whatever they want with the banking system, but if there are wars, supply chain issues and labor shortages, they cannot do anything about those critical factors which may continue to create all types of inflation. Rising interest rates have dampened the housing market but housing prices have really not gone down much from a year ago. If single family home prices continue to go up, they’re going up very slowly. Sellers are having to negotiate the price of real estate, whereas before it was a crazy potential bidding war between aspiring buyers. The big question is will increasing the interest rates translate into a slowdown in economic activity? Are we already in a recession? Is the Fed willing to cause a recession in order to temper inflation? I believe that in order to curtail the government’s future interest costs, they’re willing to do almost anything. I think the government’s interest expense is soon going to exceed the total cost annually of the US military budget. It will exceed the total cost of Medicare spending. As a result, the Fed has strong justifications to raise rates, but I’m not convinced that it will directly get rid of inflation.
Kyle: There’s a lot that’s been said about the money supply chain. Although we’re raising interest rates, there still remains too much money in circulation. We had multiple rounds of stimulus that was put into the economy during COVID. We have this huge amount of money in circulation. The Fed’s goal is to move that money out of circulation. Right now, it remains in circulation and is a big cause of inflation. Then, we also obviously have supply chain issues which are created by a variety of factors from COVID and COVID related shutdowns around the world. You also have issues in Russia and Ukraine which are leading to limitations on exports of agricultural goods, oil, or natural gas.
Rob: The Trump-era tariffs also have contributed to supply chain challenges because raw materials and construction goods became more expensive overnight. Tariffs are one of the things Biden is talking about doing away with, especially with China.
Kyle: Although the Fed is raising rates, without a real economic slowdown, they’ll probably continue to raise rates to fight inflation. It may not actually work to fight inflation until some of these other issues are resolved.
Question: What opportunities are created as a result of continued high inflation?
Rob: There are some obvious opportunities in the energy industry. Oil and gas revenue is substantially higher than it traditionally has been. We have a government-imposed restriction on oil and gas exploration and increased regulatory burdens. People that own exploration, transportation, and refining assets will benefit from the inflation in energy prices and the politically motivated curtailment of supply. Along with the military conflict in Eastern Europe, the second war going on in the Ukraine is about energy. It’s clear that Russia has weaponized their supply of natural gas to Europe so it’s a pretty serious situation. Countries have turned their back on natural gas and nuclear and now they are beholden to Russia for their energy and have to figure out an alternative.
Nizhoni: This last month, Russia had decreased the supply to the EU and then shut it off completely. The Nord Stream pipeline is the main supply of natural gas to the EU, it supplies over one third of their natural gas. Russia cut supply off completely citing maintenance concerns, but also mentioning that it was related to some of the Western sanctions. The Russian government is using their power as an essential supplier of natural gas to regain access to EU markets. The EU really does not currently have the ability to get natural gas from anywhere else in that volume. Many industrial companies are going to suffer severely to produce to capacity. If there wasn’t enough natural gas to get through the winter, the priority would be heating households. The industrial companies would have to decrease production. As Rob mentioned, many of these companies have started to make that shift towards more of a green structure which would provide for alternative energy resources, but that takes several years to implement.
The EU has considered decreasing natural gas use to for the possibility that they won’t have enough reserves to get through the winter. Chemical, gas, steel, even pharmaceutical companies are really reliant on natural gas. These industries supply a lot of jobs to the countries where they manufacture. The cost of this could mean a pullback in GDP by as much as 1-2% on the GDP, which doesn’t sound like that much, but it is very significant.
Question: What’s happening with coal usage during this time? I understand plants around the world are increasing now in coal to replace natural gas fired electricity generation.
Nizhoni: Many of these companies are putting coal burning sites directly on site so that they can use that as a more reliable source to fall back on. Some are trying to get electricity from other sources and use that 50/50 in tandem with electricity generated from natural gas. We will likely see more demand for coal going into the winter if Russia continues to weaponize the natural gas reserves.
Kyle: The discussion of nuclear power starts to come up again. This is also a slower transition and takes quite some time to implement and shift towards.
Question: How does money actually get removed from the money supply?
Rob: When the Federal Reserve was expanding the money supply during COVID, and for the last ten years – starting with the great financial recession in 2008-2009, they created additional government securities and sold them in the market to themselves and to banks. When those mature, they can just not re-issue them. The Fed, which is its own bank, and the US Treasury, can make a new deal with the commercial banks. They can decrease the volume of government securities when they have 2 trillion maturing, they can reissue only 1 trillion. Therefore, they have reduced the number and amount of securities on the balance sheets of these banks. It’s not about taking money out of circulation from consumers. It’s about taking the liquidity away from the different financial institutions which impacts their ability to lend and the interest that they earn and their profitability. Eventually this translates back into consumer spending and sentiment. When the government is accommodative with low interest rates and creates more money, people feel positive that their net worth is going to go up. They will pay more for a vacation house or put money into stock. It eventually translates into investor psychology.
Kyle: This would be quantitative tightening. They try to do it in other ways by raising the bank reserve requirements that try to remove money from circulation amongst the people and dampen spending by forcing the banks to lend less by upping their reserve requirements. Eventually, it gets to a rate which just doesn’t make sense. The banks are holding on to too much cash and the government has to pay them for holding that cash.
Rob: In China, the government has many means of manipulating the money supply and it changes the bank reserve requirements all the time. They step in and let people not pay their mortgages because many urban areas are full of big apartment buildings that were half done but investors were having to pay rent on their apartments that weren’t finished. The European Central Bank raised interest rates for the first time in 11 years. Immediately, the Italian bond market went down because Italy’s economy is super weak as they have a tremendous amount of debt, which has been hidden by a decade of quantitative easing, i.e., new security issuance, of the European Bank. The Italian bonds pay almost the same interest rates as German bonds, and their economy is not nearly as sound. The last thing the EU central bankers want to do is raise interest rates because they are well aware that it will create stress in areas (Italy, Greece, Spain) that can then become very unpredictable on a political level, such as the Italian Prime Minister Draghi being forced to resign.
Kyle: As the U.S. has raised rates, one of the ways in which we combat that arbitrage of foreign dollars flowing into U.S. Treasuries is through a strengthening of the U.S. currency. If you’re converting your Euros to U.S. dollars to invest in the U.S., your money has to weaken. Otherwise, you can just make endless money with your own currency. The U.S. is in a stronger economic place than Europe is. We have much higher interest rates, and so the European Central Bank raising their interest rates is one of the ways that they’re trying to improve their currency weakening. As you all may have seen, we’ve seen the U.S. dollar go to parity with the Euro. Meaning 1 Euro equals 1 USD That’s something that hasn’t happened since 2002. This has strong implications for the U.S., and for companies within the U.S. as well.
Rob: Exporters from the U.S. to overseas start to see the negative effects of this as they exchange goods for other currencies which are now less valuable that the U.S. Dollar.
Keren: The other impact of the strengthening of the dollar is that, developing countries are having to pay more for their debt service to the U.S. They’re also having to pay more for food and for gas. Rob was commenting on food scarcity and insecurity in Afghanistan. That also has to do with sanctions from the U.S. The strength of the dollar, even though it’s positive in some ways, it’s also very negative in others. For major corporations, like Boeing, who is a huge exporter to the rest of the world. I think about 30% of their profits comes from their overseas business. Then the other thing that I was just going to comment on, Rob mentioned Chinese tariffs earlier and whether or not Biden would lift those. There was a former White House trade negotiator who said that from what he can see that it would only be about 10 billion of 360 billion in tariffs that might be lifted. It would not necessarily be enough to move the needle in terms of inflation.
Question: When is the market going back up?
Kyle: Well, obviously we can’t say for certain when the market bottoms or when it goes back up. We were talking earlier this week about the weakness in analyst predictions and how they’re rather inaccurate in their predictions. Regardless, the predictions are that we would expect the market to be at a higher point in six months from where we are today. Would I say that with a strong amount of confidence, or would I say that we won’t have a further down period between now and six months? I think that it’s highly likely. Although we’ve seen improvement in the stock market recently, I don’t think that the market really understands quite what’s happening. Investors are trying to figure out how much risk they want to take in the markets. They’re trying to figure out how much should they be in the market in the short term. All of us, we try to be long term investors when it comes to the actual stock market. We’re trying to figure out how much risk we want to take in the short term. Really, the economy and the Fed has given us very little information on which to determine our risk. They show signs about where the target Fed funds rate is going to be. I think the market is trying to react on a lot of unknowns right now, unknowns around the world. Russia and Ukraine, when does that end or when does that slow down? When does COVID subside more and allow for fully functioning economies? I think that it’s pretty hard to have an idea. A lot of what’s happening right now is just a function of risk management for investors.
Keren: I think one of the things that we talk about with clients, is certainly a long-term strategy. We continue to research the assets in client portfolios, so continuing that due diligence and ensuring we watch those investments. Some of us have seen talk of the 60/40 portfolio going away. This is a very traditional diversification, 60% of the stock market, 40% to fixed income, and leaving alternatives and things like that out of it. From 1926-2020 or 2021, the average annualized return was about 7%. If you look at 2019-2021, we’ve seen an annualized return of 14.3%. If the market overall was down about 12% this year, end of year, we would still see annualized 7%. This is just a reminder of why we hold that long term strategy. This is not going to be right for every single investor. That differs based on suitability, time horizon, all of those things. Speaking to that long-term view.
Kyle: We’re experiencing a real reversion to the mean there.
Electric vehicles are always a really fascinating topic. They’re greatly impacted by the global supply chain. My wife ordered a Tesla. She drives from El Dorado to Pojoaque every day. I think it’s about 40 miles one-way. The efficiency of having an electric vehicle would make a big difference. We started off with an initial estimate of getting it in August and we’re now in December. Obviously, chip shortages are an issue, although right now they’re predicting that we’re going to have a glut of chips coming in. The problem is they’re going to have too many chips come 2023. We’re going to actually see an oversupply in our chips. We’re going to move past the actual need and end up with an oversupply in the economy and chips.
All the car companies are moving into electric vehicles. We know right now that there’s going to be necessary upgrades across the board to the electrical grid with utility companies. I was just in Dallas, and in the surrounding areas of Dallas they were worried about blackouts. It was 108 degrees, and everyone had their air conditioners on full blast. Texas deregulated their utility companies and it’s created a lot of problems. There’s going to be a lot that needs to get solved as we get to mass adoption of electric vehicles.
There’s a great article in The Wall Street Journal about someone who tried to go from Florida to Chicago and back in an EV, I believe, or may have been Georgia to Chicago and back. They just talk about the inefficient nature of recharging and really having to plan out the trip. Now, for someone like my wife, Tabitha, who is a commuter, it makes perfect sense to drive back and forth in comparison to the cost of gasoline. For people that have to drive longer distances, it doesn’t make sense.
Question: Is investing in solid state batteries, a good way to get into the electric car buzz? They’re less toxic. They take less time to charge. This could be where we see demand as these companies look to innovate.
Kyle: Battery technology is in dire need for additional innovation. Solid state batteries might be the answer. There’s a lot of innovation that just hasn’t occurred yet. The push to electric vehicles is a little bit ahead of that innovation right now. There’s likely to be really strong investments in those areas. It’s just a matter of how you predict or find the right companies, most of which are probably private companies at this point. The companies making the greatest innovation or are likely companies that we can’t yet invest in.
Kyle: All batteries require a certain amount of minerals which make them not as environmentally friendly as we would like. As more batteries are being developed, you need more minerals. That drives the up price of those minerals unless you find a more efficient way of extracting them from the from the earth.
Question: There was an article about a mining company in New Mexico. The company was going to build a mine out in Southern California or Arizona that would produce the mineral for batteries that is controlled by China. Does any of that resonate with you? What they’re doing?
Rob: Well, there are large mining operations in Arizona already. Given the politics of international natural resource production and transportation challenges, export controls and ongoing difficulties with China, it makes sense for US companies, if they can get permission to develop mines for these essential materials, to do so domestically. Industrial companies face very high regulatory hurdles to do any kind of materials processing. It will be interesting to see how the push and pull of the demand and the need to have a domestic source for these electric car component parts impacts the US regulatory environment. When Russia first invaded Ukraine, people started talking about how dependent we are on these other countries for industrial materials.
Kyle: Yeah, it’s a common trend. We just saw Congress pass a bill for the chip producers. I think it’s actually called the Chips Bill. The goal is basically creating incentives for domestic manufacturers of semiconductors to build plants and increase production in the U.S. because there’s big concerns about reliance on Taiwan for the world’s chips and trying to create that domestically.
Let’s talk a bit more about real estate. Do we still see those opportunities for building strong passive income?
Rob: The cost of materials has gone up so much. The cost of construction and rents have gone up concurrently with the cost of building.
Question: Do we see a future where this is going to start coming down and then it’s going to be a good time to buy back in? With the price of materials, the price of renting, everything is so high that it’s really hard to generate that passive income.
Rob: There’s nothing to say that markets can’t go higher and stay high even if they are overvalued. If you look at the price of housing in Europe, for example, where they have limited space to build, the price of housing has always been much higher than the U.S. relative to the income of the population. There are a lot of long-term renters in Europe. We have more space; we have more entrepreneurialism. Construction industry materials, from lumber to steel to appliances, each have their own story. Much depends on whether it’s produced domestically and what are the other constraints on its availability as well as labor force to keep the economy on track. People have difficulty now building for various reasons, and the housing stock in the country is still not keeping up to demand. There are still a lot of young people who live in rentals or with their parents. Young people earning salaries need to have their parents’ support to get into a house unless there are two income earners in the household.
If you’re an investor, and you’re buying real estate to achieve a certain annualized rate of return, that’s one thing. If you’re buying to live in a home, that’s another thing because if you’re going to hold on to a property for 20 years, then then it has a lifestyle value. My daughter recently bought a home in Santa Fe and if she stays there for ten or 15 years, the interest cost versus the cost of renting is still minor so home ownership still makes sense, even without factoring in potential appreciation.
Kyle: I think when we look especially at passive income producing real estate, one of those issues is going to be flexibility. How large of a mortgage is on a property, how much debt are you having to cover in the event that rents go down or tenants move out and you’re dealing with vacancies? There’s a variety of factors that you have to deal with, and it’s always impacted by your initial purchase price. You may have five good years of high rents. As production occurs or as markets evolve, there’s always the possibility that markets change. Asheville, NC is a hot market right now. The prices are outrageous in Santa Fe right now. We can’t say that it’s going to stop or change any day. You have to be in a position where you’re able to absorb and work through those fluctuations in the market. Like an investment strategy you’re going to have your stocks go up and down, and you just don’t want to be in the position where you have to sell stocks when they’re down.
Rob: There’s a big difference between residential and commercial real estate. The big hedge funds and private equity funds have bought millions of single-family dwellings for rental purposes. I saw BlackRock is raising the biggest real estate fund ever to buy more. Look at all the tract homes that you see on the south side of Santa Fe. Similar developments are cropping up everywhere as there’s tremendous momentum to build. That’s not all bad. It means that working people may be able to afford a $300,000 home because that’s the target market that the national homebuilders if they can find materials and labor to build them. I don’t think the real estate market is doomed to go down materially by any means. Higher interest rates are curtailing speculation and that’s a good thing. When people borrow money to invest, be it in real estate or stocks, they are at the mercy of the volatility of the interest rate market and that’s a bad place to be. The only time that we’ve gotten into trouble in our private real estate investing has been when we invested with Sponsors who were convinced that a high degree of leverage, or borrowing, was a good thing. It’s why we don’t buy stocks on margin. We don’t believe that people should speculate on long-term investments to any great degree.
Kyle: Thank you to everyone for joining us. If you have any questions, please feel free to call or email any of us on the team.
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