Abstract(ions)

• Markets exist in a state of confusion due to conflicting signals provided by a cut-biased Fed and problematic inflation data.
• Even in a world of sticky inflation, the Fed may find that “higher for longer” is not a fiscally palatable option.
• Risk today feels like the tails side of a coin investors simply hope won’t come up.

Dear Fellow Investors,

Mr. Market’s Fixation Continues

In January’s letter, we considered a Federal Reserve “waffle” of extraordinary proportion set upon the stove in Q4 2023. Despite inflation above target (more on that later), equities at all-time highs, and sub-4% unemployment, the Fed’s finger was positioned eagerly upon the (interest rate cutting) trigger. The market happily underwrote this approach, further flooding into mega-cap equities, “meme stocks”, cryptocurrencies, and other speculative assets, producing yet another wave of price gains in a now familiar self-reinforcing levitation. Few questions were asked as to what an alternative economic reality might look like. More recently, an inconvenient succession of adverse inflation-related data has created, it seems, just an inkling of reconsideration. As onlookers to this slow-motion train wreck with no better ability to tell the future than anyone else, we would offer two simple observations:

• First, if inflation is indeed a sticky phenomenon, as we have posited it may be, and rates are now to remain “high”, the relative prices of risky assets still likely require a structural repricing. Why? If risk-free rates are believed to be 4-5%+ indefinitely, a variety of assets should begin to produce (in expectation) a larger portion of their total return in tangible cash flows (read: dividends and interest payments). This is simply not something that has been available, even recently with ~5%+ treasury bills widely viewed as a fleeting novelty. In investing, we naturally prefer returns we can see, touch, and feel (when available) relative to those that represent a mere conjuring.
• Second, our government might do well to consider a less interventionist approach to monetary policy. Maybe it’s just us, but the Fed’s current on-again, off-again predicament and Mr. Market’s increasingly quixotic and obsessive view of the whole ordeal seem to suggest there may be a better approach. Something rules-based… something that excludes uncontrollable variables… something simple and stable… something spectacularly boring. While crises are often the impetus for change of that magnitude, we hold out hope that another path reveals itself toward monetary (and fiscal) sobriety.

Changing The Goal Posts?

Diligent readers will recall our (longing) recollection in last quarter’s letter of the sound money “Martin standard” set by Fed Chair William McChesney Martin in the 1950s. One of Martin’s most storied speeches took place in 1955 at the old Waldorf Astoria Hotel in Manhattan. In it, Martin shared a quote from a Fed colleague that illuminates a different monetary lens which, to our view of the world, may become topical again before long.

“Those who would seek to promote ‘full employment’ by creeping inflation, induced by credit policy… of, say, 3 per cent a year… should also explain… in advance that repayment of long term debt will surely be in badly depreciated coin” – Allan Sproul, New York Fed President (1955)

At face, this would seem to be an outcome the Fed would want to avoid. However, we now live in a world in which a chart of US government debt outstanding resembles an exponential function. Interest expense on that debt now exceeds all discretionary defense spending, even prior to the full incorporation of higher interest rates. Since that interest expense adds onto an already significant and growing “primary budget deficit”, it simply increases the national debt, which increases the interest cost further, and so on. Fairly bleak!

Despite its feigned independence, Mr. Powell (or whoever succeeds him) is unlikely to stand by while a deficit-debt spiral plays out. Unfortunately, the recent playbook of simply reducing short-term interest rates (or talking about it) is unlikely to find success at containing long-term interest rates (and thus expense) in such a world. The next option pursued is often an attempt to control longer-term interest rates, usually via longer bond purchases, alongside a “relaxation” of inflation targets. The Fed’s recent announcement of a reduction in the pace of quantitative tightening may be a signal in that direction. Unfortunately, if such a policy is pursued to its end, it only increases the money supply further and risks igniting accelerating inflation, currency devaluation, and broader economic malady (see Argentina, Venezuela, et. al.). While perhaps unlikely to unfold on Latin American scale given the US dollar’s reserve status, movement in that direction creates risk worth watching.

Risk On, Risk… Off?

Despite all of this, Mr. Market remains myopically obsessed with how much (and when) the Fed will cut rates. And who could blame him? A generation of investors has been conditioned as if by Pavlov himself to respond to a simple order of operations: rates lower… (risky) assets higher. It all seems so easy! Unfortunately, this year’s events have demonstrated yet again the challenges inherent in any investment program predicated on single-scenario predictions of the future of rates or anything else. Everyone knew in January there would be a succession of rate cuts in 2024. Now, everyone knows cuts will be delayed (but must, of course, still come).

Within the relative solitude of our Cincinnati offices, these gyrations factor at a rate of precisely zero into the long-term investments we make on behalf of you, our clients. Our focus is the perpetual search for actual businesses that do and make real things of value and pay real growing dividends as a result. Nonetheless, consideration of economic and market scenarios does inform our view of the other thing we care most about: risk. For many investors today, risk is the tails side of a coin they simply hope won’t come up. To us, a focus on downside risk protection across the multitude of adverse scenarios that could unfold is a far more accretive activity than frantically guessing at how many more times heads will come up in a row.

We study risk intently through many lenses, though perhaps our favorite is “downside capture” – the amount our portfolios go down when the market goes down (i.e. capital preservation). On that measure, we are running better than our historical averages and lower year to date. Our Income Growth strategy, for example, is running at just 66% YTD and 73% on a one-year basis.(3) Translation: when the market goes down on a given day, our Income Growth strategy on average has “captured” just 66% of that downside risk/move. This is a result we like to see any time, but even more so in times like these.

As always, I encourage you to reach out with questions, feedback, and comments. Thank you for the trust you place in us and your partnership with Bahl & Gaynor.

Sincerly,

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Disclosures

(1)Bahl & Gaynor annual cash income received is calculated on a gross of fee basis and does not incorporate the impact of advisory and other fees which will be experienced by investors. The Bahl & Gaynor value is calculated each quarter, beginning 03/31/2013 with hypothetical $5,000,000 starting capital split 50%/50% between the Bahl & Gaynor Income Growth SMA strategy (Income Growth) and the Bahl & Gaynor smig® SMA strategy (smig). Quarterly income earned is calculated using each SMA strategy’s historical model income, adjusted by a multiplier factor to reflect the starting capital. Income includes the reinvestment of income. Four quarters of income are summed to calculate annual income received in each period shown. The initial 50%/50% allocation occurs at the beginning of the ten-year period and is not rebalanced thereafter.

(2)US Stocks annual cash income received is calculated each quarter, beginning 03/31/2013, with a hypothetical $5,000,000 investment in the Vanguard® Total Stock Market Index Fund ETF (Ticker: VTI) which was chosen to represent an investable market cap-weighted index that invests across large-, mid-, and small-cap stocks and distributes income in the form of quarterly dividends. Quarterly income is calculated by multiplying the implied number of shares purchased with $5,000,000 at initial investment by the quarterly dividend rate and assuming income reinvestment to increase the number of implied shares each subsequent quarter.

(3)As of 05/16/2024. Source: Bahl & Gaynor; historical downside capture is the sum of strategy returns on all S&P 500 down days divided by the sum of index returns on all respective down days. Down days are defined as any trading day the index posts a negative total return. Strategy performance is derived from the daily internal rate or return (IRR) of a single non-fee paying representative account.

This report contains information sourced from third parties. Bahl & Gaynor does not represent the information is accurate or complete and it should not be relied on as such. Bahl & Gaynor assumes no liability for the interpretation or use of this report. Past performance does not guarantee future results. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial fees, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that account holdings do or will correspond directly to any comparative indices. The index and other amounts shown above do not relate to Bahl & Gaynor strategies and are for illustrative purposes only.

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The opinions expressed are those of the author as of the date indicated and may change based on market and other conditions.