July 2, 2018


Dear Investor,


The words don’t look insidious: “My hope is that the Fed, under its new management, understands that more people working and faster economic growth do not cause inflation.”

But they come from Larry Kudlow, who works for the White House as Director of the National Economic Council. This makes them dangerous words indeed.

Traditionally, the White House has wisely abstained from bullying the Fed. As a central bank, the Fed must stay vigorously independent. Monetary policy cannot be governed by politics because the Fed must do politically painful things everyday—like raise interest rates to douse inflationary fires. We’ll see if jawboning descends into outright bullying, but would anyone be surprised if it does?

There’s another nation that has recently fiddled around with badgering the monetary authorities. Turkey’s Erdogan has asked their central bank to keep rates low. The result: a stunning and treacherous inflation rate of 10.9%.

To the extent a central bank loses independence, inflation will always be the result. Incumbents will always press for lower rates to juice growth, betting that inflation will lag far enough behind for them to avoid blame. This is a dangerous game.

The Dow is already down 9% from the highs of January. A lot of damage has been done but so much more might await. Just one additional percent drop will mark a serious correction. I do believe we’re in a bear market, but no one can predict stock markets and my contention that it’s here is not worth the paper this email is not printed on.

If we are in a bear market, we’ll only know after the fact–once the decline runs to a full and miserable 20%. As I’ve said before, we are several years overdue. Like a tectonic plate goes years without shifting, a hibernating bear will be worse once it emerges. Investors should expect eventual declines of 20%–30%, possibly more.

If the Fed loses its independence, that might stoke stocks at first, as a too-permissive monetary policy fans the monetary flames. But it will catch up with them later, as inflation impairs the underlying business models of many stocks.

What’s an investor to do? First, make sure the allocation is appropriate for the risk preferences and time horizon. We have done that in all accounts. Aggressive accounts should still be fully committed to stocks, especially international stocks which have already priced in a trade war and macroeconomic shocks. Conservative accounts should be mostly in short-term or intermediate-term bonds, but should ideally keep some reasonably-sized stock position to hedge against inflation.  The case for value in international stocks is strong. The emerging markets are the most compelling. Emerging market stocks trade at 11 times earnings, approximately 21% below their average valuation and 60% below their peak multiple. At this price they have already anticipated all manner of economic mayhem. Incipient inflation could cause them to have a reflexive selloff, but they should recover faster and more furiously than overpriced domestic shares.

All should watch the Fed closely to see if it can maintain its independence. As Independence Day arrives, we have many reasons to worry about our individual liberties. Sorry to add another to your list.


With best wishes for the coming quarter.