“Are we heading into a recession?”

This is the number-one question I have been getting from clients recently. I answer with a question: How is your business? The answers vary, even inside the same company.

One of our long-term clients is primarily in the transportation business. They have other businesses as well, including a few very good restaurants, but their main business is helping goods get into our harbors, off of ships, and up rivers. They have several locations around the country, and we get to go to all of them. I shouldn’t say this on the record because now they will be on to me, but casual conversations with this client have an impact on our view of the economy. They are on the front line. I almost laugh when they ask for my view – I sit in an office reading reports. These folks are moving a significant portion of everything you buy. They will know long before I do whether the economy is slowing down.

Just a few weeks ago I was visiting their Norfolk, VA, location. Someone there asked me about the economy, and I replied by asking about their business. “We are busy,” was the response. Last year was a record year and they are expecting it to be just a little higher this year. That is an encouraging sign, but is it universal?

A few weeks before that visit I was talking to the same company’s CFO. When I asked him how business was going, his response was a little different. He said that when viewing potential mergers or acquisitions, they now had to factor in the cost of capital. In other words, higher interest rates mean that it will cost them more if they decide to purchase another company. That may mean fewer business deals this year. That isn’t encouraging.

Meanwhile, one of my colleagues visited the same client’s New Orleans location. When he asked how their business was going, they said it was good, but some of their clients are seeing a slowdown because they used to bring grain from Russia, which now isn’t happening because of the war in Ukraine. That is interesting.

The same client, yet three different takes on the economy. I have also gone on record saying that I believe the power of the Fed over the real economy is hugely overrated. I still believe that, and I still believe that Wall Street and economists in general remain overly pessimistic. How do we make sense of these mixed messages?

Albert Einstein famously said, “If you can’t explain it simply, you don’t understand it well enough.” I believe he is correct, but it goes further. Most experts can’t explain things clearly because they are more concerned with being considered an expert than communicating clearly to the everyday person. In other words, their egos get in the way. They insist on peppering their speech with jargon, or worse yet, acronyms. As a result, in my opinion, they often lose sight of the most basic fundamental understanding of what is actually happening.

The experts cite past data showing that when the Fed raises interest rates, the economy goes into a recession. They get so focused on analyzing data that they forget to ask the most fundamental questions: Why? What is really happening?

Raising interest rates impacts just one thing: the cost of borrowing money. That is what interest rates are – they are the cost of borrowing money. When one purchases a house, she usually borrows the money in the form of a mortgage. That mortgage, like all loans, has an interest rate tied to it, and the interest must be paid. The higher the interest rate, the higher the monthly payment.

However, that same consumer, if she is being responsible, doesn’t borrow money to buy groceries, clothes, or any other day-to-day item. Most of the goods we buy do not require loans, so interest rates don’t have an impact. Likewise, a company will usually borrow money to buy another company, to build a factory, or for any other major business investment. That same company hopefully does not borrow money to hire a new employee, pay their office lease, or any other routine business expense.

Those day-to-day items, which are paid for out of pocket, make up the bulk of economic activity. Roughly 70 percent of our gross domestic product (GDP) is made up of consumer spending. For consumers to spend, all they need is an income source, preferably a job. Companies mostly hire without borrowing and most consumer spending is done without borrowing, so the majority of the economy is not actually impacted by the Fed raising interest rates.

However, there are items that typically require borrowing, and these items will be impacted by higher interest rates. For the consumer, those are primarily automobiles and houses. For companies, the biggest items that require borrowing in our current economy would be other companies – mergers and acquisitions. One of the primary drivers of an individual company’s growth is its ability to purchase competitors and/or suppliers. Occasionally they will even purchase a completely unrelated business.

Mergers and acquisitions also fuel much of the financial universe. Investment bankers are the financial professionals who help negotiate and fund mergers and acquisitions. This is a large part of Wall Street’s business, and that is important to understand. Higher interest rates will make it more expensive to buy businesses, just like they make it more expensive to buy houses. That will result in fewer mergers and acquisitions.

How do fewer mergers and acquisitions impact the economy? Buying another company can be of significant benefit to the owners of both companies. The owners of the company being purchased get a big payday, and the owners of the purchaser now own a much larger company. What benefit is this to the economy as a whole? Very little, if any. Economic activity is measured by GDP, which is the gross domestic product – or in plain English, everything that is made and consumed in the country. The two companies produced a certain amount of goods. When they become one company, they still produce roughly the same amount of goods. There may be some efficiencies gained that boost production on the margin, but that also comes with the fact that two companies becoming one usually involves some people losing their jobs. This activity is great for owners and for Wall Street, but it doesn’t really help the economy.

Today we seem to be in the mirror image of what occurred in The Great Recession following the 2008 financial crisis. For nearly 8 years after that crisis, we kept hearing from Wall Street and economists that growth was right around the corner. Yet years after the crisis ended surveys suggested that most people still thought we were in a recession. Why? At that time the Fed aggressively reduced interest rates, eventually all the way to zero. Money was practically free to borrow.

This spurred a boom in housing and in mergers and acquisitions – big purchases that require borrowing. Housing will stimulate the economy, but as we discussed, mergers and acquisitions don’t really add to the economy as a whole. So, while business owners and financial professionals benefited from free borrowing, the bulk of the economy just didn’t grow. This led to an environment where economic growth kept disappointing the financial experts.

Today interest rates are rising, and the same financial experts who kept predicting growth that didn’t come a decade ago are predicting a recession that has yet to show up now. We can see why Fed policy impacts the owner class and financial professionals much more than it impacts the economy as a whole, but why can’t the economists see it? My theory is that it is human nature to see the world through one’s own view. In my experience, this happens regardless of one’s level of sophistication. We all tend to believe that people think the way we do, and that what we are experiencing is what everyone else is experiencing.

When interest rates are very low, things like mergers and acquisitions happen easily, benefitting business owners and financial firms who are the primary employers of economists outside universities. Their economic lives are good, so their view of the economy is positive. When interest rates are higher, things like mergers and acquisitions become harder, and that hurts business owners and financial firms. Their economic lives are in recession, so their view of the economy is negative.

Meanwhile, the vast majority of consumers are just going on with their lives. When there are a lot of mergers and acquisitions happening, rank-and-file employees are under stress. Things at work are changing and some are likely to lose their jobs. They may even curtail their spending. When interest rates are high, there is less change at work. The consumer hangs in there.

This explains a great deal about why, in the last 20 years or so of record-low interest rates, the gains in our economy have skewed to the owner class and financial professionals. There has been disappointing overall growth and an increase in inequality. It also explains our current situation, and the different stories from our client in the field and the chief financial officer.

But what about the slowdown driven by government sanctions on Russia? Economists love to analyze interest rates and tax rates because these are numbers and can be quantified. Government regulation, on the other hand, cannot be quantified easily, if at all. Sanctions against Russia are a great example: As long as our government says no to Russian grain, it will not come here. It doesn’t matter how much demand there is for grain, or what interest rates are. This is a structural barrier that cannot be overcome. Only the government can remove that barrier if they so choose.

I do want to be clear: Sanctioning Russia may very well be the right thing to do, but that is a political judgment and not an economic judgment. These sanctions, like all government regulations, create structural barriers to economic activity that cannot be overcome by attempting to stimulate the economy. This is important to understand, because over the last 23 years, there has been only one period of time when economic benefits were flowing to rank-and-file workers faster than to owners: that was in 2017-2020, when we saw the first decline in regulation since the 1990s.

When structural barriers are removed, then we can get real economic growth, which benefits everyone, instead of financial engineering, which only benefits the few. Today we are going in the opposite direction, which does not bode well for the longer term.

In the meantime, the economy is hanging in there better than most experts suggest. This is because rising interest rates are not actually stopping consumers from living their daily lives; they are, however, making it harder for mergers and acquisitions. They triggered a bear market last year.

This all means that those experts who are predicting doom and gloom are themselves experiencing a personal economic recession, coloring the lens through which they make their projections. What they are really saying is that they are being hurt by this environment and therefore they assume everyone else will be hurt as well. It is understandable, but it may not work out that way. We maintain our view that we will either escape a recession all together or have a very mild one. We are not basing that on our business, but on feedback we get from others.

So, how is your business?

Warm regards,

Chuck Osborne, CFA
Managing Director

~How’s Business?

We have wrapped up one of the strangest years in the financial markets in my memory. It feels like we are living in Bizarro World. For those who did not grow up with “Superman” comics, Bizarro World was a planet where everything was bizarre.

We had high inflation, which we (and every other analyst I know) saw coming, yet somehow the Fed did not. We had two quarters in a row of real GDP declines, which has always been the practical definition of a recession, but pundits insist that it wasn’t a recession this time. We experienced the worst stock market since 2008, and to add some salt to that wound, the bond market collapsed. The U.S. Aggregate Bond Index goes back to 1977, and in those 45 years, bond prices have been down only five times. The worst decline before 2022 was in 1994 with a 2.9 percent drop; In 2022, bonds dropped 13.01 percent.

The bond market carnage at least makes sense, as the big issue in 2022 was inflation. Inflation causes interest rates to rise, which the Fed’s actions accelerated. The stock market, however, is a more nuanced story. It would be easy to relate the drop directly to inflation, and inflation can certainly hurt some companies; however, inflation actually helps more companies than it hurts, at least on paper, as stated earnings get inflated with everything else. Energy companies are a great example of this and were the best place to be last year.

Stocks dropped because the majority opinion of market participants is that the Fed raising rates will cause a recession. In the 30-plus years I have been in this business, I do not recall a time when so many were so convinced that a recession was inevitable… which is precisely why I doubt a severe recession will occur this year. Perhaps I am being a bit of a wimp in adding the caveat of “severe” here, but stay with me.

Before I explain our thought process, it would be good to discuss what causes recessions in the first place. The economy flows in a way not dissimilar to nature: There are seasons, and spring leads to summer, which gives way to fall, and eventually winter. Winter, with all of its brutality, gives birth to a new spring. Trees grow, they mature, then fade and die, and in doing so, fertilize the soil for a new tree.

Similarly, a business also has a spring, summer, fall and winter. The four largest companies in America today are Apple, Microsoft, Alphabet, and Amazon. Apple was founded in 1976 and Microsoft in 1975. Alphabet was founded in 2015 as the parent of Google, which was founded in 1998. Amazon was founded in 1994. The four largest companies in the U.S. today did not exist when I was born, and two of those four did not exist when I graduated from college. How about you?

Nature has its seasons, and the economy has the business cycle. The cycle starts with new growth, new ideas, and new products. It grows into a flourishing summer, and when all looks positive, it then matures into fall and finally dies in winter.

That death brings forth new life, and the cycle repeats. This is the life of a company, and when we combine all the companies that currently exist, we get an economy. The difference between nature and the business cycle is human psychology.

The great sin of humankind is the thought that we can control things which cannot be controlled. In the Abrahamic traditions, Adam and Eve brought sin into the world when they ate the fruit of the tree of knowledge in order to be like God. In the Eastern traditions, they speak of having to give up the illusion of control. The ancient philosophers warned of hubris. This is a universal truth, and a bedrock of every tradition that has stood the test of time.

This manifests itself in the business cycle as companies experience the summer of their existence. We start our company selling widgets; our widgets are better than any widget that has previously existed, but in our spring we must overcome the newness. We must get our message out, then scale our production to meet the growing demand. If we survive this season, eventually we enter summer. Growth comes easily. We are no longer a startup but the leader of our industry. Demand is sky-high, manufacturing has been optimized, and profits flow.

If we were animals, our instinct would be to know that fall is coming with winter after that. We would prepare for our survival. But we are not animals, we are human beings, and we constantly believe that summer will last forever. At the moment when we should be storing up the fat for winter, we decide to expand instead. We overreach, and this brings on the fall.

Fall is not that bad. The colors are beautiful. It may start to get a little chilly, but it is nothing a sweater won’t fix. For our business we become a cash cow. Growth in demand has fallen, but we have become very efficient at making our widgets and they are more profitable than ever. We may be selling fewer of them, but the increased profit keeps our illusion of summer alive. While even the squirrels are wise enough to store all the falling nuts, we convince ourselves that we are still in control.

Then winter hits. In nature the animals hibernate and live off their fat stores, but our business was running very thin. We must take drastic measures. Payrolls slashed and factories shut down. We have brought on a recession. When recessions hit the unprepared, cuts have to be made. Like trees falling in the forest, those cuts lead to new growth.

We had severe recessions in the 1970s, when technology giants like IBM and Hewlitt Packard had to lay off employees – employees who would then take a chance to work for inspired startups named Microsoft and Apple. Twenty years later, a savings and loan crisis caused a recession and companies started trimming the bloat that had built up in the booming 1980s. Those trimmed workers staffed internet startups such as Google and Amazon.

Winter brings forth spring, but with all due respect, there is no cliché about people retiring to Minnesota. People retire to places like Florida because as a whole we prefer summer to winter. Of course, the four seasons take place in one year, while the business cycle historically took place over a five-year period. Macroeconomists have searched for a way to stop winter from coming. John Maynard Keynes theorized that we could stop it by having the government spend more when things began to slow.

Keynes’s theories dominated the period that led to the high inflation, high unemployment, and low growth of the 1970s. It was a disaster. Milton Friedman thought it better to use monetary policy – the Fed could keep us from recession by manipulating interest rates. As a result, we have successfully lengthened the business cycle from five years to a decade or more. The good news is that winter takes longer to come; the bad news is that the winters have become severe – the tech bubble, real estate bubble, and financial crisis. The more people become convinced that “this time it is different” and winter won’t come after all, the worse the impact of the inevitable change of season will be.

Why is that? Winter is fairly mild here in Atlanta, but those who have experienced a Southern winter often speak of it feeling colder. I blame the humidity. Years ago, I mentioned this to my boss at the time. He was from Detroit and knew a thing or two about winters. He just looked at me and said, “That is because you people don’t wear coats.” He was right, and I have forsaken my Southern roots ever since and brought out the coats anytime it gets cool outside.

This brings me back to my somewhat gutless prediction: I believe we may escape a recession in 2023, or if we do not escape entirely, that the recession will be very mild. I say this because everyone seems so convinced that winter is coming that they are actually preparing for it. Recessions happen, especially severe ones, because we constantly believe they won’t come and therefore overextend ourselves.

We are not overextended; this may be the silver lining in the very dark cloud which was our reaction to the COVID- 19 pandemic. We had not had a recession since the financial crisis of 2008, so we were overdue, but as we entered 2020, all was well economically speaking. We were experiencing the best economy we had seen since the 1980s and 1990s, then we decided to shut the world down in an effort to control the path of a virus. (There is that control thing again.) So, recession started.

We were rebounding from that self-inflicted recession when we decided to reverse course on the lessons of the 1970s and once again embrace the inflation-causing Keynesian fiscal policies of the past, which has landed us where we are today. We are less than three years removed from the last recession, and we are nowhere near the end of a new business cycle; if anything, we are closer to the beginning. This is not the environment which leads to severe recessions.

That doesn’t mean we might not have a slowdown or even mild recession. This can simply be a self-fulfilling prophecy: If everyone slows down to stock up for winter, then economic activity will decrease. Additionally, when we speak of recession, we are referring to the economy as a whole. There are always exceptions. Energy companies have been going gangbusters, but they did horribly for the decade before when technology companies thrived.

Today the economy as a whole may be hanging in there, but the mortgage business is hurting severely and certainly experiencing a recession-like environment. Any industry that is tied to interest rates or financial markets has been hurt. This is balanced, however, with others doing well. One tree falling does not mean the forest is dying.

Critics of capitalism never seem to grasp this. There is a growing movement among some today who suggest that our society is too focused on growth; this is incredibly misguided. There are only two states of being: growth and decay. If we stop growing, then we are decaying. The capitalism critics fundamentally misunderstand what growth of the economy means; they seemingly think of the economy as a tree and even use analogies of trees not being able to grow to the sky. The economy is not a tree, but a forest. The forest can grow forever without ever getting bigger or using up more resources, because the forest hosts new growth along with decay.

The four largest companies today did not exist when I was born. Two of them didn’t exist when I graduated from college. The four largest when I was born were General Motors, Exxon, Ford, and General Electric. They all still exist today, although General Motors wouldn’t if the government had not bailed them out during the financial crisis. All are mere shadows of what they once were, all in the fall of their existence. Who knows what the largest companies will be years from now. Change is inevitable. Recessions are as natural as winter itself; perhaps we would be better off if we stopped trying to control them out of existence.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Inevitable

Myths die hard. For as long as I can remember, there has been a myth that investors must reduce their exposure to stocks and increase their exposure to bonds as they approach retirement. This advice is based on the fallacy that if one is exposed to the stock market and we have a bear market (as we do today) at or close to one’s retirement, then his retirement will be forever impacted. He will have to live on less and suffer for his bad timing.

That is wrong. It is wrong in lots of ways, but most importantly it ignores a far greater risk: outliving one’s resources. In the 30 years I have been in the investment business, primarily focused on retirement, I have seen four huge mistakes that need to be avoided at all costs. The first is taking too much risk when one is young, then panicking and selling everything during a bear market. We talk about this often.

The second is retiring without a plan. I am not talking about a financial plan; I mean an action plan. What are you going to do that will take up your time and fill your life with meaning? If you do not know the answer to that question, then you are not ready to retire. Vacations are great, but they are largely great because they are short. If one retires at age 65 today, then she is likely to be in retirement for 25 or 30 years. One can only play so much pickleball. She had better have a plan as to what will keep her active and engaged with others.

The third mistake is outliving one’s health. Modern medicine is designed to keep one from dying, and they have gotten really good at it. That, however, is not the same as living. The more I deal with retirees, the less I care how long I live. I just want to really live right up until the end. Even if you have never exercised in your life up to retirement, you had better start, because your ability to physically function is a use-it-or-lose-it skill.

The fourth mistake is the one we will deal with in this article: becoming too conservative at or in the decade or so before retirement. This leads to outliving one’s resources, and if there is anything as horrible as outliving one’s health, this is it. The risk of outliving one’s resources is the risk that investors should think about the most. It dwarfs the risk of market volatility, yet that is what most people think of as risk. Most people look at what has happened to the market this year and think, “This is risk; this is the scary part.”

It is human nature. We know better, but it is difficult to see the current value of one’s investments drop and not be anxious about it. That is a normal reaction, but we have to remind ourselves that this is part of the cycle of life. We see ups and downs, and the ups will outweigh the downs over time as long as we stay the course. Time is on our side. Since 1926, the S&P 500 has been up 72 percent of the time. We get a negative year on average once every four years. This will pass, and the market will go to new highs.

This truth leads to one of the fallacies that causes people to hit the brakes too soon. They say, “If you are young then you have time to recover, but if you are about to retire, then you do not.” Wrong! This is the fallacy of the wrong time horizon. An investor who is investing for her retirement does not have a time horizon that ends on her retirement date; her time horizon is her life expectancy, which today is at least 20 years after retirement. I use 20 because when I was an economics student, we learned that as far as mathematical projections go, 20 years equals infinity. Anything beyond that time period is pure garbage. In our investment policies, the longest time horizon one can have is 20+ years, and one has that time horizon into their 70s.

How did the idea of retirement as an end date ever get started? Unfortunately, that has to do with the evolution of the investment industry and the incredible difficulty the industry has in serving investors through retirement. Many years ago, investors either did it themselves or hired an investment adviser to manage their money for them. Either way, all the actual transactions had to go through a broker. In fact, to simply know what was happening in the market that day one had to go to a “wire house” brokerage firm. These were the large New York-based broker-dealers who would pay the expense of having a wire service run to their regional offices around the country.

These firms had brokers in all of these offices because the only way to transact was in person. Technology has replaced that entire system. If your phone has a cell signal, then you can know what is happening and can trade stocks. In most businesses this would have meant the end of the broker, and in my opinion it should have. However, in the investment business, the broker transformed himself into the financial adviser. The broker’s historical role was that of a salesperson. If his broker-dealer had stock of GE, then he would be selling GE that day. The next day they might have a bond from GM, and he would sell that.

The role has not really changed, but most people today are not interested in paying the high cost of buying a stock or bond from the salesperson when they can do it far more efficiently online. Today the financial adviser sells money management; unfortunately, he isn’t a money manager. However, this works for most money managers, because they frankly are more comfortable looking at spreadsheets than talking to people. They can manage money the way they want and turn it into a product that gets sold by financial advisers, who are generally good with people.

Hence, the money management industry evolved from a service profession to a product manufacturing business. The brokerage business evolved from selling stock and bonds to selling managed products. This is far from ideal in our opinion, but it does work for accumulating resources. The vast majority of the products sold by advisers are geared toward growing one’s investments, so while a truly tailored approach is not possible, it is possible to build a portfolio of products that will grow in value over time.

The problem comes when one retires and transitions to producing income. While everyone who is still in the accumulation phase can be oversimplified as needing to make money, each person in the income phase has a truly unique situation. Designing a product for that is like trying to fit a square peg into a round hole – it simply will not work.

It also leads to the idea that when one retires, she must take all her money and put it into an income-producing product. If one did that, then the balance of the portfolio on the day of retirement becomes extremely important. If the investment industry is just a product-pushing business, then the timing of switching products becomes much more important than it should be.

At Iron Capital, we do not believe that the industry should be about pushing products. We believe it is supposed to be a professional service. As such, we build each income-producing portfolio from the bottom-up, tailored to each client’s needs. Our philosophy is simple: Build a portfolio that generates the income needed while taking as little risk as the market will allow.

We have been in a historically low-interest-rate environment for most of the last 20 years, certainly since the financial crisis in 2008. This hurts most income-focused products because they primarily invest in bonds. Bonds, after all, are simply loans. The loans are paid back plus interest, which produces income. The industry has really struggled in trying to solve the retirement income puzzle in this environment. For the most part, they just gave up and started telling their clients that they would have to live on less.

Article after article preached the demise of the so-called 4 percent rule – the “rule” that one could only take 4 percent of their portfolio as income if they wished to preserve the capital. In the meantime, most of our clients need closer to 6 percent. The product-based solutions are no solution at all. We have delivered the income our clients need by taking the best income sources available at the time. For most of the last 20 years that has meant dividend-paying stocks, preferred stocks, and higher-yielding bonds.

The good news is that while we have more in stock, the stocks we were investing in for these clients are more conservative. They tend to hold up extremely well during market downturns. The one exception to that rule was the Covid shutdown. These conservative companies that pay dividends tend to do well in thick or thin, but not when the government says you have to shut down. So, what did we do?

We put enough in safe places to pay the income needs for a few years, and then took advantage of the silver lining of the downturn. Every bear market creates opportunity. We took advantage of that opportunity to rebuild our client’s income portfolios. This is also what one should do when retiring in, or shortly after, a bear market.

When producing the needed income is a professional service and not a product, one gains flexibility. There is no need to have a one-time flip of the switch; the transition into retirement is exactly that – a transition. There is no rush, as we are going to be managing the income production for 20 to 30 years, if not longer. There is no need for a bear market at one’s retirement to be any different than a bear market at any other time.

Today we are in a bear market, and it is creating opportunities. For the income-needing client, those opportunities are now in bonds. For the first time in a very long time, bonds are paying enough interest to be a meaningful portion of an income strategy. This, however, is not going to help the product pushers. Bonds are simple: One loans his money to a company or government, and the borrower promises to pay it back plus interest. If one buys a bond, then she will get interest payments, and at maturity, the return of her principal. There is a risk that a borrower will not be able to pay it back, but that risk can be judged up front.

Bond funds, i.e. the products, do not work that way. What one is really doing is buying shares in a mutual fund. The fund then invests in bonds. Should interest rates rise further, the bonds will lose value in the market. A bondholder who isn’t selling doesn’t care, because she will continue to get what she agreed to from the beginning. The bond fund, however, will lose value. It does not behave like an actual bond; it behaves like a mutual fund that happens to invest in securities with lower return potential.

Retirement is a personal experience. It is a stage of life, not something one buys from a store. Managing one’s investment portfolio to produce the needed income is just as personal and just as unique. If one wishes to go the product route, then he had better have saved a lot of money and avoided the last-minute downfall. On the other hand, if one goes the route of professional service, then she will be able to navigate life’s ups and downs with far more flexibility. Bear markets are horrible to endure, but they do produce opportunities – even for those about to retire.

Warm regards,

Chuck Osborne, CFA
Managing Director

~Retiring in A Bear Market

As our economy slows and inflation remains stubbornly high, one must wonder if we will ever learn our lessons. We have been here before and we know what causes this, yet here we are once more. We did not learn the lesson of the 1970s; but why?

I believe it is the all-too-human instinct to look for one explanation for complex problems, when in truth it is never just one thing. In the case of inflation, most want to look towards the Federal Reserve Bank (Fed). They want to give the Fed all the blame for inflation and all the credit for stopping inflation. While there is some truth in that, it is at best a grossly oversimplified view and at worst just plain wrong.

This is not to say that the Fed can’t do any damage. They certainly share fault for the housing bubble of the 2000s, which led ultimately to the financial crisis of 2008. That too was a complex development with multiple contributors, but in that case the Fed escaped culpability as “bankers’ greed” made for better headlines. However, in the case of inflation I believe the misdiagnosis comes from the two schools of economics.

I have no idea how they teach economics today, but 30 years ago when I was a student one had to learn about “microeconomics” and “macroeconomics.” Microeconomics dealt with consumer behavior, the backbone of which was the law of supply and demand. A product which is in high demand but of limited supply will sell at a high price.

There are other laws of microeconomics such as the law of marginal utility, which explains that the fourth piece of cheesecake is not as enjoyable as the first piece. In fact, it may very well leave one so sick that he never wants cheesecake again.

Macroeconomics is the study of the economy at large. When I was a student, it mostly revolved around the theories of John Maynard Keynes, and the primary focus is what they call “aggregate demand.” This is the sum of all demand for all products in the economy. One would study the different factors that led to aggregate demand and how a government could manipulate those factors to keep the economy growing. Primarily at that time we would learn these complicated mathematic formulas that would predict the growth of the economy based on things like government spending.

In micro class we would study the various laws of economics and see real world examples of how these laws could be seen in action. These were laws, after all, and they worked then and still work today. If one is trained, then one can see them in action. One of my favorite examples would be foreign to young people today who have never seen an actual newspaper, but when I was a student, it fascinated me. Did you ever wonder why the soft drink vending machine would only dispense one soft drink at a time, while the newspaper vending machine allowed one to grab every paper inside if she so chose? This was the law of marginal utility in action. A second soft drink may have less value than the first to a thirsty consumer, but it still has significant value. A second newspaper is worthless unless you are using it for something other than reading. So vending machines allowed only one soft drink, but every remaining newspaper – knowing consumers would take only one newspaper, but would likely take more than one soft drink if given the chance. Occasionally some Robin Hood-type character would grab the whole stack of papers and place it on top of the machine for others to get a free paper, but that didn’t happen enough to hurt the newspaper business.

In macro class we would learn mathematical formulas for predicting GDP. We learned the basic Keynesian formula. We practiced it and practiced it, and then we would be tested. After the test the professor would come in and say, “Well that is the basic formula, but it didn’t actually work in real life.” Then we would learn a more complicated formula. We practiced it and practiced it, and then would be tested. After the test the professor would come in and say, “Well that is the second iteration of the formula, but it didn’t work any better.” We would learn an even more complicated formula…well, you get the picture.

It should be obvious based on my description that I gravitated to microeconomics. It should also not be a surprise that here at Iron Capital we believe in bottom-up investing; in other words, the micro view of investing. Our top-down, macro view is simply the sum of all the bottom-up micro views. What does this have to do with inflation? Everything.

The view that the Fed caused inflation and, more importantly, that the Fed can cure inflation, is a macroeconomic view. It makes for some wonderfully complex math that a professor can really enjoy teaching to young economic students, but after the test has been graded, she then has to explain to the class why it doesn’t work in the real world.

Low interest rates theoretically would encourage more borrowing, which stimulates aggregate demand. How truly effective this is in stimulating the economy cannot be known. One problem with macroeconomics is that, unlike science, there is no control group. There is no way to know exactly what impact the Fed has on the economy. We know that during the recession brought on by the financial crisis, the Fed went to extraordinary measures to boost aggregate demand and thereby the economy. We know that the recession ended, although the recovery was anemic and most thought we were still in a recession. It seems logical that the Fed’s actions were helpful in stimulating demand, but we can’t know for certain. Congress was also taking action in the form of TARP, and of course recessions will simply end on their own, so how can we know?

Fast forward to the pandemic and the Fed acted once again, but having never fully undone the actions of a decade earlier they had fewer options. They encouraged Congress, who also acted, and acted again, and again. Both fiscal (spending through Congress) and monetary (Fed action) stimuli supposedly boost aggregate demand. In theory, the boost in demand will raise prices, suppliers will act to raise supply, and the economy will grow with low controlled inflation.

This does not seem to be working, and it didn’t work in 1970 either. When supply doesn’t react but demand gets stimulated, we don’t get growth, we get inflation. Back then, as now and always, there wasn’t just one cause. We had runaway government spending from the Johnson administration that kept going under Nixon. We had an OPEC oil embargo. We had civil unrest surrounding Vietnam and we had a crisis in Watergate. In 1970 the Fed raised rates from 4 percent to 9 percent and we dove into a recession. Inflation persisted. Four years later the Fed raised again, this time from 3.5 percent to 13 percent, and once again we went into a recession. Once again, inflation persisted.

While the Fed tried to kill inflation by lowering aggregate demand, other government programs were stimulating demand. Nixon implemented price-fixing, which caused shortages but was a boost to demand. Simultaneously there were restrictions on the production of supply. Our economy was over-regulated and the maximum income tax rate was 50 percent. This has an impact. In the late ’70s my father took me to buy my first suit. He had known the salesman for several years and half-jokingly asked him why he wasn’t the manager by now. The gentleman responded that he had been offered the job, but the raise would put him in a higher tax bracket and his take-home pay would actually go down. That was a disincentive to work harder and provide more supply. The Fed couldn’t fix that.

It was not until Jimmy Carter began deregulating U.S. industry, then Ronald Reagan continued that trend and also reformed the tax code, that inflation was beaten. It should be no surprise that the official term for “Reaganomics” was supply-side economics. By stimulating supply, inflation was tamed. It still took the Fed raising rates once again, and we will never know if that was necessary, but it happened and inflation was beaten.

We failed to learn that lesson and today we are repeating history. Inflation peaked in 1980 at 14.76 percent. The government has since changed how inflation is calculated. Larry Summers, National Economic Council Director for the Obama administration, has recalculated historic inflation rates using today’s methodology. Based on his work that peak would be reported as 9 percent today, not far from the 8.6 percent we are experiencing.

We have an energy crisis today caused in part by overly optimistic “green” policies and the Russian invasion of Ukraine. We are coming off a historical reaction to a pandemic that shut down much of the productive capacity of the free world. We have members of Congress asking for price controls and a re-emergence of regulation through executive action. In other words, we are making very similar mistakes and getting a very similar experience.

The Fed can act aggressively and have an impact on aggregate demand, but that won’t help supply. The Fed gets far too much credit and blame. It didn’t get us into this mess by itself. Don’t get me wrong: they made mistakes that have certainly contributed to this mess. They should have backed off on the emergency measures long before they did. However, they had a lot of help, starting with the shutdowns and then all the extraordinary measures taken right up the last trillion-dollar spending package, which went into effect in an economy already growing at more than 6 percent.

Macroeconomic tools – fiscal and monetary government policy – impact only aggregate demand. Supply-side economics was based on a faith in microeconomics; it understood that people react to incentives, and to disincentives. If a salesman in a men’s store would end up taking less money home if he was promoted and got a raise, then he was not likely to accept that promotion and raise. That puts a cap on his productivity and therefore reduces aggregate supply. Governments can stimulate demand all they want, but if supply is simultaneously being held down, then all they get is inflation.

On the other hand, if supply is freed up, then the Fed can have an easy money policy for almost thirty years with little impact on inflation. I didn’t understand that as a young economics student. All I knew was that macroeconomic professors were always making excuses for being wrong and the microeconomic professors were always describing things as they actually were in reality. Macro class had theories and formulas while micro class had laws.

The law of supply and demand determines prices. When supply and demand are in balance, prices are stable. When demand is stimulated while supply is simultaneously deterred, we get inflation. That is how we got here. Understanding that shows us clearly the only way to get out: we must stimulate supply, in a similar fashion to how supply was stimulated in the 1980s. The Fed may need to play a role, but they couldn’t do it alone in the ’70s and they won’t be able to do it alone today.

We learned this lesson once already. While it is frustrating that we have to learn it again, at least this time we know what to do. Here’s hoping policymakers have the wisdom to do it.

Warm regards,

Chuck Osborne, CFA
Managing Director

~How Did We Get Here?

As I write this, The Masters golf tournament is getting started at Augusta National. The Masters is one of those events that transcends the sport itself. Like the Kentucky Derby and the Super Bowl, one does not need to be a fan of the sport to appreciate the event. For those who are golf fans, watching the world’s greatest live is an interesting and educational experience. One of the biggest lessons to be learned is that there is no such thing as “the right way” to swing a golf club. This is not to say that there is no such thing as fundamentals; there certainly are in golf. However, the true fundamentals are both fewer in number and more subtle than what one might hear at his local driving range.

One may hear that she can’t hit it far if she doesn’t have a big back swing, but then she sees Jon Rahm pound a ball out of sight. Perhaps she will be told that she has to keep her feet firmly planted, and then she will see Justin Thomas dancing all over as he strikes the ball beautifully. We could go on and on, but the fact is, much of what is described as absolute fundamentals are in fact just personal preferences. There is no one right way to swing a golf club.

Some will then take that observation and make yet another false conclusion, perhaps more dangerous than all the other fake fundamentals: They assume that since there is no one right way to swing a golf club, then there is no wrong way to swing a golf club. That is false. As many differences as one may observe on the fairways of Augusta National, there is a common set of fundamentals that every successful golfer must follow. There may be several “right ways,” but that does not mean there is not a wrong way. One will never see a successful golfer who has a fast back swing and slow downswing. There will never be a good golfer whose hands are behind the ball at impact. This list could also go on.

Why is this observation so important today? For the last 25 to 30, years our academic institutions have been taken over by a philosophy known as Post Modernism. The fundamental idea behind this movement is that Truth does not actually exist outside of one’s perspective. In other words, there is no absolute Truth, there is only perspective, so you have your truth and I have my truth, etc. Like all great and horrible lies – the falsehoods that have led to the most suffering in human history – there is an element of truth to this.

In the Eastern religions of Hinduism and Buddhism there is a parable of the blind men and the elephant. A wise teacher asked his students to gather four people who had been blind since birth. It was important that none of the blind individuals had ever seen an elephant. Then each blind person was led to a certain part of the elephant and told to study it with their hands. After a little while each was told to describe an elephant. Of course, their descriptions differed completely depending on what part of the elephant they had felt. One said the elephant was hairy, while another said it had no hair at all. One, who had felt the trunk, thought the elephant must slither on the ground like a great snake, while the one who felt its feet argued that it must walk.

The moral of the story is that our perspective impacts how we interpret things. This is absolutely correct. In our society we often tell a similar story of multiple people witnessing a car accident. If the police interview four witnesses, they will get four different perspectives; the stories will not match perfectly. This, however, is where Post Modernism fails: the four eyewitness accounts may vary depending on perspective, yet if one of them says, “There wasn’t an accident,” then that individual is just wrong. Just because there are multiple “right” perspectives does not mean there is no such thing as a wrong perspective.

Today there are extreme elements on the political left in our country who have embraced a concept known as Modern Monetary Policy. The idea is basically that the government can spend whatever it wants because it controls the money supply, and that it can do so without any negative consequence, i.e. inflation. The theory is wrong. In fairness, this is an oversimplified definition, but this is something academics need to understand: Their theories will always be oversimplified by the politicians who hear only what they want to hear and then use that academic theory as cover for their decisions. In other words, the oversimplified version is what is likely to actually happen in the real world.

One can certainly understand why this theory would be attractive to politicians, especially left-leaning politicians who believe that the government should have a bigger role. They can spend and spend and spend and nothing bad will happen. Why wouldn’t they want to believe this? Unfortunately for them, and for us now, this does not work so well in the real world.

Why? The basic problem with the theory is that it misunderstands what money is and how it is created. The government does not create money, it creates currency, and that is an important distinction. Currency is simply a tool which allows us to live in a society that is far simpler than it would be if we had no currency. In fact, imagining a world without currency is the best way to understand currency.

If there was no such thing as currency, we would still live in a world of barter. In other words, the plumber would do plumbing in exchange for food, shelter, etc. The doctor would be paid by giving him a chicken or a goat, or plumbing his house etc. Everyone would trade what they create for the other things they need. The obvious problem is that the plumber may need a doctor, but the doctor may already have a plumber. This is where currency comes into play. Instead of trading plumbing for medicine, we pay the plumber with money and then he can pay the doctor and she can pay the dry cleaner, etc.

Currency makes our economy work by eliminating the need to find exact trades as we would have to do in a pure barter situation. Historically precious metals were used as currency, but in the modern world we use government-issued paper currency. However, the value is sill created just as it was under the system of barter. The doctor creates value, or money, by providing us with her services. The plumber does the same and so does the butcher the baker and the candlestick maker. The private sector is what creates the value in an economy.

To put it another way, the private sector creates the supply in the concept of supply and demand. It creates the cell phones, computers, televisions, etc. It also creates the beef, fish, and chicken in our grocery stores. All of these items are created by individuals who then want to trade what they create for the other things in life they need. Currency makes that happen, but it doesn’t create the value. The value is created by the individuals who get up and go to work every day in their specific field. These individuals create the supply of goods and services we all want and need.

When government simply issues more currency, doing so does not create more value, therefore the currency begins to lose value. In other words, we experience inflation. To illustrate this, lets imagine that all the value created by the individuals who go to work each day equals 100 units. If the government issues 100 units of currency, then each unit of value equals one unit of currency. A dollar’s work equals a dollar’s pay. However, if the government issues 200 units of currency but nothing changes in the actual economy, then each unit of work now equals two units of currency: Inflation.

Another way to look at it, which is closer to what is actually happening today, is through supply and demand. Supply is the value created by all the individuals working primarily in the private sector. Supply is determined by the level of productivity – how many widgets can one person make in a day. Demand is what those individuals want to consume, and it is determined by how much currency they have in their pockets.

When the government puts more currency in the pockets of individuals while simultaneously reducing supply, they have created inflation. How does a government reduce supply when it is the private sector that creates it? Through tax and regulation. Over the last few years it has been the command to shut down, but that is short-lived and temporary. The biggest long-term issue is the over-regulation, which reduces productivity and the ability to create. The second largest threat is a tax system that penalizes the creation of excess supply.

What does it mean to be rich? It means one has created more than most. The plumber who is able to plumb the most houses will be the one who makes the most money. Of course, there will always be those who are living off money created by an ancestor and not by them. There will be examples of people who obtained money by ill-gotten means. While these are very noticeable and often unfair, the fact remains that most who achieve wealth do so by working harder and/or smarter than others around them. Therefore they create more value for all of us, and as a result get more money.

They should, as the politicians are fast to point out, pay their fair share in taxes. The problem comes from the fact that the politicians never define what “fair share” actually means. When a system is pursued that penalizes these individuals for creating more supply than anyone else, what happens is they cap the amount of supply they are willing to create. Supply is decreased, demand remains, and we all get inflation.

While this is dangerous, it is more talk than anything else. The fact is that politicians love high tax rates because they can then give out valuable loopholes. No one would pay for a loophole if it would be cheaper to pay the taxes. Did I say “give out?” Does anyone ever wonder how individuals who spend their lifetime in politics end up with so much money? I digress, but this does lead to the biggest issue with supply: government regulation. Nothing stops future supply as efficiently as regulation.

We started Iron Capital in 2003. At that time the lawyers made more money than the founders for the first three years. Today, there is no way we could have done what we did. The regulatory burden of our industry is too great and that stops others from entering into the industry. In other words, it reduces supply. That helps firms like Iron Capital as it reduces competition, and it also creates incentive for consolidation. We could sell the firm if we wanted. However, it hurts the consumer.

Where did inflation come from? It came from policymakers simultaneously stimulating demand through government handouts, while also attacking supply. Yes, they attacked supply by shutting down in response to Covid, but they are also attacking supply by increasing regulation and proposing tax regimes that even tax money that has not actually been made yet (unrealized capital gains). Inflation will not go away until this is reversed.

Some will read this and say I’m being political. That may be true in our time, but it did not used to be the case. The philosophy of limiting government interference to allow supply to be created was a guiding principle for John F. Kennedy. It was Jimmy Carter who began the deregulation credited to Reagan. It was Bill Clinton who declared the days of big government over. There is more than one right way. There is plenty of room for traditional political differences of perspective, but that doesn’t mean there is no wrong way. The current path is wrong, and the faster that is realized by people of all political perspectives, the better off we will be. +

~The Right Way