2022 is shaping up to be quite the crazy year. While this horrible war in Ukraine dominates media headlines, I can’t help but feeling like inflation might be the dominant theme of the next decade. Using “government” numbers, inflation is running at about 7.9%. Shelter is the single biggest component of CPI at 33% of the index. Despite rents being up 18% over the last year, and home prices being up 19%, the government data shows shelter prices to be up 4.7%. We are looking at double-digit inflation, which is immensely challenging, especially if it persists, which sadly I think is likely.
While I was born in 1982, right around when Paul Volcker was crushing inflation by raising the Federal Funds rate dramatically, inflation was massively influential on life in the 1970’s as many of you I’m sure will remember. Whether it was the OPEC crisis, or double-digit mortgage rates, or bonds seemingly being a surefire way to incinerate your savings, inflation could not be underestimated. As it stands now, the Federal Reserve has only raised rates by 25 bps, yet US bonds (Bloomberg Barclays Aggregate Total Return) are down 6.3% so far this year. This is by far the worst year since they started tracking it in 1977. That might not seem so bad unless you recall how low yields have been, so we are talking about wiping away several years of returns. The drawdown is about 12% from the highs last year, which is once again the biggest in recorded history from a similar tracking date.
How this impacts us is evident to anyone that goes to the store, has attempted to buy a car, refinance a home, etc. 30-year mortgage rates are over 5.2%, after hitting a bottom of around 2.68% a little over a year ago. Cars are selling for substantially over MSRP, while MSRP prices are being raised at record levels. I live in Southern California and we are regularly paying over $6 per gallon for the cheapest grade fuel. Prices for electricity are up significantly, grocery, ride share, hotels, etc., everything is pretty nuts. One worrisome thing is that due to the war in Ukraine, fertilizer prices are going stratospheric. We haven’t seen these filter through prices fully yet, which could mean food shortages in many places, but most certainly will be inflationary.
The 10-year Treasury yield has risen from 1.63% to start the year, to just under 2.5% as I write this. We’ve been saying that the best ways to play inflation are energy and material producers, as well as financial stocks that benefit from higher rates. Eventually, higher prices will result in higher supply, causing prices to decline, but supply chain issues are going to delay that development. Insurance companies are rallying nicely for us, including AIG, AGO, Berkshire Hathaway and Fairfax Financial. Regional banks are doing well, while the big money center banks have pulled back a little bit, mostly due to concerns related to the war, given many are more globally oriented. If we get a peace treaty, I’d expect significant rallies in names like Citigroup, BNP Paribas, Credit Suisse, Bank or America and J.P. Morgan. Think of what you earn on your checking account and what banks can earn by simply investing in the 10-year Treasury at 2.5%, on their trillions of excess cash on their balance sheets. Barring WW3, I think there is a lot of money to be made once uncertainty clears up, but I’m also not discounting the risk we could see WW3 sadly.
Due to the plethora of risks, we are being very tactical and strategic in our investment strategies. By not owning the stuff that was dramatically overvalued, we’ve avoided the worst of the correction. Also, our fixed income investments have mostly been limited to CLO’s that adjust upwards to higher rates, which have performed exceptionally well in this environment, while paying way higher yields than what was available in most bonds. We are making some big bets where our odds of success look most favorable. Then we are taking advantage of historically high volatility to utilize our options strategies, where we are creating just tremendous levels of protection. With this type of disruption in markets and the global economy, we will see some big blowups of funds, companies etc., but I’m confident we can protect and grow our investments in this environment. We aren’t immune to mistakes by any means of course, but the key is avoiding the really big ones that can significantly impair your capital, and I’m confident we are in good shape in that regard.