With my recent birthday, I am all the more ensconced in my middle ages, but am I yet old enough to be a curmudgeon? I sure feel like one some days. I have been called a “bear” on many occasions, and rarely a “bull”, but a stark pessimistic label doesn’t fit well. I am, after all, an entrepreneur, and optimism is a requirement for anyone wishing to be an entrepreneur. But I am also an investor, and as an investor considering the things that can go wrong is the most important aspect of protecting capital, which Warren Buffett clearly articulates in his first two rules for investing. Rule #1, Never lose money, and Rule #2, Never forget rule #1. A long enough career in investing makes rule #1 impossible, even for Mr. Buffett, but the hyperawareness of the possibilities of what can go wrong will certainly help minimize those instances of loss.
This is certainly borne out in Altus’s portfolio. In the real estate recession of 2007–2009 my portfolio was completely decimated. Coming out on the other side, the only investments that performed even to breakeven over that time period were a bunch of junky houses in bad neighborhoods… that had positive cash flow. There were lots of lessons learned from the destruction of the Global Financial Crisis (GFC), and those lessons, and especially the lesson of positive cash flow, allowed us to make decisions years in advance of the current real estate recession (where, in many cases, valuations are down a similar or greater amount than the GFC) that have largely helped us avoid the carnage that many are experiencing. There was a cost to those decisions during the times of plenty, but those costs have turned into “investments” as the benefits of those decisions now far outweigh their previous costs. This isn’t to say there is no pain, but that pain is almost entirely tied to debt duration, which, while sometimes a necessary evil, is also a tool that exposes the user to the risks and uncertainty of time. The stronger the investment pessimism, the less likely someone is to use tools like short-term debt.
And so, in this time of heightened awareness of the uncertainty that always surrounds us, I am going to let my inner curmudgeon shine. The greater we understand possibilities of what MIGHT happen, the better we can assess the risk associated with those possibilities, and with that assessment, better understand our risk adjusted returns. Truly quantifying risk adjusted returns is thus far impossible in our part of the investing universe (and very poorly done even where it is quantified), but that doesn’t reduce the importance of understanding them to the best of our non-quantifiable knowledge.
To be clear, the following are not necessarily things that will happen, they are things that COULD happen, and in each one there is both wealth and return destruction and a resulting great opportunity.
- Inflation roars: More and more pundits within the investment world are now forecasting a revival of the higher inflation rates of the past few years. There are several things that could cause this to happen:
- Many economists feel that tariffs, by their very nature, are inflationary. After all, tariffs add costs to imports (inflationary), or cause buyers to turn to other domestic alternatives – generally also inflationary.
- Even while making spending cuts through DOGE, the current administration has communicated big spending plans, including a large distribution of the DOGE savings to taxpayers of a $5,000 check (or whatever it ends up being). That is Bernanke helicopter money at work, and is certainly inflationary.
- The perception of heightened uncertainty from investors from outside the U.S., and there is plenty of that perception right now, very easily could reduce foreign investment into the U.S. At the same time, countries are doing more and more trade between their own currency instead of relying on the U.S. dollar. Both of these things reduce the demand for dollars (it’s complicated), weakening the USD. A weakening currency is deflationary.
- Deflation is the concern: I understand the inflation argument, but if I were a betting man instead of a lovable curmudgeon, my bet would be we are more likely to experience falling inflation rates, and maybe even deflation. This is not a forecast, it is an awareness of less discussed possibilities. Timelines matter here, and it is certainly possible – entirely probable – that we will have both deflation (weak inflation) and inflation (higher than normal inflation). Oftentimes one leads to the other, and if we have softening inflation, it will likely be over the short run (1 – 2 years) while there are other reasons to believe in longer term higher than normal inflation. So first, deflation.
- Even while forecasters are expecting higher inflation in the short run, they also have increased expectations of a recession over that same time-period. Recessions are almost always deflationary. A recession makes sense. DOGE is taking a chainsaw to the federal government, the source of over 20% of U.S. GDP. Easy math – if government spending drops 5%, all other things being equal, GDP will fall 1%.
- Student loan payments are back up and going. Many borrowers treated that money like it was theirs to keep, freeing up cash they would’ve spent on loan payments — and injecting it straight into the economy. The average annual student loan outlay is $6,276. I couldn’t find a quantification of the number of borrowers that are impacted, but I know it is over 16 million borrowers (~42.7 million Americans have student loans). Sixteen million times $3,000 (instead of $6,276 to be conservative), is $48 billion dollars a year removed from the economy. This is less than 0.2% of GDP, but is still a drag, especially once the multiplier effect is considered.
- The Biden administration was a huge punch bowl of fiscal excesses, most obviously as the ridiculously named Inflation Reduction Act. The already ugly U.S. debt exploded under the Biden/Yellen watch (as discussed here). MMT (Modern Monetary Theory) at work flooded the economy with dollars, hence inflation. While we don’t yet know how Trump’s first budget will look, and we assume he will overspend as he did in his first term, it is almost impossible to reach the insanity of the past four years. Removing that punchbowl from the GDP party will absolutely be disinflationary.
- Regardless of how one feels about the current immigration/deportation policies, there is no denying that the removal of such a large number of people from an economy will have an impact. One way to measure the change in GDP is the change in the population plus the change in the productivity of an economy. Yanking this many people out of the economy is a relative shrinking of the economy. While productivity gains may offset the reduction in population, relatively speaking it is still a disinflationary impact. (And certainly an impact on residential real estate demand).
- While many think tariffs will be inflationary, there is also the strong possibility that higher prices result in people spending less. Less spending = a reduction in GDP = recession = likely disinflation or deflation. We saw this same impact during Trump 1.0 when his tariffs caused the otherwise strong economy to hit the brakes a bit around 2018.
- The tariffs will likely cause foreign companies to build manufacturing facilities in the largest consumer base in the world. Those facilities will bring insane amounts of investment into the U.S. The Samsung facility being built outside of Austin is a perfect example. Between the main facilities and other Samsung satellite facilities being built in the area, Samsung is expected to spend $45 billion on construction. That is a huge amount of money, and is only one project. That spending could certainly be seen as growth inducing, so maybe inflationary, but that money coming from outside the U.S. also supports the strength of the USD, which is deflationary (see above counter argument).
- A contraction in lending is disinflationary, and lending is contracting. We have discussed lending for commercial real estate in past Altus Insights, so I won’t bore you by doing it again here, but the much larger consumer finance world is also starting to contract. The Fed started tracking car and home loan rejection rates in 2013. Rejections hit a record in Q3 of last year (I don’t have Q4 stats). Fewer buyers means fewer things purchased. That is a drag on growth, and reverting back to the most standard supply/demand curve – a drag on inflation.
- Along these same lines, borrowers are maxed. Credit card debt is at record highs, and now, a full 10.8% of card holders are only making minimum payments each month. This is also a record. Maxed borrowers do not portend for expanding credit.
- Recent bipartisan changes to government regulation limiting the amount credit card companies can charge in interest is also almost certainly going to be debt contractionary. Borrowers with poor credit are charged high interest rates because they are credit risks. If the provider of credit cannot get a return commiserate with the risk of loaning the money, it is pretty simple… they just won’t loan the money. As a result, fewer borrowers will be eligible for credit.
- Also of note, workers “not in the work force, want a job, are marginally attached, and discouraged” are now numbering in the same quantities as during the depths of the GFC.
- For years we have been warned that Baby Boomers would be retiring and that those retirements would impact the economy. To some degree, this was inflationary as coming out of the COVID lockdowns the workforce was suddenly smaller and jobs were plentiful, but there is also a second side to it, which is retirees tend to spend less than those within the work force. Less spending = disinflationary.
- Stock Market Crash: As a reminder, I am not making predictions here, just raising possibilities. Even with recent almost “corrections” the stock markets are still well above historical averages. The S&P 500’s PE Ratio is almost 30, well above the historical average of 20.4, but even that historical average is elevated from times past due to several recent years of higher than historical market averages. Other market valuation measures, like price to sales and market cap to GDP are also highly elevated. Consider also that bull markets are generally considerably longer than bear markets. If valuations are elevated for two days for each one day valuations are suppressed, valuations have to be suppressed by 2x the elevation for the long term average to be maintained.
- Oh, and did we mention that there is an incredibly heightened awareness of uncertainty right now due to the current administration’s actions, in addition to several geopolitical hotspots?
- And then there are the baby boomers (again). In the U.S., those over 70 years of age own ~40% of the stock market despite being only 15% of the population. As referenced above, baby boomers are retiring en masse (11,548 new retirees per day on average), and in general as people move toward and into retirement there is a rotation in their investment portfolio away from growth (stocks) and into safety and cash flow (CDs/annuities – or in the Altus world, 1st position DOTs). Maybe this rotation out of stocks doesn’t impact prices when being done in an orderly fashion, but what happens if prices start to fall with any sort of urgency (because of other factors)? The investor who knows they need a certain amount of wealth to retire will bail very quickly to avoid years being added to their working career. People bailing from any asset class adds to the downward pressure. Losses mount, and with many of the exiting investors exiting for reasons other than the normal fear (versus greed), there are fewer buyers to buy back into the market to help it turn around and bounce back. A stock sell off could be deep, but also be much slower than normal to recover.
None of my above curmudgeon musings are meant to scare you gentle reader. Just as the neighborhood curmudgeon has a gruff exterior, there is often a much softer heart underneath it all. As scary as some of these thoughts could be, chances are, any outcomes will be far less than feared. And even if as scary as imagined, and maybe especially if as scary as imagined, uncertainty leads to opportunity, so expanding possibilities for wealth accelerating opportunities are here and growing.
Happy Investing.
