How Inflation and Interest Rates Are Impacting the Economy

The latest Consumer Price Index (CPI) is out. And it was not as positive as many had hoped.

Spoiler alert – inflation rose 0.3% in December 2023, despite the Fed’s attempts to combat it into remission.

In today’s weekly update, Chief Analyst Adam Galas breaks down what’s happening with inflation, interest rates, and their impact on the economy as well as your Fortress Portfolio.

Adam also shares why one pick that hasn’t been performing well is still on track to supercharge your portfolio in the years ahead.

Click below to watch the video or scroll down to read the transcript.

Welcome Fortress Portfolio members to another weekly update.

Now, today, we're going to be looking over inflation, interest rates, and what their implications are for the economy and your Fortress Portfolio.

It was a long Christmas break and there was a lot of news breaking to catch up on.

So first, what's going on with inflation? So, we just had the inflation report.

And as you can see, the good news is inflation really has started to come down quickly off those 9.2% highs in June of 2022.

(Source: U.S. Department of Labor via The Daily Shot)

But the bad news is that it appears to be stuck around 3.5%, which is consistent with the Fed's official core PCE metric being stuck at around 3%.

But there is some good news because as you can see, shelter inflation is expected to come down rapidly. And shelter is about 33% of the Consumer Price Index (CPI), and 40% of core CPI.

(Source: Oxford Economics/Have Analytics via The Daily Shot)

We've already seen this in the real-time data where rents and home prices are starting to come down.

It just hasn't quite caught up. There's about a six-month lag here.

So, do we have any actual confirmation that inflation is actually coming down? Yes, we do.

We have Truflation, which uses various data partners to track 10 million data points every day.

And first, you can see here we have the aggregate total cumulative inflation since the pandemic, which peaked at 24% back in September of 2023.

(Source: Truflation)

It's pulled back slightly, which is actually quite amazing because of how inflation is measured. That's simply year-over-year price changes. Generally, prices always go up and they never come down.

So, when we look at the actual real-time inflation rate – this is Truflation – this is 97% correlated with CPI or the headline inflation that you see reported after each CPI release. That came down to 2.14%.

(Source: Truflation)

So that is consistent with about 1.6% core PCE that the Fed is looking at and would indicate that the Fed should already be cutting in January potentially all the way down to 1.6%.

But what is the Fed actually looking at? They're looking at that the Personal Consumption Expenditures Price Index (core PCE) because they cannot change their benchmark. For ten years they've said “core PCE, core PCE.”

The official goal is 2%. They can't change it now, otherwise they lose all credibility. So, what does the Cleveland Fed say?

They have a daily real-time inflation tracking model that updates as the data comes in.

Well, as we can see now, these are always talking about the next month.

For example, the December core PCE report is January, and the January report is actually February. There's always a one-month lag.

(Source: Cleveland Federal Reserve)

So right now, the Cleveland Fed expects the next CPI report, which came in at 3.4%, to drop to 3%.

Well, that's wonderful. But core CPI, because of that shelter and the lag, is expected to be hanging around at 3.8%.

But the month-over-month number for CPI is expected to be 0.2%. That's just 2.3% year-over-year.

And that is consistent with a 1.8% core PCE, though core PCE is expected to come in at 3% for the end of January and 2.8% at the end of February.

Now, that's good news. It's moving in the right direction. However, it's still a long way off.

Jerome Powell, when asked at the last press conference, continues to insist 2%, 2%, and 2%.

Why? Well, while we have had periods of core inflation of 3-4% (and economists actually point out that Main Street benefits most during those periods), the issue is that if inflation is 3% – core PCE at 3% – it means CPI inflation is around 3.5% and ten-year borrowing costs are around 5.5-6%, according to BlackRock.

And 30-year yields could potentially be as high as 6-6.5%.

And let’s talk about mortgage rates. You thought 8% was bad when ten-year yields were at 5% last October.

Well, imagine 10% mortgage rates. That would truly freeze the housing market for millions of people for decades to come.

So, what does this actually mean for the stock market?

Well, that means the stock market is likely to disappoint a lot of people, especially after that epic nine-week rally in which the Fed pivot was anticipated. The market was pricing in seven rate cuts.

Let's take a look at what is now being priced in.

So, according to the bond futures, which the stock market prices in very quickly, there may be six rate cuts this year.

(Source: CME Group)

Now, remember, the Fed has said they're planning on three cuts, potentially not starting until September.

Well, we can see here the bond market saying, “No, no. It's coming likely in March and certainly by May.”

Since 2008, every time it's 80% or higher, the Fed always does what is priced in with at least 80% probabilities.

And that's not because the bond market is telling the Fed what to do. The bond market simply takes the data in real-time, digests it, and essentially has become a perfect predictor of what the Fed is going to do.

The bond market is currently predicting with 100% certainty that by May, inflation will be down enough that the Fed has to start cutting potentially due to a recession.

Last week, we talked about how the data says we are, in fact, headed for recession, though the mildest recession in history.

Some of the data says the Fed should be cutting now, in January. We should get eight cuts this year.

So, why is the Fed being so cautious? Because of this chart:

(Source: Torsten Slok, Apollo via The Daily Shot)

Now, remember, earlier we saw the CPI come down, hit about 3%, then bounced because the economy is just too strong.

Well, this is similar to what we saw in the 1970s. Inflation soared to around 10%, then came crashing down. But then the Fed cut because they were worried about a recession, and it took off to record highs of 15%.

It resulted in a lost decade.

Well, this is what the Fed's worst-case scenario is.

Now, it's not likely. The economy is quite different for various reasons, including the oil independence that we now have. And there's a lot less risk of a wage-price spiral.

But remember what we talked about earlier. Even if inflation just gets stuck at 3%, suddenly the government has to borrow, according to BlackRock, at 6%.

Well, take a look at this chart here from the Congressional Budget Office.

(Source: CRFB.org via The Daily Shot)

It estimates what amount of GDP is going to service interest cost for the national debt. This assumes 2.7% inflation or 2.7% long-term borrowing costs.

Now, imagine how bad this would be at 6%. Well, it'd be about 13% of GDP, about one in every $7 produced by the economy going to service just interest on the debt.

You can see why that would be a disaster.

Multiply that out even more to 4-5% inflation. You can see why the Fed has to absolutely beat inflation.

I'm not talking just dead. I'm talking stone-cold dead. I'm talking about shoot it in the head, set the corpse on fire, and launch the ashes into the sun dead – because this is about the solvency of the entire U.S. government and, thus, the safety of the entire economy.

So, what does this mean for Fortress Portfolio members?

Here is the good news. While the market faces some massive headwinds –  because even if the economy stays hot and earnings grow at 11% – the problem is that all of that good news has been priced in and then some. And the Fed is not cutting six times this year.

But it's always and forever a market of stocks, not a stock market.

And while the market is 17% overvalued by some historical metrics, Fortress is dirt cheap with a 6.3% very safe yield. And it's trading at 9.3X forward earnings. The cash-adjusted earnings are just 8.5X.

Those are anti-bubble valuations.

In fact, according to Ben Graham, the father of value investing, 8.5X cash-adjusted earnings means you’re priced for zero growth. You only have to grow at zero to make great, market-beating returns.

And as long as you grow faster than zero, the dividends are always safe and you cannot mathematically lose money in the long term.

Well, what is the actual growth expected from our Fortress Portfolio? 7.4%. That's how fast these companies are growing.

And in fact, that means that long term, you're looking at a 6.8% yield and 7.4% growth. That means if this portfolio is trading at fair value, long term, over a decade, you're looking at 13-14% returns.

That's better than the Nasdaq's 12.5% expected, while earning 6.3% very safe yield and income growth of around 12%.

And over the last five years it’s been 12%.

But wait, there’s more.

Remember, it's 14% undervalued, which means over the next five years, that's a 3.3% annual boost. So that's around 17% annual return potential for the next five years compared to just 5% for the S&P 500.

Now, let me share with you one specific example of a company perfect for this opportunity.

In the last few weeks, I've shown you some victory laps in some of our hottest-performing companies.

Well, let’s take a look at Toronto-Dominion Bank (TD). This has not actually been a major winner.

We recommended it when we launched the portfolio in January 2023.

You can see it's down about 6%. This is not justified by the fundamentals.

(Click to Enlarge)(Source: FAST Graphs)

Here you can see about a 5% reduction in earnings. This is because of a tight job market. They had to basically pay some higher wages. They're doing some restructuring costs and have a lot of recent acquisitions.

So, they are digesting that. That's the short-term reason for that.

But notice 2%, 6%, and 10% growth accelerating back.

Now, management here is guiding for 8.5% long-term growth. They have historically delivered around 9-10%, historically worth 12X earnings.

Right now, it is trading around 10X earnings, including the dividend yield, about a 23% historical discount.

So, this is a perfect example. While the market was red hot and the Magnificent Seven was doubling in value and trading at 40X earnings, you got the opportunity to buy a AA-rated company.

According to the rating agencies, this is in fact the 10th safest bank stock you can buy in the entire world. It is growing as expected and absolutely firing on all cylinders.

(Click to Enlarge)(Source: FAST Graphs)

And even factoring in all the headwinds it's faced, it has around 16% annualized return potential for the next three years, and 51% upside compared to 5% annual return potential for the S&P.

But wait, there's more…

So, we have a 5% very safe yield. We have 8.5% growth guidance from one of the world's premier management teams in banking.

What does that actually mean for the next decade when the S&P is expected to deliver about 130% returns?

It yields 1.5. So, you're getting no income and modest returns for the next decade.

Not necessarily a lost decade, but certainly not anything that investors are used to compared to the last ten years when it was around 16% annual returns.

Well, with Toronto-Dominion, you've got the 5% yield, 8.5% growth, and it's 23% undervalued. That means you're looking at a 17% return guidance.

These are not just my estimates, and these are not analyst estimates. This is management saying expects 17% annual returns for the next decade.

Well, what does that actually mean? That is a 331% return guidance, more than quadruple your money, and nearly three times the market's expected returns for the next ten years.

And in the meantime, you're getting almost 5% from a bank so safe that it has never cut its dividend in 167 years. Not in the Great Depression, not in the Great Recession, not in the pandemic.

In Canada, they like to joke that if Toronto-Dominion ever cuts its dividend, the sun has burned out and we're all too dead to care.

And that is the power of Fortress. We have world-class companies, ultra-high yield you can trust in any market or economic conditions, and an opportunity to always put your hard-earned money to work safely and smartly, no matter how crazy the markets are acting.

Thank you for joining us. Please join us next week when I'll highlight some surprisingly good news for the U.S. economy and your Fortress Portfolio.

Reminder, please send us your questions or comments so I can respond to them in our monthly issues and these videos.

Just remember, I can't provide personalized investment advice.

Until next week, this is Adam Galas, wishing you and your family safe investing and a healthy and relaxing weekend.