Video Update: Preparing for a Worst-Case Inflation Scenario

The Federal Reserve continues on its self-proclaimed mission to do everything it can to tamp down inflation. So every couple of weeks, we either get news of a likely interest rate hike or an actual hike…

But let’s assume the worst-case scenario.

What if, despite all this Fed action, inflation stays high forever?

In today’s video update, Chef Editor Adam Galas takes a high-level view at the relationship between inflation, the bond markets, and volatility.

By watching it, you’ll be able to understand what we’re likely to see the Fed do, our chances of hitting a recession, and how our Fortress Portfolio can survive even the worst-case inflation scenario. 

He’ll also tell you about some news out of one of our portfolio holdings, Toronto Dominion Bank (TD).

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

Happy SWAN (sleep well at night) investing,

Brad ThomasEditor, Fortress Portfolio

Welcome, Fortress Portfolio members to another weekly video update.

Today's topic is one I'm sure a lot of you have been wondering about-- what if inflation stays this high forever?

Core inflation, right now is about 5%, and we have had some troubling economic data recently indicating that it potentially could stay this high for several years, or even a decade.

Maybe some of you are wondering, how is that necessarily a terrible thing?

Well, maybe not 5% inflation.

But what if the Fed simply says 3% or 4% is good enough. After all, we've had 3% to 4% inflation for much of America's history, including times when our economy was growing at 4% to 5%.

Mainstreet was thriving, America was a military superpower, and everybody was getting rich on Wall Street. So what's the problem?

Well, there are a few.

Perpetually high inflation is something that the Fed simply can't tolerate. For example, right now, inflation expectations, according to the bond market, for the next 30 years are 2.24%, pretty much what the Fed wants over time, 2%.

Now, the Fed's goal is to keep the Fed funds rate at what it calls a neutral rate, 0% to 1% above core inflation, meaning 2% to 3% over time.

But what if inflation is allowed to come up to 3% and stay there? Well, for one thing, higher inflation tends to be more volatile, meaning there can be spikes in inflation as the economy cools or accelerates.

That makes it harder to predict what inflation will be, which means the bond market has a tougher time pricing risk assets and setting interest rates, which, remember, is the cost of money.

And if you don't know what the cost of money is, it's tougher for businesses to plan and invest for the future.

However, the biggest issue is that if inflation is allowed to stay at 3% to 4%, that means the bond market is going to have to set its own interest rates higher than what we currently expect.

For example, right now, the bond market thinks the Fed's long-term rates will be about 3% and about 3% to 3.5% for 10-year Treasuries.

Well, if inflation is 1% higher, it means that those interest rates have to increase by 1% as well.

And, of course, if today's inflation of 5% persists, then we're looking at around 6% interest rates forever.

Now, this, of course, would be very challenging for many companies. Remember that companies borrowed record amounts during the pandemic.

Now, the good news is, on average, they locked in those bonds for 11 years. But if inflation stays high enough for long enough, then those higher rates will still be there when they have to roll over that debt.

That means companies would have to spend more on paying down debt and less on investing or, at the very least, less on share buybacks, which were the number one driver of the stock market in the last decade.

But the biggest problem with higher interest rates forever is government debt. The Congressional Budget Office just brought out its latest long-term forecast, and it expects for the next decade $20 trillion in deficits.

That means we're going to have to add $20 trillion to the national debt.

Now, the good news is, they expect the economy to grow by $14 trillion, so it's going to be more easy to service that debt.

However, the Congressional Budget Office is making some assumptions, as you'd have to, for a 10-year model.

And in fact, they model out for 30 years. They assume average borrowing costs of 2.9%.

Well, right now, for new debt, the government's borrowing costs are 4.5%, and if inflation were to stay this high forever, that would actually increase to around 6%, possibly even 7%.

So what would that actually mean for the government?

Well, right now, the Congressional Budget Office estimates that we're looking at around $1.3 trillion to service the national debt. Those are the interest costs that we're expecting by 2033.

For context, that's about four times higher than in 2021, when interest rates were at record lows. But that's assuming 2% inflation.

 If inflation is stuck at 3%, then interest rates will actually be about 4%, and those interest costs will be $2.2 trillion.

And if today's 5% inflation persists, then we're looking at potentially 6% to 7% borrowing costs and $2.7 to $3.2 trillion per year that the government will be spending just to pay the interest.

For context, that would be about 5% to 8% of the entire economy just going to debt, and that's only for the next 10 years.

Over the next 30 years, such high borrowing costs could balloon the annual deficit all the way to $20 trillion by 2053. That's in a single year.

Government debt would be over $300 trillion, and annual borrowing costs would soar to around $20 trillion per year, or 25% of GDP.

Now, these numbers sound shocking and horrifying, and believe me, they are. They're certainly not sustainable. And the good news is, they're not actually going to happen. Because, of course, the Fed knows all this, and that's why the Fed has to beat inflation.

It knows it has no choice. It can't tolerate 5%, 4%, or even 3%.

Because if the Fed says 3% is OK with us, then people will say, well, what if you change your mind and allow 4%?

You increase that uncertainty, and interest rates will rise. And, of course, as we've just seen, the US government certainly can't afford that.

So what does this mean that the Fed has to do?

Well, right now, it’s planning to keep hiking, steadily, 25 basis points at a time each meeting for as long as it has to.

So, right now, that means most likely, according to the bond market, the Fed goes to 5.5%. But it could hold it there for as long as it takes for inflation to come down, and, of course, that means the economy is likely to go into recession.

Maybe not until the second half of 2023. Maybe not even until 2024. But the bottom line is that with the economy so strong right now, it's almost a paradox.

The economy is too strong not to have a recession eventually… Unless inflation comes down faster than currently expected…

Good news, of course, is that, as we've been discussing in recent weeks, your Fortress Portfolio is perfectly positioned to protect you in all inflationary and economic conditions. Close to 70% of our holdings are poised to benefit from high inflation or high interest rates and perform well in normal inflationary conditions.

Now, I want to make one final note about one of our Fortress Portfolio regarding Toronto-Dominion Bank (TD).

In recent weeks, reached a $1.2 billion settlement with regulators for an alleged Ponzi scheme.

Now, if any of you have seen these headlines, they might seem scary. You might be wondering, “My god, one of our banks that we own is involved in a Ponzi scheme, and a big one at that.”

Let’s be clear, it was a $7-billion Ponzi scheme that blew up in 2012.

Now, here's the good news. This, essentially, is not a fine. It's simply a settlement.

You see, Toronto-Dominion was being sued for the last decade over this.

And let’s be clear, all they did was move the money for this person that was doing the Ponzi scheme.

Essentially, that's like Mastercard or PayPal processing the payments for a criminal.

Well, in order to finally get this behind them, they went ahead and settled-- them and two other banks, including HSBC, one of the biggest banks in the world.

So they were not the perpetrators of the fraud.

And this does not change our investment thesis. The rating agencies have not indicated any changes to the ratings. And I have been following this for a long time.

In fact, with with a AA- credit rating, TD Ameritrade is still the 20th safest bank in the world according to rating agencies.

And S&P says they have the 96th-percentile best risk management overall, meaning they're in the top 320 companies of all companies in any industry at managing risk, including reputational risk such as this.

So rest assured you have nothing to fear and do not need to make any immediate changes.

Thank you for joining us for this video.

Please send us your questions and comments here. I will answer them in these weekly videos as well as our monthly issues.

Just keep in mind that I can't provide individual investment advice.

Thank you again for joining us.

Next week, we'll be looking at the latest jobs report and what that means for the inflation outlook, the economy, and most importantly, your Fortress Portfolio.

Happy, safe investing.

This is Adam Galas signing off.