Jamie Dimon’s annual letter to shareholders, released April 8th, mentioned the word “inflation” 21 times. That would’ve been unimaginable five years ago. Last fall he said in an interview that interest rates could hit 7 percent. In his annual letter he told shareholders that his bank is preparing for a rate environment of anywhere from 2 to 8 percent.
Interest rate futures prices indicate that the markets expect lower rates over the next five years. So, what are Dimon’s reasons for having a rate outlook that’s so much higher than Wall Street? “Equity values, by most measures, are at the high end of the valuation range… these markets seem to be pricing in a 70% to 80% chance of a soft landing – modest growth along with declining inflation and interest rates. I believe the odds are a lot lower than that.”
For Dimon, persistent inflation will drive persistently higher rates. Here’s what he believes will keep driving inflation higher:
- Ongoing fiscal spending. Translation: The US government is projected to spend at least trillion more dollars than it receives in taxes for the next infinity years.
- Remilitarization of the world
- Restructuring of global trade
- Capital needs of the new green economy
- Possibly higher energy costs due to “lack of needed investment in the energy infrastructure
It’s hard to argue against any of these factors. The bad news for our wallets is that there’s a high chance that Dimon is correct. The only thing that would stop higher inflation is a widespread banking collapse, a 2008-type of event. But there is good news for our investments: we can profit from all of this.
What should we decrease exposure to?
- Market-cap weighted stock funds, like SPY and QQQ, which are overweighted to information technology. For every $100 you invest in the SPY, $35 is currently going to just 20 tech stocks.
- “Low risk” bond funds, like TLT, IEF, VCIT, and LQD. VCIT holds intermediate term corporate bonds issued by investment grade corporations. The average interest rate on those bonds is 4.2 percent. So the average bond in the fund pays 1 percent less than a money market mutual fund is paying right now. If rates stay the same – the fund will slowly appreciate as low interest bonds mature and are replaced with bonds paying higher interest. If rates rise, the fund keeps losing value. This applies to all bond funds.
What investments will pay?
- Energy stock funds, like the XLE
- Materials and Chemicals stock funds, like the XLB
- Together, the two sectors above make up only 6.5 percent of the S&P 500.
- Gold and silver
- Cash – but not in banks, which have been low-balling savers with miniscule rates for almost three decades. If the Fed keeps its policy rate higher than inflation, money market mutual funds will offer a positive return on cash.
- Commodity funds – but we have to be careful with these…
Commodity funds, like DBC, invest in commodity futures contracts. These are highly volatile and often come with a cost of carry (meaning you lose money just by holding them). For that reason, it’s better to let someone else manage exposure to the commodity markets, like a Commodity Trading Advisory (CTA) fund. CTAs go long futures contracts when they’re trending upward and go short futures contracts when they’re trending downward. They deploy capital in a multitude of markets, 50 at the lower end and hundreds at the high end. The Arrow Managed Futures Fund (MFTFX) is a mutual fund that invests with Dunn Capital, one of the original Commodity Trading Advisory firms with about 50 years of experience. Bottom line: you can buy and hold commodity companies, like Exxon and Baker Hughes, but buying and holding commodity futures is a recipe for losses.
There’s no need for investors to suffer through a period of higher rates and inflation. We need only shed the average 401k mindset (70 percent market-cap weighted stocks, 30 percent bonds) and think outside the box.