In the Urban Dictionary, a Great White Buffalo is defined as "the big one that got away". Can the Federal Reserve engineer a soft-landing for the economy with slower growth, lower inflation and no recession? Maybe. Interest rates and bond market interventions are blunt policy tools and soft landings are as rare as Great White Buffalos.

• During November, the bear market rally continued. Trader hedging, short covering, strong employment and nervous central bankers all encouraged the stock markets to grind higher during the month.

• Economic data continues to indicate that the mild recession that began in early 2022 continues to deteriorate, despite the positive 3Q2022 GDP reading. Next year will be a bumpy ride.

• Inflation may have peaked in June at 9.1%; October's inflation reading was 7.8%. Core inflation has not yet made this downward inflection.

• This month's note is a deep dive on inflation:
• To survive 2023, you must understand inflation
• Monetary policy is inflationary
• Government spending is inflationary
• The bond market says the days of low rates are over, for now
• Bank lending is increasing
• Consumer inflation expectations are rising
• Demographics are inflationary
• Recession update
• Market strategy
• LIWM composite performance report through October 2022

Table 1: Performance update (as of 11/30/2022)

Performance discussion

November performance was higher across the board despite signs of economic weakness. Federal Reserve members recently dropped hints that smaller rate hikes are being planned. The market already expects this. Earnings continue to weaken slightly. Employment remains strong, allowing consumers to continue to spend despite higher costs for many items. Bonds appear to have put in a cyclical bottom beginning with the Bank of England intervention in mid-October. Commodities remain weak and oil especially is performing poorly.

If you are concerned about your portfolio, please call us if you'd like to discuss.

Inflation dominates Fed policy today and Fed policy dominates the markets. Let's start by reviewing the key factors that affect inflation, because it isn't just Fed policy that drives inflation up and down.

Inflation in the United States peaked in June 2022 and has been slowly declining. However, because the Fed waited so long raise rates, we still find ourselves in a situation where the Fed is raising rates as the economy falls into recession and inflation declines.

1. High inflation that has peaked and is falling, BUT
2. The Fed continues to raise rates
3. Earnings are weak, but generally ok
4. Employment is strong

Let's review the key factors driving inflation today and discuss each one by one.

Table 2: Factors affecting inflation

Monetary policy is inflationary

Monetary policy refers to whether the Federal Reserve is stimulating or constricting growth and inflation in the broad economy. While its policies are directed at the real economy, they significantly affect the financial economy and markets. This is because interest rates and quantitative easing policies directly affect leveraged or financed positions carried by Wall Street.

While interest rates are higher than last year, they are still significantly below inflation. Generally, this situation is called a "negative" real interest rate environment and is generally understood in economics to be stimulative. So, even with their rate increases, the Fed is not trying hard to suppress inflation. There is a strong political angle to this. The party in power will be blamed for the recession triggered by the Fed's anti-inflation policies, so there is tremendous pressure to NOT trigger a recession.

Figure 1: Federal Funds Rate v. Consumer Price Index (CPI)

Government spending is inflationary

While the peak pandemic stimulus spending is ebbing, the level of government spending appears to be stabilizing at a new higher level. On an absolute level, government spending never seems to decline; it just rises at variable levels of steepness. On a relative basis compared to GDP, US Federal spending was ~20% of GDP prior to 2008, stabilizing at 22% after the financial crisis. Now it appears to be stabilizing at 24% of GDP after the pandemic crisis.

Government spending is a drag on real economic growth because dollars are removed from the private sector by either taxation or debt driven spending. I'm not saying this is good or bad, but as a policy choice, it implies lower growth and higher inflation going forward.

Figure 2: Government Expenditures: Absolute and Relative to GDP

The bond market says the days of low inflation are over for now

For most of the 1980-2020 period, interest rates have fallen. Sure, there were the occasional pullbacks in this trend, but overall rates have fallen and inflation has been quiet. No longer. Inflation is much higher than desired and the Fed has been dragging its feet to fix the problem.

Naturally, the bond market gets a vote and the current vote in 2021-22 was DOWN. Bond investors are voting with their feet and refusing to buy bonds unless the yield is higher. This is inflationary because it makes debt more expensive forcing everyone's cost of business to go higher. This is true for government as well as private organizations.

Figure 3: Long duration government bonds have been falling since early 2020

Bank lending is INCREASING as rates rise

If the Fed was hoping higher interest rates would slow lending and economic growth, they are sadly mistaken. As we saw in the lead up to 2008, as rates increase, the incentive to lend increases because higher yields mean higher interest income to lenders.

This implies that the money supply affected by credit expansion is increasing rapidly at the same time the Fed is trying to slow things down. In our view, credit market expansions are an important part of money supply and associated inflation/deflation.

Here is the key question: with long-term yields now falling, will the credit expansion slow thus starving the real economy of cash to keep expanding? This is highly likely and very much in line with our 2023 cyclical views on inflation and interest rates: lower next year.

Figure 4: Bank loan growth over time

Consumer expectations of inflation are rising

Luckily for the Fed, consumer expectations for inflation are nowhere near the headline CPI numbers. That's the good news. The bad news is that inflation expectations are the highest in years and MAY be on a long-term upward slope. We won't know for sure until we get to the other side of 2023's recession.

You see, inflation tends to fall in recessions. While the long-term trend in inflation might be higher, for the next few quarters it is likely to ease as growth slows down. This will raise many hopes that the pop in inflation is temporary and that we can get back to the low-growth-low-interest-rate environment of the 2000s and 2010s. It is too early to tell at this point.

Figure 5: Consumer Inflation Expectations (WolfStreet.com)

Bank regulations are not inflationary

Before you claw your eyes out over this section, just look at all the innovation that happened in the 1960s and 1970s. (Table 3 below)

Not only were banks interested in lending money because rates were rising, but it was also EASIER to originate and move around credit exposure during the 1970s. This increased the speed of money moving around the economy, increasing the effective money supply.

This is not happening today. The most recent pieces of bank legislation were tweaks to the 2010 Dodd-Frank law passed after the financial crisis that made banking more difficult. In this recession, the financial risks are not concentrated in banks, but spread out among mutual funds, pension funds, insurance companies and private equity firms.

The one financial area NOT heavily regulated is cryptocurrency. The recent FTX bankruptcy has many wondering whether the whole space is a big ponzi scheme.

Table 3: Significant changes to bank regulations: then and now

Demographics are inflationary today

After decades of shifting labor-intensive factory jobs overseas, the United States finds itself in a new Cold War and a reversal of globalization. This is causing problems as we run into work force limits here in the United States. Not only is population growth low, but the percentage of the population willing to work has been in secular decline for decades.

How to get more people to work? Higher wages will help, but that will hurt corporate margins. It is too early to see any changes to this situation, but it is pretty easy to see the wage inflation at lower end jobs. So far, no improvement in labor participation which means wages will keep rising.

Figure 6: Labor force participation over the last 20 years

Long-term inflation is rising, but there will be short-term cycles

Markets do not move in straight lines. They chop up and down around long-term trends as market forces, traders and news flow batter them about. During the 1970s, there were 3 major recessions that were characterized by:

1. Falling earnings

2. Falling employment

3. Falling inflation

4. Falling yields

Remember, for bonds "yields down=price up". That means that as bond market yields fall, investors collect the interest payments and some capital appreciation on the underlying bond. There are opportunities here for those who follow the logic.

Here is a chart of bond yields and inflation during the 1970s with the recessions marketed out. The picture is a textbook example of cyclical short-term movement around a secular long-term up-trend in yields and inflation. Do you see it?

Figure 7: Consumer Price Index, Federal Funds Rate, and 10-year Treasury bond yields 1960-1980

Recession update

It is our view that we are in a mild recession that is deteriorating into a more severe recession. There are different ways to define "recession", but there is no need to bore you with the details.

Purchasing Manager Indexes are very sensitive to recent changes in economic behavior. They continue to edge down. Once the readings fall below 45, we can declare ourselves in a more severe recession.

Figure 8: Purchasing Manager Index (PMI) composite versus real GDP growth still point to weaker economy (S&P Global)

Corporate earnings fell slightly, but do not indicate a severe recession. Companies are very comfortable raising fees and prices in the current environment. This is supporting inflation, earnings and margins. In severe recessions, we expect earnings to fall 30-50%.

The two major headwinds for earnings in coming years will be higher interest and labor expenses. These problems will manifest slowly over time.

This following chart is based on analysts' forecast earnings estimates over the next 12 months. It is a lagging, not a leading indicator, unfortunately. The analyst community is rarely early on any major development. To quote Yogi Berra, it's really hard to make predictions, especially about the future.

Figure : S&P 500 Forward 12 Month EPS estimates

Market strategy

The current equity bear market rally rose ~17% from the October low. Our view is that we remain in a bear market because the Fed is still raising rates, earnings are ok, employment is tight, and inflation is still high.

For the S&P 500 (SPX) we see major resistance in the 4100-4200 area and support at 3400 and 2700. These are not targets, but price levels many traders are watching and thinking about.

Incidentally, the move up from the 2020 high (SPX 3400) to where we are today (SPX 4000) is approximately 18% or 6%/year for that 3-year period. This rate of return is close to what we use in our retirement planning tool for stock returns. Even though the market is 15% off of its all-time high, this is not a bad place to reduce risk, if needed.

Figure 10: Equity market chart for 2019-2022

Conversely, the bond bear market is about 2-years old and may have paused its decline as the economy goes into recession. Remember, bond yields tend to fall in recessions. This has important implications for 2023 positioning.

Please call us if you want to talk about your individual situation: 281-886-3039.

Figure 11: Bond market chart 2019-2022 (remember: yield up=price down)

In 2021, the combination of low yields and high stock valuations created an all-time low in the yield on a traditional 60% Equity/40% Bond portfolio. This means that from a yield or income perspective, this common asset allocation has never been more expensive. Similar valuations occurred in 1901, 1929, 1965 and 1999. Some of those years should ring a bell for you. Now that the Fed is raising rates and inflation is rising, we must consider strategies appropriate for periods of high inflation.

Figure 12: Yield on 60E/40B portfolio 1881-2021 (yield down=price up) indicates extreme overvaluation in 2021. Look at 1982. (MacroMonitor)

Our performance through 10/31/2022

Here is an update on our model composites. Composites are the weighted average returns of live portfolios over which we have complete investment discretion. See our disclosure below for more information.

During 2022, we have been underweight stocks and overweight bonds across the board, with critical over-weights in short-duration treasuries and floating rate debt. In general, we are beating the benchmarks solidly across the board. It has been a difficult year for most as both stocks and bonds fell.

Table 4: LIWM strategy performance compared to relevant benchmarks as of 10/31/2022 (November performance won't be ready for another week)

Final Thoughts

We are in the midst of a bear market rally, in our view. The Fed is still raising rates, inflation is high, earnings are slightly weaker, and employment is strong. We expect the Fed to continue raising rates, which will have negative effects on the markets and economy.

The key theme from this note is to watch inflation. Inflation drives the Fed and the Fed drives the markets.

We wish you all a Merry Christmas during this month of December!

As always, please call if you'd like to discuss:

Rob 281-402-8284

Chris 281-547-7542

Robert Lloyd, CFA^®

President and Chief Investment Officer

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Christopher Lloyd, CFP ^®

Vice President and Senior Wealth Planner

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-547-7542

Chris.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

Lloyds Intrepid LLC is an Investment Advisor registered with the State of Texas, where it is doing business as Lloyds Intrepid Wealth Management. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy, or the completeness of, any description of securities, markets or developments mentioned. We may, from time to time, have a position in the securities mentioned and may execute transactions that may not be consistent with this communication's conclusions. Please contact us at 281.886.3039 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions. Additionally, we recommend you compare any account reports from Lloyds Intrepid LLC with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. Our current disclosure brochure, Form ADV Part 2, is available for your review upon request, and on our website, www.LloydsIntrepid.com. This disclosure brochure, or a summary of material changes made, is also provided to our clients on an annual basis.

Performance Disclosures

INVESTING INVOLVES RISK, INCLUDING THE POSSIBLE LOSS OF PRINCIPAL. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS.



NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE.

Lloyds Intrepid LLC is doing business as Lloyds Intrepid Wealth Management. Lloyds Intrepid LLC offers investment advisory ser-vices and is a registered investment adviser in the State of Texas where registered and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. Lloyds Intrepid LLC and its advisers do not provide legal, tax or ac-counting advice. Lloyds Intrepid LLC formulates retirement plans, investment strategies, portfolio construction and investment due diligence for clients with signed investment advisory agreements with us.

This presentation is offered for informational purposes only and is not a specific offer or solicitation by Lloyds Intrepid LLC to buy or sell any investment product or service. This presentation is not investment advice. All opinions and outlooks are subject to change. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. Investments possess a variety of risks. Equity securities possess more risk than bonds or other debt securities and are particularly subject to fundamental change as well as changes to economic, legal, regulatory, and monetary policy, both in the U.S. and abroad. Smaller and international equities have more risk than large US stocks. Bonds are subject to credit risk, interest rate risk, inflation risk and default risk. Treasury bonds tend to have little credit and default risk but are highly sensitive to changes in interest rates and inflation. Corporate bonds tend to be more sensitive to credit risk and default risk. Municipal bonds typically pay tax exempt interest and despite being government entities are subject to credit risk, interest rate risk, inflation risk and default risk. Mortgage bonds possess credit risks and prepayment risks not found in other bond categories. In-vestments in real estate are subject to interest rate, default, and economic risk. International investments, either through direct investment, ADRs or funds, possess unique risks associated with currency translation, different accounting standards, and legal risk from operating in a foreign jurisdiction. Commodities possess unique risks that include regulatory risk, high price-volatility risk, along with interest rate risk, inflation risk and credit risk. Portfolio strategies that use asset allocation, diversification, re-balancing, indexing, or security selection do not ensure profit gains or loss avoidance. Indexes are unmanaged and not available for direct investment; index fund performance will differ from index performance due to management fees. Losses will likely occur in declining markets.

This performance report is generated from the returns of actual portfolios. Composites represent actual portfolios that are managed together in a single discretionary strategy. Lloyds Intrepid LLC performance has not been independently verified. All advisory fees, commissions and client paid expenses are reflected in this net-of-fees presentation. Some portfolios are portfolios that pay no fee and have less than $10,000 of value. These will be disclosed if requested. There are no material factors for comparing returns to benchmarks; each strategy is matched with an appropriate benchmark for comparison. Strategies presented reflect the performance of Lloyds Intrepid LLC discretionary portfolios. Investment objectives are consistent with the assigned benchmarks. 

These portfolios have a potential for losses as well as gains. Returns are presented net-of-fees. Risk measures, when presented, are calculated gross-of-fees. Performance is reported in U.S. Dollars. Composites exclude portfolios that have changed model during the measuring period. Internal dispersion is not presented for composites with less than five portfolios. Dividends are included in portfolio return. Investments cannot be made directly into an index.

Lloyds Intrepid LLC offers discretionary portfolios where holdings and asset allocations are actively managed. Unless noted otherwise, these strategies do not use leverage, derivatives, or short positions, are generally liquid and carry the risks associated with index, mutual fund and exchange-traded-fund investing. Occasionally, these strategies will hold individual stocks. The investment objective for each strategy is to exceed the long-term performance of the associated benchmark. Here is a list of our strategies:

Bonds

  Bond portfolios target an asset allocation of 99% bonds.

Conservative

  Conservative Portfolios target an asset allocation of 25% stocks and 75% bonds and cash.

Moderate Conservative

  Moderate Conservative portfolios target an asset allocation of 37% stocks and 63% bonds and cash. 

Moderate

  Moderate portfolios target an asset allocation of 50% stocks and 50% bonds and cash.

Moderate Aggressive

  Moderate Aggressive portfolios target an asset allocation of 63% stocks and 37% bonds and cash.

Aggressive

  Aggressive portfolios utilize an asset allocation target of 75% stocks and 25% bonds and cash.

Stocks

  Stock portfolios target an asset allocation target of 99% stocks.

Blended benchmarks are custom benchmarks that are applied to the performance of each named composite and reflect the long-term asset allocation target for each strategy. The composites presented here are those where LIWM has complete portfolio and asset allocation discretion. 

Bond composite benchmark is 100% Bloomberg Barclays Aggregate Bond. The Bloomberg Barclays Aggregate Bond benchmark is used in the blended benchmarks below. 

Stock composite benchmark is 100% S&P 500 total return. The S&P 500 benchmark is used in the blended benchmarks below.

Conservative composite blended benchmark is 25% stocks and 75% bonds.

Moderate Conservative composite blended benchmark is 37% stocks and 63% bonds.

Moderate composite blended benchmark is 50% stocks and 50% bonds.

Moderate Aggressive composite blended benchmark is 63% stocks and 37% bonds.

Aggressive composite blended benchmark is 75% stocks and 25% bonds.

While returns are presented here as net-of-fees, gross-of-fees returns are available for institutional investors on request and reflect the deduction of transaction costs and custodian fees but not the deduction of investment management fees.