Is Now When the Fed Pauses The Rate Hikes?

Closed-End Funds, Fed Rates, Inflation

It is a confusing time to be an investor, especially if your primary investing goal is generating a stream of income. We are in bear market territory on the back of successive rate hikes as I write this but there is an almost total absence of real fear.

As we saw in last Friday’s 658-point rally, investors and traders are grasping at whatever straw they can grab as an excuse for confidence.

There have been bear market rallies this year because the economy is tipping toward a recession. The expectation has been that the Federal Reserve will pause the pace of interest rate hikes.

Federal Reserve headquarters in Washington, DC, USA

That’s not going to happen.

Fed officials have already told us that they will not stop until inflation decreases to near the 2% level they consider to be a part of their mandate.

With the Consumer Price Index (CPI) up more than 9% and producer prices more than 11% higher than they were last year, we have a long way to go.

The rally last Friday was in large part because retail sales were better than expected. No one has stopped to think that the retail sales numbers released by the Department of Commerce were higher because consumers were paying higher prices. A substantial part of the spending increase was at gas stations.

If consumer spending is so good, why are the University of Michigan Sentiment numbers at levels not seen since the end of the Carter Administration?

All of this reminds me of a junkie trying to justify one more dose before rehab.

The market rally of the past 12 years was largely driven by low interest rates. That is changing. The Fed foolishly let the inflation dragon out of the cage, and much like it did under Chairman Arthur Burns back in the 1970s, it has discovered that this particular dragon is not very well behaved.

Keep in mind that inflation has never been tamed without the Federal Reserve raising the Fed Funds rate over the inflation rate. We will need several more rate hikes before the Fed will see the results it needs to see to be comfortable that inflation is under control.

I don’t think the Fed will have to go up to double digits to accomplish its mission, but the point at which inflation falls below the level of rising rates is going to be at a much higher level than what we currently see.

If the Fed does bend under popular or political pressure to prop up the economy and the markets, we could see a reemergence of the stagflationary environment of the 1970s. Fortunately, Jerome Powell gives every indication of being smarter than that.

The most likely path for markets from here is for rates to keep rising, which will put pressure on stocks.

So, what do we do as income-seeking investors in this environment?

First, it makes sense at this moment in time to avoid large cap stocks and longer-term corporate and government bonds.

You should favor special situations right now. It is no secret that I like to look for heavily discounted closed-end funds that have an activist investor or two pressuring management to shake things up if the discount gets too large or is ignored, and then to take steps to reduce it.

It also makes sense to favor infrastructure and real estate assets that are producing massive cash flows.

We can recreate the strategies used by the world’s leading private equity funds at a discount using closed-end funds. Energy infrastructure is on sale in the current market environment. You can buy these discounted assets in the closed-end fund market and collect double-digit cash dividend yields.

Best of all, the magic of closed-end funding accounting turn partnership payments into ordinary income—eliminating complicated tax hassles.

If we use a 1970s playbook, real estate should do very well for patient investors as well. The REIT market has been hit right along with everything else in 2022 but I am seeing opportunities develop in certain sectors like industrial, single-tenant offices, and non-gateway multifamily markets.

Segments of the single-tenant office and retail markets are also very attractive and throw off lots of cash in the form of dividends

Bank stocks are as cheap as they have been in years, despite the industry being in fantastic shape and able to withstand anything the economy or markets can throw at them. You can buy quality banks with yields of as much as 8% right now.

Slightly more adventurous investors can make note of the fact that if U.S. banks are cheap, then European banks are ridiculously cheap. Europe is going to start raising interest rates above negative levels this year and that should be fantastic news for the banking industry.

I am watching two closed-end funds that are managed by proven small cap investors with fantastic track records that currently trade at steep discounts to net asset value that should provide outsized returns for patient aggressive investors.

The markets are confusing right now. Odds are they stay that way for the rest of the year, at least. If you keep doing what everyone else is doing or using last year’s growth stock playbook, things could get very uncomfortable for you.

If, however, you know the right data to track and can blaze a path into areas of the market other investors are ignoring, you will be able to find the income and profits you need to reach your investing goals.