For most of the last fifty years, portfolio construction has responded to an economic system defined principally by demand.  Fractional reserve banking historically created an abundance of capital.  Globalization expanded the available labor pool.  Supply chains stretched across borders in search of the lowest marginal cost, and persistent technological advances generated rapid productivity gains.  When demand ran too hot – too much money, too few goods – central banks raised interest rates; when it weakened, they cut them.  Most investors today have grown up knowing no other framework.

Increasingly, in our view, the global economy is transitioning from a financial system defined by demand to a physical system constrained by supply.  The policy tools developed for the former would appear poorly suited to the latter.  For example, monetary policy may destroy demand for scarce goods, but it may not be able to easily reverse the scarcity itself.  Similarly, we believe it is worth considering that the portfolio approach most often used in that environment, i.e., “60/40,” may not be best-suited for the future.

Supply constraints have historically lifted commodity prices and, with them, inflation.  Higher inflation may be pushing interest rates higher, particularly at the short end of the curve, while we believe increasingly strained fiscal conditions are weighing on the long end.  In our view higher real yields may be fueling currency market volatility.   Historically, FX volatility would lead to softer demand, helping to regulate excesses, but three independent developments – weather, war, and artificial intelligence –may be colliding with this reality simultaneously.

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Start with the weather.  The developing El Niño may be increasing the risk of disruptive weather across several key agricultural regions. Southern Hemisphere farming and fishing may be particularly exposed: coffee in Southeast Asia, cocoa in West Africa, sugar production across parts of Asia and Brazil, and Peruvian anchovies have historically been vulnerable to changes in rainfall and temperature.  In the Northern Hemisphere, drought conditions are colliding with already constrained agricultural supply, a problem that has been especially acute in the Colorado River Basin for several years.  Regardless of one’s political views on the cause, if the climate has shifted toward persistently drier conditions in important commercial agricultural, fishing, and ranching regions, lower yields and higher prices will be difficult to avoid.  Similarly, the “impaired-availability/higher-price” principle could be applied to metals and energy. That brings us to war.

In our view the U.S./Israel-Iran war in the Middle East matters economically not only because it can raise crude oil prices, but also because it threatens the physical infrastructure that connects production with consumption.  We believe that limited throughput at the Strait of Hormuz and Bab el-Mandeb is not an abstraction on a spreadsheet, nor is the impact of the recent drone strike that knocked Saudi’s East-West Petroline offline.  They are geographic chokepoints through which the physical economy must pass.  While crude prices remain higher than pre-war levels and relatively stable, this may have obscured a larger problem. Refined products matter enormously, particularly diesel and fertilizer.  Diesel moves the economy; fertilizer feeds it.  When refining capacity is scarce or the available crude stock is impaired, its derivatives could become considerably more expensive without a corresponding move in headline crude prices.  This might create a transmission mechanism from geopolitics directly into households.

Then there is artificial intelligence (A.I.).  Initially, in our view A.I. appeared similar to the earlier phases of the tech revolution that preceded it, asset-light at scale.  But the next stage of A.I. appears to be the opposite.  As commercial and geopolitical intensity ramps, we believe it may be among the most physically intensive investment projects of the modern era.  Each improvement in capability may require substantially more compute.  Compute currently requires capacity anchored by a continuous supply.  These physical constraints may ultimately become a more important governor of A.I. deployment than either capital availability or technical capability.  This also argues against treating the entire A.I. investment cycle as a repeat of the internet era.  There can certainly be an A.I. “bubble” – transformative technologies can still be terrible investments when the wrong assets are purchased at the wrong price – but whereas the Internet still largely operates on fiber laid more than a quarter century ago, the perpetual renewal of physical infrastructure required to deploy A.I. at scale is real – and a constraint that may not be easily overcome. 

As capital expenditure accelerates, the sector has increasingly tapped the bond market to fund itself.  While notional issuance differs by several orders of magnitude, ongoing federal budget deficits and maturing federal debt are expected to contribute to the U.S. Treasury’s borrowing needs. Whereas hyperscalers and adjacent operators offer investors ostensibly investment-grade corporate paper with exposure to arguably one of the most important capital-investment cycles in a generation, we believe the Treasury’s borrowing needs are made more consequential by the rapidly changing preferences of foreign reserve managers, most notably Japan, which have, for almost thirty years, provided a relatively price-insensitive source of demand for U.S. duration.  As Japan normalizes rates and Japanese government bond (JGB) yields become more competitive, Japanese institutions may have less incentive to export capital in search of yield.  The same process that threatens the Yen carry trade may threaten an important source of marginal demand for global duration.

Which brings us to Mr. Warsh.  In our view the challenge confronting the Federal Reserve (Fed) is not just the level of inflation and its proximity to target; it is whether the Fed is trying to manage a physical, supply-constrained economy with a policy framework designed principally to regulate debt-financed demand.  We believe that distinction becomes particularly problematic when the federal government itself is the economy’s marginal borrower.  Higher rates may suppress private demand, muzzle inflationary impulses, and temper the economy, but the Fed might simultaneously increase the government’s financing burden.  Monetary restraint may now begin to collide with fiscal expansion.  The harder the Fed presses the brake, the more pressure the Treasury may come under to press the accelerator.  This is where we see the fiscal dominance begin to alter traditional market relationships.  For what it’s worth, I am of the view that Fed chairman Warsh and U.S. Treasury Secretary Bessent are clear-eyed that their institutional objectives are, in the moment, at odds.

Investors in Strategas’ Macro Allocation Portfolios (MAP) program will know these dynamics impact portfolio construction.  We have tactically – though not aggressively – rotated our portfolios toward exposures that we believe this emerging economic architecture cannot function without – energy-related industrial operators, industrial commodities, and selected agricultural exposure.  Thematically, this is expressed in our Industrial Power Renaissance, Analog Edge, and De-Globalization exposures.

For forty years, investors could assume that when prices rose sufficiently, supply would respond, globalization would find capacity, and central banks could curb demand without threatening sovereign solvency. We believe weather, war, A.I., and fiscal arithmetic are challenging each part of that assumption simultaneously.  Where physical lead times are measured in years and sovereign liabilities constrain fiscal and monetary policy, the adjustment mechanism becomes slower, more volatile, and considerably more political.

Nicholas Bohnsack

This communication was prepared by Strategas (“we,” “us,” or “our”), a brand that offers investment advisory services through Strategas Asset Management, LLC, an SEC Registered Investment Adviser, and provides research to institutional investors through Baird Strategas, LLC, a broker-dealer and FINRA member firm and an SEC Registered Investment Adviser. Information regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this communication, and are subject to change. This communication is provided for informational purposes only and should not be construed as an offer, recommendation, nor solicitation to buy or sell any specific security, strategy, or investment product. The information contained herein has been obtained from sources we believe to be reliable, but no guarantee of accuracy can be made. This communication does not constitute, nor should it be regarded as, investment research or a research report or securities recommendation and it does not provide information reasonably sufficient upon which to base an investment decision. This is not a complete analysis of every material fact regarding any company, industry, or security. Additional analysis would be required to make an investment decision. This communication is not based on the investment objectives, strategies, goals, financial circumstances, needs or risk tolerance of any particular client and is not presented as suitable to any other particular client. Past performance does not guarantee future results. All investments carry some level of risk, including loss of principal.

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