Elon Musk Says Deflation Is Already Here: Our Top Picks

In a recent interview, billionaire SpaceX, Tesla (TSLA) ,and Twitter (TWTR) CEO Elon Musk asserted that we are already in a deflationary environment and that the Federal Reserve’s apparent persistent hawkishness is misguided. Mr. Musk went on to state that the Federal Reserve is basing its interest rate decisions on old data that is not reflective of the current state of affairs in the economy. He used the analogy of driving a car on a windy road on the edge of cliff using only the rearview mirror for vision to reflect just how inaccurate the Fed’s data is and how dangerous the ramifications are for the economy. Mr. Musk believes that if the Federal Reserve persists too far with its interest rate hikes, the broader economy and the stock market (SPY) will pay a pretty dear price.

In this article, we will share our thoughts on Musk’s comments, our approach to the current environment, and some of our top picks to outperform the market in 2023.

Our Thoughts On Musk’s Macroeconomic View

In our recent Market Outlook report, we come to a similar conclusion, albeit perhaps not quite as strong in our assertion that deflation is already here.

Given that the most recent CPI data revealed that prices rose by only 0.1% on a month-over-month basis in November, the annualized inflation rate was ~1.2%. Though not deflation, this is extremely low. Granted, this includes very volatile energy and food prices, but even the Core CPI number – which excludes energy and food prices – came in at 0.2% month-over-month. Once again, not deflationary, but certainly indicative that inflation is slowing rapidly and arguably is already under control.

Back to Musk’s main point: note that this data was from November, which is nearly two months ago on average. If prices have continued their deflationary momentum since then, it is very possible that we have fallen into deflation today, though again, it is hard to say for sure.

Ultimately, our view is that inflation is quite likely under control – at least for now – and that this will become very evident in the upcoming CPI releases. As a result, we expect the Federal Funds Rate to reach its peak at some point in the first half of 2023 and then – assuming the widely anticipated recession manifests this year – to pivot to cutting interest rates at some point in the second half of this year. Whether or not this will be too little, too late for the economy remains to be seen, but our view is that a recession is highly likely this year regardless of what course the Federal Reserve takes. This is because the yield curve has already sharply inverted and the money supply (as measured by M2) has already begun to decline. Both of these data points are very strong recession indicators. When you add to them the growing stream of significant layoffs being announced by companies, a recession seems imminent.

Our Approach And Top Picks

Given that we think inflation is effectively under control and likely to dissipate this year amid a pretty meaningful economic downturn, we believe that now is the time to focus on defensive companies that weather recessions well and also benefit from falling interest rates.

While we are not completely letting our guard down against inflation, we think that it is not necessary to overweight inflation-proof investment in our portfolio either. We think that in the current environment utilities (XLU), investment grade midstream companies (AMLP), triple net lease REITs (VNQ), preferred equities (PFF)(PFFA), conservatively positioned business development companies (BIZD), and bonds (BND) are likely to outperform, especially since the yields on most of these securities have recently been reset higher thanks to rising interest rates.

Some defensively positioned stocks that we particularly like in the upcoming environment where inflation and interest rates are likely to fall include:

(1) Energy Transfer (ET): While ET is an energy-based business that has benefited from soaring energy prices in the high inflation environment, we believe it is still positioned to outperform in a falling inflation and falling interest rate environment. This is because ET generates nearly 90% of its EBITDA from commodity price resistant sources, primarily fixed-fee take-or-pay pipeline contracts. These generate very stable cash flows regardless of the macroeconomic environment and provide a strong base of funds for the business to fund its capital expenditures, its distribution, and pay down debt as it sees fit. As a result, a recession and deflation should not hurt ET nearly as much as it will upstream energy exploration and production companies like Exxon Mobil (XOM) and Chevron (CVX).

Furthermore, ET trades at a steep discount to its historical averages as well as peers in its sector, is widely expected to hike its distribution meaningfully this year, is benefiting from an energy export boom for North America in the wake of the war in Ukraine, and is paying down debt aggressively in pursuit of a credit rating upgrade that may be in its near future. Therefore, we see plenty of upside catalysts for this security this year that could offset much or all of any potential downturn in the energy sector in the face of a recession and deflation. You can read our recent exclusive interview with ET here.

(2) Algonquin Power & Utilities (AQN): AQN is far from a low risk investment given that its balance sheet is overleveraged and management is set to announce its new capital allocation strategy on Thursday morning (January 12th) which, as of this writing, is tomorrow morning. Many expect that this could include a dividend cut. However, there are several compelling reasons why we think AQN will make a very attractive investment during a recessionary period with falling inflation and interest rates. You can read our recent exclusive interview with AQN here.

AQN has a very defensive business model with long-term power purchase agreements on its renewables portfolio and the remainder (and majority) of its cash flow coming from its recession-resistant regulated utilities businesses. As a result, recessions should have little to no impact on its earnings stream. Furthermore, given that its cash flows are very stable and that it relies heavily on debt financing – including some at floating interest rates – to fund its large capital expenditure requirements, falling interest rates will be a significant upside catalyst for earnings. Last, but not least, a declining inflation environment will make its cash flow stream look more attractive to investors on a relative basis since discount rates will be declining. Given that AQN stock was beaten down severely in 2022 due to headwinds from rising interest rates, we expect AQN to outperform this year as the narrative shifts.

(3) Blackstone Secured Lending (BXSL): BXSL is an investment grade BDC that benefits immensely from its parent manager Blackstone (BX). BX is the world’s leading alternative asset manager with nearly $1 trillion in assets under management. As a result, it has access to superior deal flow, market intelligence and business data, underwriting expertise, and business relationships relative to most if not all of its peers. This competitive advantage is demonstrated in its underwriting success, with a 0% non-accrual rate in its investment portfolio.

Furthermore, the company has virtually all of its investment portfolio in senior secured debt, giving it strong downside protection if/when the economy goes into recession. Last, but not least, the stock is currently offering a double-digit dividend yield that is well-covered by earnings and is trading at a 10% discount to its net asset value. In other words, the market is pricing in an assumption that BXSL’s Blackstone management will be meaningfully value destructive. This seems ridiculous to us given their strong underwriting track record to date and the enormous competitive advantages that BX brings to the table. On top of that, BXSL has one of the lowest management fees among its peers. As a result, we think BXSL is a great place to invest for the coming deflationary environment.

While falling interest rates may reduce BXSL’s net investment income given its focus on floating rate debt, its interest rates are already very high and a falling interest rate will improve the interest coverage ratios for its counterparties while also reducing BXSL’s cost of capital. You can read our full investment thesis here.

Investor Takeaway

Elon Musk seems pretty adamant that we are doomed to face a severe economic downturn and that we are already in a deflationary environment. While we are not quite as convinced as he is that the economy has already slipped into deflation, we do believe the trend is strongly in that direction and that the Federal Reserve continuing to aggressively raise interest rates could be very damaging to the economy, at least in the short-term.

As a result, at High Yield Investor we are overweighting defensive business models that are poised to weather a recession well and also benefit from falling interest rates.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.