Well, if you can believe it, 2021 is a little more than halfway over. To commemorate that fact, we are here with another edition of our Quarterly Asset Management Newsletter. We hope that life is treating everyone well, and as always, don't be a stranger if we can be a resource to you or someone you know.
Now, without further ado…
Our Three-Point Investment Philosophy
- Proper allocation results from justifying the addition of risk, first.
- Long-term results come from prudence and discretion in the short-term
- The best allocation is governed, in part, by what is best for your plan.
NOTE: All information used in the production of this newsletter can be found by clicking here, unless otherwise noted.
Four-Point Near-Term Outlook
Since the bear market associated with the Great Depression, there have been four macro-economic conditions associated with bear markets:
- Commodity Spike
- Aggressive Federal Reserve
- Extreme Stock Valuations
With that being the case, those are the four characteristics that we evaluate to gain perspective on the investing environment in the short-term.
Recession: Cautiously Negative
If you would like to join the chorus that is our public discourse, there are certainly no shortage of issues for you to pick from to get your opinion out there. If we had to produce a distilled list of the issues most pertinent to the economy, however, we would most likely narrow the list down to three: employment, inflation, and whether responses to COVID will allow our progress back to normal to continue. Having said that, we would be remiss if we didn’t mention the tension and uncertainty currently surrounding our politics—at minimum, the rhetoric does not serve to promote prosperity, and at worst, it may very well contribute to issues that we are experiencing in getting back on our feet. Further, there is also no doubting the fact that there is potential for other topics to become more prominent, but as of now, employment issues, inflation, and nonpharmaceutical interventions are what is top-of-mind, because they are here and now.
We have made solid progress in our recovery from the impact of the nonpharmaceutical interventions (NPIs) implemented during the pandemic. The latest GDP measurement puts us back on par with where we left off at the end of 2019, and we started 2021 off with solid, annualized GDP growth of 6.4%. Unemployment has declined to 5.9%, after peaking at 14.8% in April, 2020, and jobless claims continue to drift toward pre-pandemic numbers. Further, high-frequency economic data indicate that the service industry is almost back to its pre-pandemic strength, and to the extent that a lack of income caused credit issues for folks, things don’t seem to have gotten as bad as they could have and they seem to be resolving themselves (Source). Lastly, in what is certainly a good sign, especially in terms of demand and capacity, employers are sweetening the pot for employees and offering sign-on bonuses to attract workers.
While the willingness to offer sign-on bonuses could, and most certainly should, be interpreted as businesses having confidence enough to make an investment in the future, it’s also a sign of some constraint in labor supply—i.e., businesses are having trouble finding workers. Some of the problems with labor supply are the result of legitimate shifts in the labor market brought on by the pandemic—e.g., folks seeking work in an industry that is more essential, in an effort to insulate their source of income from NPIs, and that offers better working conditions. (Source) Others are the result of the average worker being disincentivized to look for work, because accepting employment would mean forfeiting healthy unemployment benefits that arose out of the pandemic environment. (Source) Regardless, if it is true that at least some workers don’t want to return to work and forfeit their unemployment benefits, and independent of whether you think maintaining increased and extended benefits is the right course of action, the fact that businesses are having to offer bigger carrots to attract workers ironically means that the unemployment benefits are contributing directly to an increase in labor costs, which is most certainly can be counted as an inflationary pressure for prices.
Speaking of inflation, it seems to be one of those funny things in life where people can’t get out of their own way fast enough to identify when there’s too much or too little of it, but when there’s a need for someone to be prescriptive about the right amount, the crowd seems to thin a little bit. The bottom line, however, is that inflation is absolutely a tax on consumers, at least to the extent that wages don’t keep up with the advance of prices. Looked at from this perspective, it is a reasonable conclusion to draw that the immediate impact of significant inflation would be to reduce consumer demand. Over the long-term, it would be expected that an increase in wages would cause a corresponding increase in demand, thus offsetting the initial reduction. So, the real issues surrounding inflation would seem to be a matter of how sharp and how sustained the initial surge of appreciation in prices is and the extent to which wages keep up.
The latest data reflect annualized Headline CPI inflation of 4.9% and Core CPI inflation of 3.8%--Core CPI excludes food and energy, because of how volatile they can be; while wage inflation is reported at 4.6%. Implied in those numbers is the fact that something in either food or energy is driving Headline CPI inflation to be much more substantial than Core CPI inflation—energy jumped an annualized 25% and 27.8% in April and May of this year, respectively. There are those, however, who would attribute the latest inflation numbers to vehicle price increases, and argue, therefore, that the recent spike in inflation is temporary, or transitory (Source). Vehicle sales might be a strong driver, but they are far from exclusive, as evidenced by the discussion of energy, labor, and commodities.
Commodity Spike: Cautious
Recently, we have written about the potential for a commodity supercycle. We would never be so bold as to certify or invalidate such predictions, especially without the benefit of sufficient hindsight, but there is no doubting the fact that substantial price appreciation has been experienced in the commodity sector recently, thus leaving the question of whether it will continue (Source). Further, while the price appreciation could certainly be the result of a whipsaw effect, involving an initial sharp drop in prices in the early stages of the pandemic, followed by a sharp rebound in demand as NPIs have been relaxed (Source), it doesn’t change the fact that oil, natural gas, silver, industrial metals, and gold are all above their 10-year averages.
Aggressive Federal Reserve: Cautiously Positive
As we experienced recently, interest rates can take on a life of their own, independent of what the Federal Reserve might like to do. It seems, however, that any momentum in the increase in interest rates might have been short-lived, at least in terms of the yield on the 10-year Treasury, as it declined from 1.74% to 1.45% in the latest quarter. An additional note of potential interest is the corresponding drop in the yield of the US government’s 30-year bond—a decline from 2.41% to 2.06%, from March 31 to June 30 of this year. While there’s no way to pinpoint the cause of such movements, it is interesting to consider what it might mean for economic expectations. It’s also important to note that the Federal Reserve has affirmed its accommodative stance, but it has also moved up its timeline for an interest rate increase in the future, which is certainly at least a hat tip to its own expectations (Source).
Extreme Stock Valuations: Cautiously Negative
For the first time in quite a while, we have some negative movement in valuations. While it might be a little bit counterintuitive, negative movement in valuations is positive for someone looking for markets to move higher—i.e., buy low, sell high. On that note, a few sectors are firmly within striking distance of their 20-year valuation averages. Financials: 14.2x (20-year average: 12.4x); Health Care: 17x (20-year average: 15.4x); and Energy: 17.4x (20-year average: 13.9x—has delivered 45.6% return YTD while P/E has declined). Reductions in valuations can come from two sources: stock price reductions and earnings increases. Yes, we have experienced volatility recently, but the overall trajectory of the markets has remained positive. What this means is that the bulk of responsibility for the reduction in valuations lies with earnings increases, and that is absolutely a good thing.
Since not much has changed with stock market valuations, we wanted to take a moment and address the buzz around cryptocurrencies, with much of this being applicable to some other niche asset classes that have appeared in headlines recently. We have been fielding quite a few questions on the matter of cryptocurrencies, and for good reason, but we believe that some insight can be gained by observing and taking note on what has happened with cryptocurrencies.
The first place we would start with this discussion is simply with the context: an overvalued stock market and easy money, thanks to the Federal Reserve and stimulus efforts by the government. Generally speaking, when someone holds cash, they want it to work for them—i.e., earn more money. Further, the more cash you hold, or the wealthier you are, the more risk you may be willing to assume when you invest. If that is the case, then we think that what we have seen out of the cryptocurrencies and some other niche assets is simply the inevitable, given the overvalued stock market and the easy money policies followed by the Federal Reserve and the US government.
The reason we believe in the inevitability of what we area experiencing is because people have cash and the stock market doesn’t seem to offer a good opportunity for profit. Further, when it comes to judging the performance and/or valuations of cryptocurrencies, we have no idea how to distinguish a movement supported by the evidence from one that is not. The reasons for this are simple: first, cryptocurrencies are not consumed, used in, or made from a manufacturing process, so we are unable to see how demand can be evaluated; second, cryptocurrencies are not currently accepted as a mainstay of any country’s economic fabric. Given the difficulties that those factors imply, we believe investment in cryptocurrencies to be a purely speculative investment, at best.
Conclusion: Cautiously Negative
The unfortunate reality is that when it comes to the economy, it’s usually easier to identify sure ways to mess up its chances for success, as opposed to ways that will guarantee its success. With that being said, there are times where things are a little more obvious, and this would seem to be one of them. It’s no secret that if we hope to avoid the economic consequences of the pandemic, then we need to avoid the policies that created them. Obviously, that is much more easily said than done, for a whole host of reasons, but that continues to be a major piece, if not the major piece, in the economic and market puzzle that is being worked right before our very eyes.