Second Quarter 2021 - Waking Up The Inflation DragonSubmitted by Alsworth Capital Management, LLC on July 26th, 2021
Stocks around the globe continued to surge in the second quarter. The U.S and developed international markets led the way, with the S&P 500 Index gaining 8.5% and developed international stocks rising 5.7%. Emerging-market stocks trailed in terms of progress on the COVID-19 front and in turn rose by a more modest 4.9%. In bond markets, the 10-year Treasury bond prices rose, as interest yields dipped to 1.45%, despite higher inflation readings during the quarter. This contributed to a solid 2.0% return for the core bond index. In fact, inflation fears were felt more strongly last quarter, and core bonds remain down 1.6% for the year, as a result of the first quarter selloff.
Ultra-low interest rates are propping up stock prices due to the discount rate applied to valuations, as well as the lack of competition from safer bond yields as an alternative. The Federal Reserve is once again buying up Treasury bonds and corporate bonds in the open market to artificially bid up the value of those bonds and lower the interest rate required to compensate for the risk of default or inflation. This bolsters the perception that the Fed will act as an insurance policy and prevent too much damage from being inflicted on holders of these securities. They have been successful in keeping bond rates low, which in turn forces conservative savers to take on more risk to find reasonable rates of return. Fiscal government policy has also been extremely accommodative, with historically low tax rates and steady drops of cash on the economy. Successive stimulus packages have transferred large sums of money to the economy through unemployment benefits, tax credits and forgivable loans. Looking ahead, there are new promises of broad infrastructure programs to invest even more money in the economy. To maintain consumer and investor confidence, little detail has been provided on how taxes will be raised to address our pre-pandemic budget deficits and growing national debt, let alone addressing the massive tax cut and stimulus packages of recent years. With a booming economy and skyrocketing stock markets, it is hard to argue that these policies haven’t been successful. We averted a financial depression and with the rollout of effective vaccines, life is migrating back toward normalcy, with travel restrictions lifted and people feeling comfortable resuming normal activities.
I have learned the lesson from other post bubble economies (dot.com and Great Recession) that central planners can and will exert their power to prop up investment markets to boost the “wealth effect.” So long as investment markets are going up, perceptions of the economy tend to stay positive and consumer spending tends to expand. The psychology of the consumer is very important to maintain. We are now seeing spikes in price inflation and product shortages in the economy, owing mostly to pandemic related supply disruptions coupled with spendable cash being made readily available to consumers through stimulus and cheap loans. Buyers are chasing rising housing values with vigor and scrounging up used cars with enthusiasm. This frenzied buying behavior is important in that it drives up prices without boundaries. The perception of scarcity is self-reinforcing, as the eagerness to buy at any price attracts even more interest. Think empty toilet paper shelves and cleaning product aisles. The dominant fear in the market this quarter is that at some point, higher prices for houses, cars, microchips, and lumber will leak into higher prices for everyday products. If the perception of scarcity becomes widespread, it becomes part of our psychology and we become accepting of paying higher prices for everything. As price increases become pervasive, it can be very damaging to the economy, much like was experienced in the early 1970’s. Experience has shown that the inflation dragon can be slayed if the Fed raises interest rates high enough to choke off an overheating economy. The last thing a booming stock market wants is higher interest rates or runaway inflation. We need a “Goldilocks” condition of not too hot and not too cold.
At this stage in the economic cycle, growth is very strong and investor psychology is bullish. It is unlikely that the Fed is going to raise rates anytime soon and risk derailing the wealth effect. They have instead indicated a willingness to accept higher inflation until employment gets back to pre-pandemic levels. We have recovered about two-thirds of the jobs lost during the pandemic, but we have a long way to go. Wages at the lower end of the income spectrum have come up substantially, as service industries have had to offer higher pay to induce workers to come back. However, wage increases have not yet moved into middle income salaries. Unlike the 1970’s, there aren’t strong labor unions pushing middle income wage increases and many workers are trading work-at-home flexibility for higher incomes. So far, there is no evidence of widespread wage push inflation. The vast majority of recent inflation spikes can be attributed to travel related costs and vehicles, which are based on temporary re-opening factors. There has been an over 23% spike in average house prices, but little evidence of that translating into higher rents being charged. We are mindful of inflation risks, but we are not making reactionary adjustments to the portfolio for this risk at this time. Our base case expectation is that inflation will subside as pent-up demand normalizes. However, we expect that it will remain somewhat higher than we have seen in the last couple decades. It is likely that the inflation mentality will creep into everyday staple goods, raising inflation for more goods. Though, we don’t see signs that it is becoming a long-term pervasive threat requiring immediate action to remedy.
There have also been increasing concerns among investors about the surging COVID-19 cases, as a result of the more aggressive Delta variant. Vaccination rates in the US have stalled, allowing the virus to continue to transmit and mutate into more contagious variants along the way. This is a cause for concern, but our base case expectation is that vaccination rates will increase in response to the new higher risk of the Delta variant and that natural immunity from new infections will partly curb the spread. We are also encouraged by the improvements in treatments to reduce the death toll from infection. However, we are mindful of data on the reduced effectiveness of vaccines against new variants and we will respond accordingly as the data becomes clearer.
What We Are Doing
We are maintaining a broadly diversified portfolio to hedge against a variety of possible scenarios. We added to our stock allocation over the last quarter and continue to favor higher quality companies trading at lower valuations. We expect that the global disbursement of vaccines and subsequent reopening outside of the US will be a boost to non-US stock markets going forward, providing opportunity for those positions. In the event that inflation does become more widespread, we expect that our existing positions in gold, floating rate bonds, emerging market stocks and value stocks will benefit. In the event of a macro shock, such as requiring another virus related shut down, we expect our core bond positions will provide a hedge. We continue to adjust the allocation to various asset classes based on prevailing trends, but we remain committed to a well-diversified allocation, to reflect an unpredictable future. It is easy to be diversified when the unpredictable shocks hit your portfolio. It is often harder when a few asset classes are strongly outperforming the others. Managing our own fear and greed cycles is one of the most important elements of successful long-term investing.
We expect that tax policy is going to be an important topic in the coming quarters. As potential changes come into focus, we will be advising on potential strategies and making adjustments to the allocation accordingly. This may result in taking higher than normal capital gains in the portfolio to capitalize on current low capital gains tax rates. As always, if you have any questions on our investment allocation, financial planning or tax planning, please let us know.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth only
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research