The good times continue to roll. After back-to-back strong years in the markets for stocks, bonds, and real estate, the first quarter of 2021 continued the streak with double digit annualized returns. Consumers are loaded with cash as the third round of stimulus checks were recently released. As this extra cash is hitting the streets, demand for corporate goods and services will skyrocket. One question is whether corporate supply chains can keep up, and there is a strong likelihood that prices (inflation) will go up in response. The Big Question is whether inflation will be temporary or sustained over time.
Global stocks continued to power upward this quarter from their pandemic bear market low on March 23, 2020. The S&P 500 Index gained 6.3% year-to-date, developed international stocks gained 4.5%, and emerging-market stocks gained 4%. These benchmarks are now up an astonishing amount (over 50%) since the bottom. The S&P 500’s one-year trailing return, as of March 23, 2021, was its best since the 1930s. Clearly, it paid not to panic (even if you had to close your eyes) and stay in the markets last spring.
One concerning fact from our perspective is that there is a lot of gambling going on right now. Reference GameStop, Bitcoin and NFT arts where astronomical prices are being paid without reflection of fundamental value. Gambling rarely ends well for most individuals and some markets. In the end there will be big winners but even bigger losers as a result. This is not a game we participate in, and our intention is to stick to good old-fashioned fundamental investing and diversification. In baseball terms we don’t have to swing for the fences, but rather our goal is to hit consistent singles and doubles. Success in the end comes from keeping a level head and making steady progress.
For a couple of quarters now, equity investors have been betting on more economically sensitive small caps and value stocks and avoiding large caps and previously high-flying growth stocks. We are starting to see this rotation (from growth to value) happen as growth stocks have underperformed the broader markets.
The reflationary winds have hurt the bond market. The prospect of higher growth and higher inflation caused interest rates to jump. The 10-year Treasury yield more than tripled from the historic low it set last August. Correspondingly, the core bond index fell 3.6%, suffering its worst quarter since 1981.
The primary variables that will determine the direction of the economy and markets remain COVID-19 developments and the fiscal/monetary policy response. These currently imply a strong case for a substantial economic rebound, particularly in the United States but also globally. This will support the fundamentals underpinning higher-returning asset classes (stock, in particular) —as-long-as interest rates do not move sharply higher too fast.
Substantial progress has been made on the vaccine rollout. Ninety-three million Americans have received at least one dose. At the current vaccination rate, experts estimate the United States could achieve herd immunity by late summer. Daily new cases, hospitalizations, and deaths from COVID-19 have plummeted. We are not out of the woods yet and there are still risks, but overall, the light at the end of the pandemic tunnel certainly appears brighter.
Controlling the pandemic will enable us to start getting back to normal lives, boosting economic activity. Growth forecasts had already reflected a rebound. Now they are being revised higher with the massive American Rescue Plan Act of 2021 fiscal stimulus being signed into law. The Federal Reserve forecasts the U.S. economy will grow at its fastest pace since 1984. Economic growth should feed into corporate earnings. The Wall Street consensus expects S&P 500 earnings to grow over 40% in 2021.
Yet the Fed continues to reiterate that it will not preemptively raise interest rates. It intends to wait until it sees inflation above its 2% target for an extended period of time, a new policy that suggests this economic cycle has plenty of room to run. The Fed has to taper its asset purchases first, which are still going strong at $120 billion per month, before they even think about raising rates. We take the Fed at its word that it won’t be raising rates anytime soon.
So high economic growth, strong earnings growth, but low interest rates? What’s s not to like about that? Equity investors could not ask for more. In anticipation, a bull market has roared to life. The main threat is our old friend – valuation risk. How high can stocks go before they are simply too expensive even in ideal circumstances. However, in the shorter term, historically high valuations should continue with all the positives that are in place. Stocks remain reasonably attractive relative to bonds.
Speaking of bonds, longer-term interest rates have risen in anticipation of a higher-growth, more inflationary environment. That has hurt bond investors this year. Unless rates start rising substantially most of this pain should be over for now, but the long-term outlook for bonds is still low returns. Our clients have felt less of this impact as we strategically reduced bonds substantially in our model portfolios several years ago in favor of private real estate. A long-accepted guideline for retiree investors had been to have 60% of their nest egg invested in stocks and 40% invested in bonds. We modified this approach (for our Medium Risk portfolios) years ago by cutting back the bonds to 20% and replacing them with steady paying conservative private real estate. As we experienced last March, bonds still can play an important role in a retirement portfolio. For individuals that found themselves in need of cash, bonds gave them a safe place to access funds, thus allowing time for their stock portfolios to recover.
Speaking of real estate, some clients naturally questioned the logic of having real estate in our portfolios during the Covid Crisis. Well, it depends what kind of real estate you are invested in. Fortunately (or strategically depending on your point of view), a vast majority of our private real estate was placed in apartments and industrial warehouses, each of which ended up being among the strongest sectors in real estate. We found ourselves with very little office and retail real estate which bore most of the economic burden during the crisis.
As a result, our real estate positions turned in a positive year.
What About Inflation?
Inflation has been at the top of investors’ list of concerns lately. Governments all over the world have passed large fiscal stimulus packages in the wake of the pandemic, spending money they do not have and firing up the printing presses. The United States takes the cake: Congress has spent the equivalent of 25% of GDP in a single year on the emergency and may spend even more with an infrastructure plan on tap. Our national debt has ballooned from $19 trillion at the beginning of the Trump Administration and could exceed $30 trillion when the Biden Administration’s infrastructure bill passes Congress. Folks, that is a lot of debt and that is a lot of potential pent-up spending. Add in an expected economic rebound from the pandemic, and the Fed doing everything it can to stoke a healthy level of inflation, and investors and consumers are understandably worried about maintaining their purchasing power. A strong inflation spiral would be bad for stocks, bonds, and pocketbooks.
In the coming months, we will in fact see year-over-year inflation increase, most likely to the 3%-plus range. But this is largely due to prices rebounding from the pandemic lows. However the market reacts to this well-expected data, we want our clients to know that what really matters is meaningful, sustained inflation. That could be the catalyst to raise inflation expectations further, and fear of inflation can work like a self-fulfilling prophecy. If consumers think future prices will be higher, they will increase their spending today. Increased near-term demand raises prices for goods and inputs across the economy. Eventually workers will demand higher wages to compensate for higher inflation. Then businesses must raise prices to offset higher labor and input costs – and off the wage-price spiral goes. It is critically important that the Fed anchors inflation expectations before price trends get out of control. In summary, short-term spikes in inflation will be manageable but sustained higher inflation year after year will be difficult for everyone.
The jury will still be out even after the next couple of months as to whether this higher inflation will be transitory or the beginning of a longer-term trend. Our thought at the present time is that it will be a short-term inflationary spike rather than a long-term trend. Here is why we feel this way:
- GDP growth will sharply rebound this year, but we will not be close to full employment for at least a few years. Wage spiral inflation cannot really take hold as long as there is slack in the labor market.
- The size of the fiscal stimulus that has been issued is staggering, but it is a one-time injection. The fiscal impulse will turn into a fiscal drag next year.
- Also, not all of it will be spent or spent right away. A meaningful portion will be saved, and some will go to paying down debt.
- Finally, offsetting structural disinflationary forces such as demographic trends and technology adoption have not gone away. In the latter’s case, it has accelerated during the pandemic.
In the shorter term of the next six months, we remain cautiously optimistic, but we are diligent to keep informed of the economic numbers as they develop. The easy money of the past two years is over, and gains will be more modest going forward.
We have repositioned our portfolio over both the past few years and recently to take advantage of these trends.
However, one lesson that became very clear once again last March is that it is extremely difficult to use logic to predict the direction of the markets on a day-to-day basis. Very few people could have guessed the substantial and quick rebound that we experienced. It is extremely important to reevaluate your acceptable level of risk during good times (like right now) and then stick to your position when times get rough. With over 40 years of investing experience, I have never witnessed anyone winning by making emotional decisions during times of stress. So, I reiterate, if you have any concerns, now is the time to revisit your financial plan and acceptable level of risk. Adjust your portfolio risk to find a balance between what you need it to produce in income and what you can stomach during hard times. When the hard times arrive – and they always do – you must simply cross your arms and do nothing until we come out the other side of the storm. This simple truth will help you reap the long-term benefits of investing and avoid the gut-wrenching losses from selling at the wrong times.
I am proud to state that our clients have most always come out on the positive side of listening to our guidance.
We thank you for your continued trust in us.
Ron Dickinson, CPA, CFP