Prospects for the economy continue to improve markedly. In most of the US the pandemic has abated to a diminished threat, with case and death counts becoming less of a news event. Stocks have continued to rise on the re-opening of the economy as people, long tired of “staying safe” at home, start to take long deferred vacations and return to their dusty offices. The airlines are flying and highways humming. Life is almost back.
The economy has been relentlessly “chasing the Bull.” Historically, equity markets are leading indicators of future economic activity. This appears to be what we observe as stocks rage higher on expectations of continued strong economic expansion. There is probably more room for this to run, even as business supply chains are strained, and they struggle to fill empty positions.
The first question we are getting from our clients is “how long can this rally continue?” The second is “what will be the impact of central bank money printing of digital dollars by the trillions to pay for an expanded bag of political promises?” A little wordy perhaps, but with a purpose.
Let’s take a crack at answering these so you can impress your friends while on vacation, at the beach, with cocktail in hand.
How high can this market go?!
The Investor sentiment can drive a raging Bull for a longer time than you think before exhaustion kicks in. Prior to the pandemic the economy was strong, running on full employment, and it could have been expected that a cyclical correction or recession was overdue. This is a natural progression in the course of boom-and-bust economic cycles.
Then came the pandemic. The global economy stalled abruptly, prompting an end to the expansion in the form of a head-on crash, as opposed to a slow-motion fender bender.
The recession was fast, deep, and global. But a year later, matters are substantially relieved by the spread of vaccines and recovery of key areas of the economy. As fast as the economy and markets crashed, the recovery has been equally as powerful.
Many activities have returned faster than others, which is also true of the entire global economy, which the US leads. The creative destruction of a boom-and-bust cycle will permanently alter some economic sectors. Relief will eventually be seen as both supply chain disruptions, especially in semiconductors, and labor shortages, correct themselves and extend the recovery over the next several years.
One obvious example of this is the shortage of both new and used cars. Without microchips, you cannot build cars and a lot of other things. It has been reported new cars are selling above sticker prices. I have never seen that before, after years of negotiating the last nickel out of every purchase.
Markets can therefore move higher. Corporate earnings are exceeding forecasts and are expected to continue to do so.
Let there be no doubt – markets are at very high fundamental valuations, with many pundits regularly using “bubble” terminology as a descriptor. It remains to be seen how far the Bull can run, but if the economy continues to grow, and we experience some moderation in equity prices, we will approach a more normal state of market valuations. This will also lower the stress level of certain portfolio managers.
What about Inflation?
What about the rampant money printing by the global central banks? Everyone is starting to feel the pinch as more and more dollars, euros, and yen are created to cover what can only be described as huge fiscal deficits. Few politicians appear willing to address the madness of relentless money creation in pursuit of meeting every promise made. Never let a crisis go to waste.
Let’s not kid ourselves – the spending creates the illusion of prosperity but erodes the standard of living of the whole society in the longer-term. Housing prices rise, stocks rise, land and real asset prices appreciate, giving the owners of these items more relative wealth. Yet everyone will pay the price in higher rents, food prices, clothes, cars, etc. This does nothing to address populist issues of income or wealth inequality.
Technological progress has kept the inflation monster at bay for decades as microchips became more powerful, productivity surged, and the internet disintermediated away whole economic sectors, especially retail. Tech-driven productivity allowed for fiscal profligacy, but we may be hitting that limit, with a kick from Covid.
If one combines outsized deficits with troubling demographic trends (more retirees and declining birth rates) it raises the question of exactly who is going to pay the bill?
There is really only one answer – print money and devalue the currency. Everyone will pay!
What do we do?
Our commitment to our clients is to seek to preserve and grow their financial assets ahead of the inflation beast. This requires limiting the downside while achieving a positive inflation-beating rate of return We are currently reviewing our asset allocations. We believe that equities remain the best vehicle to achieve this goal. As I write this commentary, 10-Year US Treasury bonds are yielding 1.29%. They are unlikely to exceed inflation.
We remain overweight to technology and healthcare for growth, and underweight fixed income. As the Bull rages on we will seek to rebalance to targets, taking profits, and managing risk.
We are living in very interesting times. Have a great summer!