1st Quarter, 2021
Government spending programs, historically, are not the most efficient users of capital.
THE MARKETS
On balance, first quarter returns continued to follow the risk on scenario fueled largely by the Federal Reserve’s interest rate policy of lower for longer and the corollary of TINA (there is no alternative to equities). The tailwind of post (hopefully) pandemic euphoria has also added momentum in pushing markets higher. Equity sector returns have not been even. There has been a pronounced sector rotation wherein the worst sector performers in the COVID-19 onslaught suddenly became the best performers in the first quarter of 2021. Energy and Banking highlight the upswing rotation that has seen large cap shares double in market value from the 2020 trough, while the technology sector has retreated from euphoric highs set in February.
The markets have responded favorably to continued growth in the domestic money supply, which has increased more than four-fold since February 2020 to $18.4 trillion, while currency in circulation has grown 17 % over the year. During the same period, the Federal debt has risen by 18% to $28 trillion compared to a year over year GDP decline of 2.4% to $20.93 trillion. These statistics reflect the massive fiscal and monetary stimulus injected into the domestic economy to halt what was then an impending free fall of the COVID stricken economy.
The markets must now face an era of reckoning wherein the joint economic rescue effort of monetary and fiscal policy is likely to return to traditional pre COVID-19 roles. As such, the Treasury will focus on revisionist tax policy and the Federal Reserve on employment and price stability. The latter will have the greater influence on near term market direction. The present lower for longer interest rate policy will be tested by growing investor concerns about inflation and the challenges to current interest rate policy. Thus the stage is being set for market tantrums in the event the current tremors in the long bond markets and attendant steeper yield curve materialize into Federal Reserve policy changes which then become a tipping point in stock market sentiment.
The monetary punch bowl has been replenished several times and markets have generally responded favorably, with the exception of a couple of hiccups that caused quick and sharp tantrums. However, the elixir of cheap money continues to build both credit and speculative risk in the markets. The seemingly never ending train of IPO’s built on cumulative earnings deficits and the parade of SPACs (Special Purpose Acquisition Companies) strongly suggest a course set on capital destruction as is the case with enterprises being kept on life support by junk credit.
Thus, markets in the near term will likely continue to rotate within as various investment strategies are either tweaked or refocused to hedge against the aforementioned risks and challenges.
THE ECONOMY
What a difference from a year ago when we were facing a cratering stock market, dour forecasts of 6 to 10 % declines in GDP, unemployment rates of 20% in the USA and the prospect of a quarter million fatalities from the unanticipated COVID-19 pandemic, all with no known medical remedy at hand. By and large, the U.S. population’s response has been as credible as one could hope for in a democracy, however the scientific response to understand the origins, treat the afflicted and develop multiple vaccines has been exceptional and is unparalleled in history. Now we must temper our euphoria on the medical and economic recovery to date and recognize we are not approaching the beginning of the end of the pandemic but rather the end of the beginning. As mentioned in previous letters, the length of the pandemic cycle is likely to be somewhere between 1,000 and 1,500 days. We are now some 400 days into the cycle, and we must concentrate on maintaining the progress achieved to date, rather than celebrating victory prematurely. COVID-19 and its variants are still with us, and social missteps and failure to adapt to the new norms of wellbeing heighten the risk that a third wave of infections could challenge the health and economic progress achieved thus far.
The economic recovery must continue to advance hand in hand with the public health campaign to eradicate COVID-19. The massive economic stimulus of coordinating and targeting monetary and fiscal policy has stabilized an economy that was in free fall and headed in the direction of the Great Depression. The dollar cost of stabilization thus far exceeds $5 trillion, and the national debt has increased from $23 trillion to $28 trillion, with the likelihood of a further $4 trillion if current government transfer policies are continued to year end and a national infrastructure plan is initiated. We would note that government spending programs historically are not the most efficient uses of capital.
Although the private sector has been quick to respond to the new norms of commerce and personal well-being, some sectors will undergo painful restructuring while others will adjust more moderately. Many will not return to the labor force, with some of them requiring on-going subsidy. The newly educated will likely find entry into the workforce more problematic than envisioned when they began their higher education pursuits four years ago. The trend to remote work appears to be evolving to a new hybrid norm of part remote, part onsite. All of these things factor into a changing employment landscape, with significant and lasting economic and social repercussions.
Of greater impact is the likely restructuring of global supply chains. One of the lasting benefits of late 20th century globalization was the development of “just in time “ inventory practices now known as global supply chains. This was a trend that developed out of the growth of global aviation, further enhanced by significant capex in railroads and trucking and fast tracked by the entry of specialized shippers like Federal Express. It has been a real boon to corporate CFO’S who reduced inventory costs and boosted profit margins. Then the COVID-19 shock arrived, with its disruption of both global and domestic air, sea and ground transportation. The result has been massive shortages of materials and components and finished goods. The recent closure of the Suez Canal, which carries 12% of global trade, has further highlighted the fragility of global supply chains.
Recent forecasts, including statements emanating from the Federal Reserve, are projecting GDP growth of 6.5% or higher for 2021. The question is, how much of this is simply making up what was lost during the pandemic and how much represents sustainable new growth? Because of supply chain disruption, profit margins and earnings may suffer in spite of sharply higher growth. A related impediment to highly productive growth is the growing shortage of computer chips and circuit boards that are the mainstay of the digital age. Overall, demand by an economy heavily tilted to restructuring seems likely to exceed available supply.
INVESTMENT STRATEGY
Our investment strategy continues to focus on building real inflation adjusted value and income in our clients’ portfolios. Continued execution of this strategy in an environment where real interest rates remain negative requires greater emphasis on stock selection with a particular focus on sectors and companies that have well articulated post pandemic growth strategies. IIM pays significant attention to macro-economic factors and their impact on major market sectors. We expect this emphasis will lead to broader stock selection in those sectors that will do well as the new post pandemic norms gain traction in the economy and market place. Stock selection places a premium on companies with a low payout ratio and high dividend growth rate.
The present negative real interest rate environment and the pressure of a rising yield curve limit investment opportunities in all but high quality corporates with a maximum maturity of six to seven years. As always, known liquidity needs should be kept in short maturity Treasury Bills to avoid credit and interest rate risk, accepting that associated returns are minimal.
A FEW THOUGHTS ABOUT INFLATION
Inflation is defined as a general increase in prices for goods and services and a decline in purchasing power of the unit of exchange used to purchase them. Throughout the post WW II economy nominal annualized inflation of 1 to 2 % has been considered a necessary factor in achieving real GDP growth tied to full employment and capital creation. This trend has now been twice disrupted, first by the financial destruction of the Great Recession of 2009-2011 and again by the Pandemic of 2020. In both instances, massive fiscal and monetary stimulus measures were deployed to forestall a global slide into a deflationary spiral. We are now some ten years into a series of global rescue efforts where we have had only one round of attempts to achieve interest rate normalization, while at the same time the national debt has more than doubled.
The present lower for longer interest rate policy has clearly driven inflated values in some asset classes such as residential real estate where pandemic driven demand has reduced inventories to near record lows. It has also led the banking system to take on pockets of over-leveraged risk. This is now materializing in significant capital destruction as evidenced by the recent collapse of Greensill and Archegos.
Now we are beginning to experience a sharp rise in producer input costs due to global supply chain disruption, a prolonged period of underinvestment in basic materials, and a sharp rebound in petroleum prices. Our expectation is that growth driven demand will exceed supply and that inflation will rise, leading the corporate sector to make every effort to pass through costs increases. Firming final demand will likely lead to renewed wage pressures thus spawning a higher rate of CPI which may force the Federal Reserve to reign in its easy money policy, resulting in tighter credit policies and greater headwinds for financial markets.
Corporate America will feel the imperative to pass on input price increases as they face additional pressures from a likely 30% increase in the corporate tax rate, higher working capital requirements due to supply chain upheaval, and the likelihood of rising credit costs.
Consumers have not had to face inflation head on for some time, even though it has existed in an almost stealth form in the service sectors such as video and internet services and communications in the last few years. Now they are facing sticker shock in home improvement, property insurance, and the cost of imported goods should the dollar’s decline prove to be secular.
Thus a convergence of rising business and consumer inflation sentiment may become a global concern which will exceed the reach of the Federal Reserve and markets will have to confront a wall of worry that hasn’t appeared for many years. If we remain vigilant and look at the future, these challenges can be managed and overcome.