2nd Quarter, 2021
Inflation is a global concern in the post pandemic recovery.
THE MARKETS
In the second quarter, markets rallied around the post-pandemic growth scenarios with continuous upward revisions to G7 GDP and earnings forecasts. Propelled by global vaccination progress and the exiting of national lockdowns, many economies are now experiencing a demand driven economic surge with forecasts of 4% to 7% GDP growth, nearly twice the rate achieved in the recovery from the Great Recession!
Fueled by a continuous flow of both monetary and fiscal stimulus, global markets are saturated and awash with cheap money that is now being challenged by broad inflationary pressures. This translates to negative real returns or simply put, currency depreciation, hence an unprecedented investor embracement of the TINA (There is No Alternative to Equities) strategy that grows at the expense of traditional fixed income investment.
While investors have positioned themselves heavily in the foregoing strategy, they nonetheless remain fixated on the durability of the “Risk-on Risk-off” scenario currently in play. The real drama can be likened to a ship transiting Scylla and Charybdis in Greek Mythology. Do you lose a few men to beguilement by the Siren song of Scylla or do you risk foundering the whole vessel to the whirlpools of Charybdis? Thus, appetite for risk remains vulnerable to any monetary misstep by central bankers or a Black Swan event triggering a systemic risk adjustment.
Current earnings forecasts appear reasonably priced on the basis of transitory inflation assumptions and manageable supply chain disruptions. However, they do not appear to reflect the likely effect of one-time inventory profits as price increases are passed on to existing inventories which will be liquidated first. This may cause some market volatility during the balance of 2021 as inventories valued at more current (higher) prices are sold and the tug of war between growth and value continues.
THE ECONOMY
The cumbersome domestic political policy of each state having its own reopening policies is in stark contrast to the national protocols exercised by other nations. This difference further confuses data collection and interpretation, which in turn may misguide policy makers and the public. In spite of moving in the right direction, the US appears to be losing ground to other countries in the race to achieve maximum vaccination rates, which are important for a full force recovery.
Current forecasts of US GDP growth for calendar 2021 continue to rise as the post pandemic economy reopens. Initial forecasts were for 3.5% to 4.0% growth back in March, now a full quarter later we are seeing estimates of 6.0% to 7.0%. The latter are giving rise to concerns of renewed inflation pressures above the Federal Reserve’s 2% threshold. Globally the recovery trajectory appears steep. Some economists think we are in a pent-up demand driven recovery in which the steepness will revert to the post war mean within the next year and any inflation surge will be transitory. Others believe a higher growth rate will prevail for longer as new post COVID norms are achieved. There appears little doubt that the vast stimulus of household and business liquidity injected into global economies by coordinated fiscal and monetary policy, along with the welling up of asset values, has powered consumer confidence to new heights.
Consumer resilience is a tricky phenomenon. In the present, it is a mixture of pandemic relief, regime change, the reopening of the digital age and the old refrain of “Happy Days Are Here Again.” Meeting consumers’ pent up demand for goods is a continuing challenge due to flaws in the global supply chain. Once consumer demand is calmer, we can expect the focus to change to spending on services rather than goods. Sectors such as travel and leisure, dining, sports and recreation as well as postponed medical care are increasing. COVID-created demand for digital services is enduring.
Anecdotal evidence at present suggests a serious bottleneck in workers. Significantly higher wages and incentives will be required if we are to satisfy demand for lower skilled employment mobility. This is a critical element in the reinvigorated service sector.
The final chapter for the consumer in the reopening is a seemingly insatiable demand for residential housing, where the urban to suburban housing shift continues to push up asset values in the face of record low inventories. This trend is beginning to concern policy makers, who want to avoid a housing bubble at all costs as a systemic shock here would be a major setback to a broad reopening of our country.
On the corporate side of the economy, business is partially constrained and in some cases hemmed in by the conundrums of supply chain disruption and the mandated shifts to the green agenda. Supply chains will be re-worked over time, reflecting current appreciation of the limitations and costs of just in time inventory management. Government mandates relating to transportation and green agenda initiatives are inflexible as to the timing of transition. These changes add both complexity and costs for business in general.
Raw materials inflation is real and is at the bottom of the cost pipeline. Many basic materials such as copper, aluminum, strategic minerals and cement have undergone a super cycle of underinvestment – the natural result of poor investment returns produced by years of over-supply. Now that global demand has recovered, it is finally a suppliers’ market. Unfortunately, the suppliers’ pricing power translates to cost-push inflation, which is very difficult to control once it enters the pipeline.
Although a robust demand environment would seemingly lead to new capacity, there is a critical drawback to increasing supply: new capacity has become more costly due to environmental sensitivities and much higher replacement costs. It appears that to achieve an acceptable return on invested capital, higher prices will be necessary. This suggests that inflation is not going to be transitory and will be passed through the entire pipeline.
Inflation is now a global concern in the post pandemic recovery, and its tentacles are well beyond the reach of any central bank. A policy position that inflation in the U.S. is transitory elevates the risk to the markets. If this view is overrun by global factors such as protracted and significant materials inflation, the Federal Reserve will be forced to play catch up to fulfill its mandate of “full employment and price stability.” Thus, the risk-off card will likely be played, and markets will face a forced readjustment, with the prospect of global collateral damage.
INVESTMENT STRATEGY
Our current strategy continues as before - investing to achieve real long-term returns on capital that exceed the current and expected rates of inflation. In short, our objective is to help you maintain and enhance the purchasing power of your assets.
In the near term, our challenge is to maintain balance in the face of market risk posed by excessive global stimulus wherein interest rates are artificially depressed and the safest assets offer negative real returns. The current investment environment has pushed enormous liquidity into the TINA strategy exposing investors to the risks of rate adjustments as central bankers are being forced to rethink their views on not only employment but also inflation.
Last week’s Federal Reserve utterings that “transitory” may be stretched out suggest that the Federal Open Market Committee (FOMC) may need to avail itself of an escape hatch with respect to inflation and market risk. Our view is that inflationary pressures are global and likely to persist, thus bringing rate adjustments forward sooner rather than later. With this scenario in mind, we will continue to stress test and tailor equity portfolios.
Fixed income investment opportunities are few and far between. We are maintaining short duration portfolios and cautiously deploying proceeds of maturities, with the expectation that rate adjustments will take place well before the much-heralded 2023. As always, client needs and risk appetites are primary considerations.
A FEW THOUGHTS ABOUT INFLATION
Inflation has many facets and like a forest fire, it can burn underground for a long time and suddenly explode on the surface with great fury. The causes are many and varied but once out in the open inflation can create a pandemic of fear about destruction of capital.
We have had a long cycle of massive underinvestment in global raw materials in addition to which we now have significant global supply chain disruption thus we have at least two sources of inflation driving material costs higher by cost and scarcity.
Businesses are moving quickly to pass on price increases and the consumer is beginning to see them at the cash register. We expect this disruptive trend to continue, and as it does, pressures will build for wage increases while entitlement programs execute cost of living increases. Additionally, we must consider how the inflationary impact on extraordinary global stimulus programs will interact with ballooning budget deficits and what the fallout of higher interest costs will be on future government financing requirements.
And so the scenario goes on until policy tightening the money supply and the unpleasant elixir of austerity are employed and capital becomes significantly rationalized as liquidity is withdrawn. This scenario is not preordained but is illustrative of the fallout of going a bridge too far.