April 1, 2021
As society starts to turn the page on the pandemic, investors are beginning to imagine how “normal” might look. Judging from the activities, the markets appear both cheered and rattled. Cheered that the economy continues to recover – U.S. GDP in 2021 is set to rise 5.6%, aided by a forecasted 11.7% jump in the second quarter.1 Employment remains roughly 11 million souls lighter than pre-pandemic levels; however, it continues to march higher. The unemployment rate in February registered 6.2% and will likely fall as the economy continues to reopen.
Driving this economic revival are rising vaccinations, lower U.S. infection levels relative to the start of the year, and the slow return to the normal pattern of daily life. However, the efforts of government in the form of economic assistance and low interest rates are cause for concern as waves of money flood the economy, raising fears of inflation with it. Buffeting bond markets are fears of too much money sent to too many people just as the economy was moving to a more organic phase of healing. In truth, the dual narratives of economic recovery and inflation worries are natural travel companions. It was always a matter of time before the tide would turn from fears of economic woe to inflation worry as the economy establishes a firmer footing.
Catalyzing this narrative are successive waves of fiscal stimulus: first, the leviathan $1.9 trillion stimulus package passed in March that itself was hard on the heels of the $900 billion package in December. “Is this too much?” and “Will this cause inflation to ignite?” are common questions among the financial set. A former Treasury Secretary recently averred “…this is the least responsible macroeconomic policy we’ve had in the last 40 years.”2 His worry is inflation.
And so it is with the bond markets as well. A look at the Bloomberg Barclays U.S. Aggregate Bond Index reveals that not one sector of the index has logged a positive return for the year so far (Exhibit A). Overall, the index is down more than 3%. Long-dated bonds are down more than 10%. Outside investment-grade bonds, a closer inspection reveals positive returns reside in the lower-rated sectors of the market.
Investors hoping that central banks will referee the differing economic views will not find comfort. The monetary chieftains at the Federal Reserve are “all in” on making sure the monetary spigots remain open. The central bank will continue to purchase more than a trillion dollars in government and agency securities over the next 12 months, while keeping short-term interest rates floor bound. Clearly, inflation is a concern for another, distant day.
We are sympathetic to the arguments of both camps. Indeed, the truth resides in the middle ground. Recovering the 11 million jobs that the economy needs in order to return to pre-pandemic levels will be a tough slog, as the damage done to the service side of the economy will take time to heal (Exhibit B). It is hard to return to a job in a business that has permanently closed. Moreover, some consumer patterns that changed due to the pandemic will likely remain so and, at best, only partially revert to the “old ways.” To wit, how quickly will people be willing to go through the drudgery of a day trip for a face-to-face meeting, when the same is accomplished via Zoom, Teams, or Webex? Changes in behavior such as this will have enormous implications on capacity utilization for the travel and hospitality industry built, in part, on a highly profitable business traveler.
The big driver of inflation that the government measures relates to housing and food. On both fronts, prices have been stable. Furthermore, prices tend to be “sticky,” which means detaching from the low levels of the last 20 years will require time and a change in both consumer and business behavior. Indeed, there have been several episodes of inflation flaring higher during the last decade, but none endured (Exhibit C). Will this time be different? If the trend in de-globalization continues; if the dollar drifts lower as government deficits continue to balloon; and if people spend down their stimulus checks that, until now, were placed in savings and brokerage accounts, it’s possible that these factors could combine to produce durably higher prices. Without a doubt, these things are all possible and some are very probable. (Does anyone think Congress will embrace fiscal probity and the balanced budgets it requires?) Nevertheless, it will likely take time for a new price regime to unfold, which makes inflation fears both appropriate and ever so slightly premature.
Threading this needle from a portfolio perspective is challenging. Low interest rates force investors to commit capital for longer periods in order to capture incremental income. Those longer capital commitments (or “duration,” in fixed income parlance) introduce additional risk, as these assets are more sensitive to changes in interest rates. Our solution has been to keep fixed income durations shorter and get yield through sectors such as high yield, structured credit, and investment-grade bonds.
Surely, the double-barreled fiscal and monetary policy has created a pleasing form of inflation: asset inflation. Stocks, bonds, commodities, real estate, art (both physical and digital), and cryptocurrencies have all enjoyed a breathtaking levitation in prices. The wave of liquidity hitting markets lifts everything in its path. Consider the extreme example of a challenged retailer of games: how does a company’s share price go from roughly $19/share to almost $500/share (intra-day) in less than a month without a material change in its business? (Exhibit D.) Other, more troubled companies saw their share prices move parabolically without much in the way of transformational news. Social media, cash from stimulus checks, free online trading, and a desire for Main Street to show Wall Street “what for” by squeezing hedge fund short positions are the ascribed drivers of this phenomenon — not fundamentals. One could only imagine (with tongue very firmly in cheek) the heights that the stock might achieve were it to announce that it would be selling its wares on the blockchain as well as come fitted into every new electric vehicle.
Perhaps nowhere is the mixture of animal spirits and money more clearly demonstrated than that of the curious case of Bitcoin and its myriad brethren (Exhibit E). Aside from the flash of something new and the prognostications — from those long the cryptocurrency — about the dawning of a new Libertine day and with it a paradigmatic shift in how we transact with money, there is little to grab hold of with Bitcoin. It is probably the dirtiest currency on the planet, both literally and figuratively, as it comes into existence by enormous quantities of energy from fossil and nuclear fuel. It is a questionable store of value, since it has a volatility that would make the stock market blush. As a medium of exchange, it is incomplete since, in most cases, it needs converting to dollars before it buys anything. Finally, as a unit of account, it is immature: no company accounts for sales or assets in Bitcoin. Yet demand seems insatiable as the stories of a new frontier capture the attention and cash of those willing to go along.
If past is prologue, the Bitcoin saga will be a lot like the dawning of the era of personal computers. Recall that then, investors focused on the makers of the box (computer) while the real function change came in the software and the networks, that ran and connected the boxes. The computer was merely the on-ramp to the new paradigm. Bitcoin strikes me as the same dynamic. The real transformation will likely come with the blockchain and not the coin. In this instance, the coin is the box and the chain is the software and networks. The interest in a digital ledger by large financial institutions confirms the possibilities of blockchain.
As we posited in the 2021 Outlook, the further reopening of the economy has broadened market participation. In our last letter, we suggested swapping market exposure from market-capitalization-weighted exposure to an equal-weight exposure, essentially in order to provide more exposure to the “average stock.” We also highlighted the likelihood that smaller companies would perform better as the recovery took hold. Both recommendations have unfolded nicely as the equal-weighted S&P 500 Index has bested the market-capitalization-weighted index by roughly five percentage points in the first quarter. Small companies have beaten both, advancing more than 12% (Exhibit F).
Expectations are high among many that the United States will achieve herd immunity this year. Combine this with new government programs aimed at infrastructure spending and climate change, assisted by continued quantitative easing by the Federal Reserve, and one might recall A.A. Milne in asking “How high is up?” We reckon 2021 will be a pivot year for markets. Equities will likely push higher, fueled by an abundance of liquidity, while the bond market worries about what comes next.
To be sure, taxes are set to rise on both personal and corporate income, as well as on capital in the form of an increase in the capital gains tax rate. Levies will have to rise to fund the transformational programs that the new administration wants to enact. With those tax increases, after-tax returns on equities will fall, making for difficult markets starting in 2022.
Perhaps investors are misplacing their worries about inflation when thinking about markets. Rather, the concern should be a policy pivot that reduces the after-tax return on financial assets, which answers the question: “How high is up?”
Maybe less than markets hope.
1 Bloomberg estimates as of March 22, 2021
2 Business Insider, March 21, 2021
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.