July 1, 2021
“Impressive.” This is undoubtedly the best adjective to describe the markets during the first half of the year. Investors continue to favor U.S. and European companies as year-to-date returns in these markets are all in the double digits. (Exhibit A) With rising vaccination rates and falling infections, it appears the tide is truly turning against the spiky virus that upended societies across the globe. Investor confidence is buoyed by the mountains of cash that are being supplied by central banks and governments. This, in turn, has lifted the share prices of companies, as well as the prices of homes, crypto assets, and a host of everyday consumer items. From our perch, the rise in asset prices appears to make sense. U.S. GDP growth in the first quarter registered north of 6% while second-quarter growth likely ran more than 10%.1 For the year, U.S. GDP is expected to grow more than 6.5% and more than 4% in 2022, a run-rate significantly above the 2-3% range since 2014.2 (Exhibit B)
Identifying the Known Unknowns
We are now seeing a vertiginous pivot from fears of a pandemic-related economic meltdown to worries over rising prices. Have policymakers inadvertently released the hounds of inflation onto an unsuspecting populace? This is the big question hanging over markets now. However, there are several other large questions investors will have to consider. First, is the crypto craze the first step in a digital revolution that has come to financial services, or is it a flash in the pan — a sort of digital tulip? Second, is the meme-stock phenomenon — which appears to combine elements of fad, populist rebellion, and a suspension of critical thinking — a durable development that changes the nature of investing? Third, as the global economy recovers, how will monetary policy be unwound without upending the economic well-being of Main and Wall Street?
On the matter of inflation, breaks in supply chains were always going to be part of the reopening story. For more than a generation, global businesses have honed their manufacturing and supporting supply chains to such a degree that any disruption in the network would impact business. This was evident after the 2011 earthquake in Japan which caused all matter of perturbation in parts of the economy that relied on semiconductors. It was a clarion call for a supply chain that was built for “just in time” to transform into one built for “just in case.”
Temporarily shutting down a large part of the more than $20 trillion U.S. economy, and then restarting it months later, comes with glitches. The clearest glitch occurred with lumber prices. Prior to the pandemic, contracts on lumber traded in the $400 range per thousand board feet. During the shutdown in March of 2020, prices fell roughly 35% to $264. As reopening took hold, prices rocketed higher, eventually topping out at almost $1,700. (Exhibit C) A pickup in homebuilding collided with a shortage of workers to operate lumber mills and truckers to transport the boards. This lifted prices. As I write this, prices are retreating. Highlighting the adage that the cure for high prices is high prices, the rise in lumber prices resulted in a change in consumer behavior as buyers postponed purchases. With demand abating and workers returning to mills, the stage is set for a drop in lumber prices.
Problems in the supply of both material and labor is readily seen in the automotive and service sectors, where a shortage of computer chips in one and workers in the other are causing disruptions in the path to recovery. It is hard to see how this continues as generous unemployment benefits end and workers return to work. The bottlenecks in the supply chain will eventually clear and the price pressures should ease in time. In short, it seems quite likely that fears concerning an enduring episode of high inflation are premature as current price pressures will prove temporary. (Exhibit D)
Understanding the Market’s Exuberance
The crypto markets continue to amaze and befuddle. Bitcoin has become the avatar of a new digital frontier that, if the hype is to be believed, will usher in a new and improved financial future. The price action of Bitcoin and its various spawn does not inspire confidence. (Exhibit E) If it is ever to become a unit of account, store of value, or medium of exchange — that is to say, a currency — it must change. It is hard to think that any corporate treasurer interested in keeping his or her job would add Bitcoin to the corporate treasury. Yet, that is exactly what has happened this year. Crypto assets and the ledger that maintains them are likely to have a future. However, that future is unlikely to involve any country of import using crypto assets as a currency, since any nation that does will cede the critically powerful ability to coin and control the subsequent supply of money. The Chinese government recently made this point, which caused the prices of crypto coins to collapse. Eventually a price of money that is above zero, when adjusted for inflation, will cause a rethink of Bitcoin et al. as a currency. Like gold, Bitcoin has no cash flow. When interest rates are low, the opportunity cost of holding such an asset is low, which draws short-term money to it. Like all things financial, the attractiveness is cyclical, and the cycle looks like it is at a peak. We continue to give this part of the market wide berth, preferring instead investments and markets that enable valuation and business analysis.
The meme-stock phenomenon is another development that appears to have an expiration date. This phenomenon has always been around, but the trinity of unspent stimulus checks, commission-free online trading, and social media chatter amped up the “darling stock” trade. Typically, the objects of affection of retail investors, these stocks tend to have questionable prospects and stories that are thin on substance propelling them. For those who have spent a career navigating markets, this is a familiar occurrence; these periods form when animal spirits are running high, and markets are rising. Fundamentals be damned, the story is good. Sadly, these episodes typically end in a similar way, with the separation of capital from the investor. (Exhibit F)
Navigating the Recovery
The second half of the year is unlikely to promise a smooth return to normal. The path to restarting the global economy will likely remain bedeviled by hiccups, as the British economy recently demonstrated. However, the recovery remains in fine form. In the months ahead, investors will increasingly focus on how policy normalization will be achieved. A “taper tantrum” V2.0 is likely in the cards over the next 12 months. As this becomes more apparent, bouts of market volatility will inevitably ensue. These are all things to be navigated and not feared, for they are part of the recovery.
Our current recommended portfolio positioning now includes overweighting equities relative to fixed income. As growth continues around the world, equity markets are best positioned to capture the ongoing recovery. We have been particularly impressed with the performance of high-quality companies globally. Consequently, we recently cut our underweight to developed international companies as we are witnessing the expected broadening of market participation of non-U.S. companies.
As we have lifted our recommended equity exposure, we have trimmed our recommended fixed-income positions, as the potential for rising interest rates and poor prospects for income generation from these markets offers scant protection or return. (Exhibit G) We continue to find the broadening of market participation encouraging as small- and mid-sized companies are performing well compared to their larger brethren. This should continue as the economy recovers and growth continues.
1 Annual rates of growth. The second quarter GDP run rate is from the Federal Reserve Bank of Atlanta GDPNow model.
2 Bloomberg private forecast composites
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.