Friends,
Thus far, almost eight full months in, 2021 has proved to be a productive year for investing. Led by the US market, global stock market returns are broadly positive. Bond returns have been essentially flat, reflecting low interest rates across the board. We are not free of the covid pandemic, but life is making a return to a degree of normalcy for most of us. Household incomes are up, and consumer demand is resilient. Businesses are back on line, although still hampered in spots by supply shortages and higher costs. The last eighteen months have not been always smooth, and at times they’ve been frightening, but they’ve also taught us an evergreen investing lesson: it’s not timing the markets, but rather “time in” the markets, that helps for positive investor outcomes.
We wanted to share with you some of our inside discussions; what we are thinking about as we navigate the investing landscape. This note is a bit longer than our others, but we wanted to give sufficient air time to important issues in front of ourselves and our clients.
- What’s going to happen to the economy with the Delta variant?
The covid Delta variant refers to a highly contagious strain of the virus that has spread throughout the globe. Delta is capable of making vaccinated persons sick in “breakthrough” infections, although the vast majority of vaccinated people suffer only mild symptoms if they become infected. Delta has been hard on unvaccinated populations, however. There are numerous hot spots in the country at present, many in the South, where vaccination rates have lagged. Multiple hospital systems have reported critical ICU bed shortages, and nationally, covid deaths are again running at over 1,000 persons a day.
Despite the raft of bad news, there are causes for optimism: in response to the Delta wave, vaccination rates have picked up notably, and the FDA just cleared the Pfizer vaccine for regular use (its prior authorization was for emergency use), with Moderna’s approval expected to follow. At present, about 52% of the eligible population (ages 12 and over) has received full vaccination, and 62% of the population has received at least one dose for partial protection. Vaccinations, combined with naturally-occurring covid infections, are providing an increasing protection level to the population. The current run of Delta infections is showing signs of peaking, although we expect case counts to continue to grow at a slowing rate. Last, we have learned a great deal on treating persons actively sick with covid, and though it can be a deadly disease, the vast majority of people recover from an infection.
With mounting case counts and increasing fatalities, a natural question is what will be Delta’s impact to the economy, and to life in general. At present, we see the impact on the economy as limited in scope, although community resources will be burdened in hard-hit localities. Covid-exposed industries such as travel and leisure could see dampened demand and a slower recovery. Employers are likely to delay the return of remote workers. However, we see the prospects for wide-scale shutdowns to the economy as being quite remote, barring no adverse developments with new covid mutations.
- How is the economy doing in general, and what’s the outlook there?
We see the national economy as strong, but dealing with a few noteworthy challenges. The economy grew at a 6.6% rate in the second quarter, and has recaptured its output losses related to the pandemic. The US economy is approaching $23 trillion in aggregate value, representing a record. Record pandemic-related government spending has helped to support the economy, and a massive, multi-year infrastructure spending bill is set for a vote next month.
Due in part to the pandemic, there are supply disruptions in a host of industries, with autos being the most prominent. Persistent shortages in semiconductor chips have affected new car manufacturing, resulting in uneven availability of models and very low dealer inventories. New car shortages, in turn, have helped to keep used car prices high, as consumers turn to that market for their needs. Other shortages have presented in the last several months—furniture, various food items, lumber, chemicals—affected by demand surges, poor weather, even factory fires, but most supply situations are improving, save for semiconductors.
Perhaps the biggest shortage of all currently is labor. Simply stated, there are over ten million job openings in the economy, a record, at a time of relatively low unemployment. At present, labor shortages are common in-service industries such as restaurants and retail, but in truth the economy is short of workers far and wide. There’s little doubt the worker shortage is limiting the full operational flexibility of businesses, but it is also forcing them to think about how they organize and dispatch work. Ironically, fewer workers may be good for the economy, from a productivity perspective.
Our outlook is for continued growth in the economy, although at a slower pace as the reopening matures. The recovery in corporate earnings has been substantial and we expect further growth there, too, helping to work off stretched valuations on the stock market. For the full year of 2021, S&P 500 earnings should set a record, helping to support stock prices.
- What’s the outlook for inflation?
The inflation question is one of the most significant facing investors. Following years of quiescent inflation, running about 2% annually, the economy has experienced a burst of inflation as the global economy restarted itself. Price spikes from supply-demand mismatches were relatively common earlier this year, but have largely moderated. The shortages we noted above, in used cars, lumber, food, and also several commodities and energy, led to
significant price surges. Many price increases have moderated, but others have not fully. The Consumer Price Index (CPI) rose 5.4% in July from a year earlier, 4.3% on a “core” basis which excludes changes in food and energy prices. The Fed has told investors to expect a bout of demand-driven inflation with the reopening. That has been the case, of course. Investors, and we, are watching closely how the story unfolds from here.
The bond market, at present, is telling us not to worry about longer-term inflation, past our current moment. A popular forward-looking view on inflation expectations called a break-even spread is showing inflation expected to be a modest 2.27% over the next ten years. This measure hit a high of only 2.54% in May, even when we were dealing with the worst of the price spikes mentioned above. In the eyes of the market, inflation expectations remain well-anchored, and current concerns over future inflation are simply that, concerns.
There are some reasons to believe that inflation may be more persistent than the Fed hopes for. It stands to reason that, if the economy stays strong, the tight labor market would resolve in the direction of higher wages, which will tend to ripple through all wage scales. (If an employer is raising new worker entry-level pay, persons already employed will want a wage bump as well.) Higher wages are a positive at the individual level, but they will tend to drive up the prices of things we buy as consumers. Another factor lies in the hot housing market, and the sharp increases in home values. Housing price changes do not directly affect the “Shelter” component of CPI, but they can feed into inflation statistics indirectly. (Changes in rents are a direct feed into CPI.) In sum, we believe there is upside risk to inflation expectations; price changes could stay higher for longer.
- Will interest rates ever go up again?
Courtesy of the Federal Reserve, very low interest rates have been a hallmark of our investing times, dating back to the 2008 financial crisis. Since the pandemic’s onset, rates have been slashed to near-zero, and the Fed has also been a heavy buyer of US government securities, which has the effect of injecting additional money into the financial system, and helping to keep a lid on longer-term interest rates. (The Fed mandates the level of short rates.) There is little doubt that plentiful and cheap money has impacted investment markets, helping to keep both stock and bond prices elevated. Low rates are not only a US phenomenon, as they are low around the world, in some cases negative.
The Fed has come under increasing scrutiny for its easy money policy when the economy is showing strong growth and inflation is running hot. In recent years, the Fed has provided ample advance communications to the markets regarding its policy and any anticipated changes. At present, investors expect the Fed to, first, reduce its bond buying, followed at a later juncture by beginning to raise interest rates toward a normalized level. Few serious market observers would contend that rates are at a normal level now; the reality is they are too low, influenced by the heavy hand of the Fed. Inflation is eroding the value of money at a faster pace than interest rates can pay investors to earn on their cash.
We believe the interest rate conundrum is dependent on the path of inflation. If inflation runs higher and longer than is expected, interest rates will have to move higher. The laws of financial physics will demand it. If inflation remains in a moderate zone following its current burst, rates may not move appreciably higher. Awash in indebtedness, the global economy is sensitive to higher rates, and can ill afford them. Central banks have every incentive to keep rates low in a bid to boost growth. Higher inflation may force their hand, however.
- If I had new money to invest, is it a good time? Where would I put it?
On behalf of our clients, we continue to navigate a dynamic investing landscape. Across the several investment programs here at Ascent, we have been active in repositioning client funds in light of prevailing and expected market conditions. We have increased our exposure to non-US stocks, and for suitable accounts, have introduced a new equity strategy (Ascent Income Portfolio). This strategy steers toward stocks with below-market valuations and paying above-average dividends. In our fixed income investments, we have boosted holdings in inflation-protected bonds, and kept our maturities below benchmark averages. For qualified investors, we continue to expand our reach in alternative investments, comprising a spectrum of private market investments with attractive risk and return profiles, and just as important, not subject to the daily volatility of the public markets.
We believe it is (almost) always a good time to invest. With our investment rigor and focus on quality, as we noted above, success will come to those with “time in” the markets.
Respectfully submitted,
Scott C. McCartney, CFA
Partner & Chief Investment Officer
Mark Moshier, CPA
Partner
Bradley M. Kowalczyk, J.D., LL.M
Partner
