John Gorlow
| May 20, 2021
On the heels of a global pandemic and economic shutdown, the financial press has something new to obsess about: inflation. Not much of the discussion is reassuring. Will inflation’s long-anticipated return eviscerate fixed income returns? Will it knock growth stocks out of the ring? Will it derail the market’s recovery? Will it erode the value of the dollar? How will investors be harmed? Here we offer our perspective and advice. First, a recap of last month’s numbers.
April Market Report
The markets greeted April with a spectacular spring bloom. The S&P 500 posted its best performance since November, returning 5.34% with dividends. There was hope, and progress, as large-scale coronavirus vaccination programs continued across the country, helping people return to work as restrictions loosened. Stocks surged higher on the back of massive support from the U.S. government and Federal Reserve, and economic data bolstered expectations for robust economic growth and corporate profits in 2021. Indexes remained near their all-time highs.
With earnings season nearly over, most companies in the S&P 500 surpassed analysts' profit expectations. Forecasters expect that performance to continue, with company profits rising more this year than at any time since the 2008-09 financial collapse. According to S&P Global, results from 85% of those companies that have reported were better than expected and are on track to set a new record that wasn't expected until the second quarter. Analysts expect that in the next three months ending in June, companies in the S&P 500 will notch a 54% rise in profits compared to a year ago. For the full 2021 year, analysts forecast aggregate earnings per share of $185 for S&P 500 companies, rising to $200 in 2022.
The S&P 500 is currently trading at nearly 23 times expected earnings, which is high by historical standards. Though this is where valuations have hovered for most of the past year, bearish investors will also point out that it’s close to where valuations stood at the end of the 1990s, just before the S&P 500 fell roughly 50% before bottoming out. Still, that was then and this is now. Earnings may continue to meet and exceed expectations, but it could be challenging.
After jumping earlier in the year as concerns about inflation rose, Treasury yields stabilized and turned in a solid performance across all categories. The 10-year U.S. Treasury Bond closed at 1.62%, down from last month's 1.74%. Barclays U.S. TIP index returned 1.4%, the U.S. High Yield bond index returned 1.1%, and the Municipal Bond Index returned 0.83%. Barclays U.S. Government Bond Index returned 0.73%.
Oil closed at $63.49, up from last month’s $59.55. U.S. gasoline prices increased, closing the month at $2.96 from last month's $2.94 per gallon. Gold closed at $1,768.80.
Small cap stocks, as measured by the Russell 2000 index, underperformed for the month, posting a 2.02% return for April. This was subpar compared to domestic large cap stock indices.
Overall, foreign markets, as measured by the MSCI All Country World Ex U.S. Index, continued to move higher, with developed markets outpacing emerging ones, returning 2.94% and 3.15% respectively, ex the emerging markets.
U.S. Real Estate securities and Emerging Market small caps were among the top performing equity categories for the period, returning 8.28% and 6.04%, respectively.
Reflecting significant demand over a short period of time following the pandemic, commodities as measured by the Bloomberg Total Return Commodity Index continued to soar, returning 8.29% for the period.
Now let’s take a look at the inflation debate and how we got here.
A Surge of Worrisome News
Everyone saw this coming, right? First, the Covid-19 global shutdown sent commodity and oil prices plummeting, to the point where oil producers were giving away barrels of crude. But once a global economy is crushed, it has nowhere to go but up. That said, few people anticipated the current rebound would happen so fast. Economists predicted that the return to “normal” would be choppy, and they weren’t wrong. Supply chains could be broken or strained. Demand for commodities would spike. Consumers would be ready to spend, but shortages of key components would make prices rise as things got sorted out. This was all predicted. There might be a brief surge in inflation. Give it a matter of months, said some. Give it a year, said others. It will be short-lived, most agreed.
Still, when a measure of U.S. core prices last week registered an annual gain of about 3%, many analysts and economists were caught off-guard. It was the largest annual gain since 1996.
Another concern: a tepid April jobs report that pointed to a slower-than-expected recovery. Economists had expected 975,000 new jobs but instead saw a measly 266,000 added to payrolls. Why were so few people going back to work? Some point to an overly generous fiscal stimulus package that was enacted as the economy was already in recovery, suggesting that lower-paid service workers stood to make more by staying home. Others pointed to the challenges of returning to work while coping with the uneven reopening of schools, daycare centers and other support systems.
The inflation data rattled the financial markets, temporarily driving bond yields to new heights. A long period of inflation could hamper the ongoing recovery, forcing the Fed and central banks to tighten the money supply. It would lower the value of portfolios, debase the currency, and dampen consumer spending power.
Many investors under the age of 60 have never experienced prolonged inflation. Some have become complacent after a decade of raking in huge gains in equities and bonds, aided by aggressive central bank action. If the outlook has now turned muddy, as economists suggest, it will take 6 to 12 months to get a clear idea of the inflation trend. Meanwhile, assets seen as traditional inflation hedges have already seen steep price increases. And it’s unclear whether these assets would be a valuable protective device if inflation was a short-term event, as it was in 2000 and 2008. Disinflationary forces at work then are still at work now, including an aging population and technological innovation.
Battle of the Bankers
The vocal battle of financial policy titans over how inflation should be managed makes for excellent press coverage. An unprecedented firehose of money has been aimed at the economy, including the $1.9 trillion Biden government stimulus and some $9 trillion pumped into the economy by central banks. On top of this is the Biden administration’s proposed $4 trillion infrastructure program. Taken together, it adds up to the biggest infusion of money since the end of World War II. JP Morgan estimates the total spend worldwide of about $20 trillion, an astonishing sum. The IMF predicts a global growth rate of 5.5% in 2021, a superheated pace that would be the highest in five decades.
Treasury Secretary Jay Powell has been explicit in his intention to tolerate higher inflation, based on the idea that fiscal austerity lengthened the period of pain felt by average Americans following the mortgage meltdown in 2008-2009. He believes that growth will roar back and inflation will subsequently subside. Other central banks around the world have followed his lead with aggressive bond-buying programs. Powell has indicated that he will not raise rates until the economy has reached full employment and inflation has hit or slightly exceeded a 2% target. This leaves investors with plenty of questions and no clear direction on when, or how swiftly, rates might rise.
Vocal critics have lined up on the other side. While most would not want to return to the 1980s, when Paul Volcker raised rates to a record 20%, the idea that inflation must be firmly controlled is widely accepted by conservative economists. Critics have seized on the inflation and jobs data to argue that warning bells are going off, but no one is listening. They believe that Powell will act too slowly, and that the excessive fiscal stimulus will ignite an inflation fire that grows beyond control.
Former U.S. Treasury Secretary Larry Summers has been a particularly vocal critic of Fed policy. “I think the prospects for avoiding turbulence over the next several years, both in the real economy and financial markets, would be substantially greater if there was a sense that monetary policy authorities in the United States were focused on the need to avoid overheating ….I would rather see us go back to a Fed that is concerned about preempting inflation….” Summers told MarketWatch (18-May 2021).
Summers assigns equal odds to three possibilities: that all goes according to plan and inflation returns to normal after a one-time surge; that a cycle of ever-rising inflation develops; or that the Fed ultimately causes a downturn that prevents the inflationary cycle. Of course, anyone can predict anything. Real odds are impossible to assign, but the stock and bond markets will signal a direction.
The Investor’s Dilemma
Let’s cut away from the battle of the bankers and policymakers to look at the facts for investors.
- Inflation will mechanically accelerate in the coming months, given the base effects from last year’s incredibly steep economic drop-off. The surge in inflation was predictable based on the turmoil caused by a global pandemic, though the exact number wasn’t. A spurt of post-lockdown spending could make inflation worse in some sectors.
- The longer-term inflation outlook remains clouded. “Inflation dynamics do change over time, but they don't change on a dime,” Jay Powell told a Senate committee, and he is correct. Inflation is a process that takes time, in the same way an overheated pan takes time to ignite a kitchen fire.
- The inflation hyperbole in the press has gone far beyond what the market is actually pricing in. And what the market has priced in has most likely gone beyond what is likely to happen. The current reading for the two-year break-even rate, a proxy for future inflation derived from prices of U.S. inflation-protected government securities, sits above 2.8%, while the 10-year measure has risen to 2.5%.
This is not to deny that investment risk lies ahead. A Fed that is wrong or only half-right could result in an economy that is weaker than it appears but with persistent inflation, creating the kind of “stagflation” last seen about 50 years ago.
As always, the best defense is a soundly constructed strategy for your portfolio, based on your timeline, long-term goals, and risk tolerance. I advise against risky inflation-hedging bets that may not pay off.
If you have questions or concerns about your portfolio, please call me. I am here to help.
Regards,
John Gorlow
President
Cardiff Park Advisors
888.332.2238 Toll Free
760.635.7526 Direct
760.271.6311 Cell
760.284.5550 Fax
jgorlow@cardiffpark.com