The St. Nicholas Viewpoint: 2021 Mid-Year Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist July 12, 2021
Second Quarter Performance Review
US equity markets experienced another bountiful quarter, leaving all major domestic stock indexes with double-digit YTD returns. After a weaker first quarter, NASDAQ led the group, up 9.5% for the quarter. The S&P 500 was not far behind, up 8.5%, and the Dow Jones Industrial Average came in third, up 5.1% for the quarter. YTD, the S&P 500 leads the pack with a 15.3% total return, followed by the DJIA and NASDAQ at 13.8% and 12.5%, respectively. On the international front, Developed Markets (MSCI EAFE) led the way, up 5.2% for the quarter and 8.9% YTD. Emerging Markets (MSCI EM) are a close second, up 5.1 for the quarter and 7.5% YTD. China’s Hang Seng returned 1.6% in the quarter, resulting in a YTD return of 5.9%. And, trailing all major equity markets and reflecting a Covid resurgence in Japan, the Nikkei was down 1.3% for the quarter, leaving the YTD return at 4.9%. Fixed income markets bounced back nearly 3% in the second quarter, but YTD returns are still down about 2% through the end of June.
The market continues to favor cyclical stocks that are rebounding from 2020 Covid lows. While the rational move would be to stick with reasonably-priced growth stocks that have much more consistent earnings with greater visibility, today’s investor is all about short-term performance. What have you done for me today? This naïve attitude is forcing money managers to abandon long-term disciplines and chase cyclical stocks that might get 3% or 4% more this year, but will be a rotten place to be next year when earnings collapse – or completely disappear in some cases. We’re willing to wait out what may be short-term underperformance in 2021 in order to stick with stocks that have very visible earnings going forward – regardless of the slowing recovery. GARP (Growth At a Reasonable Price) worked extremely well for our clients last year, and should continue to see relative performance gains when the economy slows from its initial explosive peaks. We may yet outperform in 2021, but even if we don’t, it’s not worth abandoning a strategy that has consistently and significantly beat the markets, just because the market’s short-term rotation may not favor our style. Continue thinking longer-term and the rewards will accumulate.
While it’s no surprise that the Fed remained on its pre-prescribed path at its last policy meeting in June, it was quite obvious that discussions are beginning to simmer. Last month, the Federal Reserve Bank board voted to maintain rates at 0%, as well as to continue their monthly bond purchases – quantitative easing – in the amount of $120 Billion per month. The surprise came when the Fed made specific mention of forecasted rate increases – two beginning sometime in 2023. This is the first time in a very long period that the Fed has actually laid out specific actions that were tied to a particular time period.
However, this was not the only hawkish tone coming out of that meeting. Though it has long been speculated that the Fed would begin to “taper” its monthly quantitative easing before it initiated rate increases, the timing of any initiation of that tapering has never really been discussed. While the Fed did not actually provide specific dates for the initial tapering, they did disclose that they were “talking about talking about” it. Obviously, there is now little doubt that tapering will be on every Fed meeting agenda going forward, so be prepared for a tapering announcement sometime this year.
On the inflation front, the Fed has already committed to letting inflation run above its long-term target of 2%. Clearly, the latest CPI numbers suggest that price increases are not only occurring steadily, they are hitting levels that even the Fed probably didn’t expect. As a matter of fact, we’ve seen some numbers that are higher than anything we’ve seen since the 1990’s. Oddly, the Fed shows little concern, instead falling back on their preferred interpretation that such price jolts are only temporary and looking at recent price behavioral anomalies like the recent 50% decline in lumber prices (in just a month or two) as justification that patience is warranted.
While we’ll admit that we have greater inflation concerns than Fed Chair Powell, we can indeed understand and accept that the “inflation is temporary” thesis might actually hold water. Getting back to fundamentals, recall your basic economics and the notion that price is simply a function of supply and demand. If we hold to this logic, we can break down the two main causes of price increases. First, let’s examine demand. Demand push inflation occurs when demand increases and supply either stays the same or even declines. 2021 has seen a huge increase in demand simply as a function of the Covid rebound. Consumers are finally out and about after months of being shut-in. Discretionary consumer spending fell off the cliff last year. Now, all that pent-up demand (and the inherent cash build-up), is back, with consumers making up for in a few months what they have been unable to do for well over a year.
Now let’s break down supply. All that excess demand has to be met by growing supply or inflation ensues. Logically, if there has been little discretionary spending, there should have been a natural accumulation of unused supply, right? Perhaps at first, but don’t forget that manufacturers were also shut-down (or partially shut-down) for months as well. On top of that, no revenue for these businesses meant that many had to unload excess supplies at cut-rate prices. And now, right when manufacturers and other suppliers need help rebuilding inventories, workers aren’t coming back, partly because of safety concerns, but partly also because welfare and Covid relief programs have made it easier to simply stay home. Let’s not forget either, that a global recovery is not yet happening, and there will continue to be measurable deficiencies in many components of international supply chains that directly impact the US economy.
So, we’ve got a double-whammy on prices: demand has increased dramatically, and supply can’t possibly keep up in the short-run. Is this temporary? You bet. Will it result in an extended period of inflation, or will it too taper off as the Fed hopes? We can’t really say ourselves at this point, but we’d be more inclined to believe in the temporary argument. Our biggest concern is that, even if supply catches up as demand subsides and we eventually reach price equilibrium, will the residual inflation be too high to ward off the more lasting impacts from wage-push inflation? Even though Covid relief transfers will be severely curtailed, firms will still be paying higher wages to attract (and retain) enough workers for normalized production. Our best guess for now is that inflation will be controllable, but more likely at higher levels than what the Fed is hoping for. We’re not talking double-digit levels, but more likely in the 3%-5% range, which is enough to impact markets – particularly bond markets.
The Equity Markets
Stocks continue to climb higher, based mostly on the momentum behind cyclical stocks as the economy springs back from nearly nothing just six months ago. This in spite of the fact that we are starting to see a peak in the level of growth we’re experiencing. Please don’t misinterpret this – growth is still very positive, but the rate of growth is actually starting to fall. Decelerating growth is probably an apt term. This early peak is certainly not unexpected. The explosive onset of the economic recovery was fueled by pent-up demand, massive fiscal stimulus, bloated savings from a year of doing nothing, and Covid stimulus programs and payments. The real question now is whether stocks have adequately discounted future economic growth and its impact on earnings. We’ve mentioned before that stock prices will peak well in advance of the economy, so the real unknown is whether the growth that is left is more than what is already reflected in stock prices…or worse, vice-versa.
This is where valuation and stock selection can really come back into play. Unfortunately, valuation metrics are still a blur. We’ve never experienced a shutdown like we had last year, and we don’t have a crystal ball to re-create accurate forecasts. Realistically, we’re also working from a severely distorted base, and the basic valuation calculations are very distorted as well. We’ve said in the past that we’re flying blind and guided mostly by intuition, and that’s still mostly the case. On the plus side our stock selection methods have focused on stocks whose earnings (and earnings growth) are more visible. These companies also had less disruptions than most of the more economically-reliant businesses. We did not pick these companies with the notion that they would do best if the world shutdown. Prior to 2020, that type of a consideration would have been deemed not just irrational, but marginally insane. However, it was a conscious choice to use GARP (Growth At a Reasonable Price) as our primary methodology, fully knowing that such a strategy would leave us with companies that had visible earnings growth – earnings that we knew would be much less sensitive to declines in economic activity. A – maybe more important for the next year or two – less sensitive to interest rate increases.
Speaking of interest rates, we’d also like to see the equity markets stop looking to the 10-year US Treasury yield for direction. While we understand that there are equity valuation models that use the yield as a discount rate in determining the future value of equity cash flows (like the widely known Dividend Discount Model), we just don’t see the value in using a single rate as a buy/sell signal. The notion of it is really kind of ridiculous, especially considering the laughable number of vacillating targets that have made their way to becoming “the buy/sell signal du jour”. All it does is create unnecessary volatility for short-term traders who have no defined discipline. By example, we talked last quarter about an extreme equity sell-off that was triggered by the 10-year rate surpassing 1.5% – a fairly arbitrary level that had been passed and revisited several times in the past few months. As we write this, the market is now dealing with a 500-plus point sell-off because the 10-year now dropped below 1.25%. Make up your mind traders…which level do you want? Even for novices, the dual logic simply doesn’t work.
We look for equity markets to continue to trend positive, with the upward bias dependent upon the good economic news continuing to dominate headlines. Yes, there will still be short-term threats – the fear of a Covid resurgence, weather-related catastrophes, the fear of inflation spikes, etc. – but the markets will generally remain healthy as long as earnings continue to grow. Earnings reports coming this month should be as expected – healthy with few surprises. We think third quarter earnings will look good as well, but at some point many of these companies will feel compelled to warn of the coming slowdown, and those warnings will be enough to halt the general rise in markets. Further price increases can certainly continue for companies with the earnings growth to support it, but the rising tide that has thus far lifted all cyclical ships will begin to ebb.
Given our earlier extensive discussion on inflation, it’s a pretty good guess where our bond examination goes. There’s no doubt that unexpected inflation will put upward pressure on interest rates. Higher prices typically mean higher than expected demand, and it’s the Fed’s responsibility to use monetary policy to modulate that demand so that the economy doesn’t grow too fast and result in even further inflationary pressure. So, what would we expect the Fed to do? That’s right…raise rates to slow things down. So, inherently, inflation expectations translate to Fed actions which in turn result in higher rates – that’s what cause the upward pressure. So, it’s puzzling then, in the midst of all these CPI increases, that not only have rates not gone up, they’ve declined yet again.
Short term, we have no explanation other than a reversal in inflationary expectations. This theory is not supported by anything other than the Fed’s comments that insist these price increases are temporary. We know that the Federal Reserve Board works as a cohesive unit, but don’t think that they all support the “temporary” theory. Still, is that enough to cause rates to decline? We don’t think so. Like stocks, bonds are a trader-dominated market, and we think this recent rally is a result of short-term trading surges. We still have to look at the evidence. The US economy – still in recovery mode – is building, not topping. Prices are still going up a lot and the labor market needs to improve significantly to reduce supply-side inflationary pressures.
We simply cannot justify chasing bond yields that offer so little. We’d rather own cash and get nothing than buy bonds yielding under 1% that also hold the potential to decline 5%-10% or more when rates go up. Additionally, since we’d have to go out three years or more to get 1%, we risk not being able to lock-in 2%-4% in just a year or two without selling at a loss. Again, better to exercise patience than take losses on bonds. The question then becomes why pay a money manager to hold cash? The answer is that the cash we’ve been holding so far has missed out on 5%-plus bond market declines. Holding for the right yield level also saves your bond allocation from further declines. Finally, getting the right yield at the right time is what good managers do. The best long-term returns (in any asset class) always include periods of negative returns. We’re going through that presently. It’s how one manages through the entire cycle that makes it worth the cost.
The irony of writing this conclusion is that we are not even close to a true conclusion as far as the pandemic goes. Truth be told, the end of Covid is nowhere in sight. While it feels like we’ve turned a corner here in the United States, the rest of the world is still suffering. There are many countries still in the heat of the battle, while other recovering countries are getting hit a second time. At this point, it isn’t safe to even conclude that the US won’t suffer a second impact. This would be devastating to our recovering economy and the markets as well. The Covid tome still has many chapters to be written.
Absent a resurgence of the virus, the US still has to deal with the implications of a Covid-strained recovery. Frankly, with all of the negative global news, it is very surprising that our markets have not discounted the much lengthier battle. Still, there is hope. US Vaccination rates are high, but not as high as we’d like to see. Full crowds in restaurants, theaters, concerts, and sporting events without material outbreaks is very encouraging. Let’s hope this trend continues. Even so, we’ll still have to deal with figuring the magnitude and length of the recovery, as well as the impacts of the new administration’s fiscal policies (tax increases, welfare transfers, antitrust legislation, and civil unrest policies) which are certain to have constricted impacts on long term growth. The road to true recovery is still far into the future, and any guess as to what a normalized Covid-controlled world will look like is pure speculation.
P.S. We would like to remind clients that all of our written Policies and Procedures are available upon request at any time. We are also required to notify clients of the availability of our regulatory Investment Advisor Brochure/Form ADV and Form CRS on an annual basis, so please contact us at 904-470-0102 with any requests.