It’s hard to believe it has been more than a year and a half since the outbreak of COVID-19. While the world seeks to move forward, the latest headlines raise concern over the delta variant threat. Meanwhile, it’s quite evident the capital markets have put the pandemic behind us, at least for now. Nearly $10 trillion dollars injected by the central bank apparently can do wonders to calm the nerves of investors. Given how far we have come in the markets in such a short period of time, the number one question we are being asked from clients and investors is what we should reasonably expect as we move into the second half of 2021. Of no surprise, many are concerned about equity valuations and inflation risks.
I could address various economic data and market fundamentals to identify what should happen over the course of the rest of the year, however, I believe since the end of the 2008 Financial Crisis we’ve seen that what “should” happen really does not matter. Clearly, if the markets effectively have a financier with an unlimited checkbook (as in the Fed), the markets can apparently stay rather irrational for far longer than perhaps you or I can remain sensible.
For instance, when you see the likes of AMC Entertainment Holdings you can’t help but wonder what sort of alien has possessed investors. Consider that pre-Covid, AMC had fallen by -60% and subsequently dropped by another -75% through the end of 2020, but has rallied by as much as +3,700% so far in 2021, AMC is now trading at levels that are nearly 10x the price it was trading before the crisis, which begs the question: Is the movie theater business really going to be ten times better than it was before we had the pandemic?
And then there’s Hertz Global Holdings, now trading nearly 3x the price it was trading before it declared bankruptcy last year. We must ask the million dollar question: Why? Is Hertz suddenly a well-managed, healthy long-term company to own? You don’t have to look very far to find many familiar, and rather nonsensical, stories in our equity markets. Which brings me to a key point as we look ahead to the second half of 2021 and beyond.
THERE MAY BE ONLY TWO WORDS THAT MATTER GOING FORWARD
There may be only two words that matter going forward. The first is the Fed. After all, they are the big “financier” these days. It doesn’t seem to matter how rich stock valuations get, how tight credit spreads become, how much credit quality diminishes, or how speculative some of the trading activity is - as long as the Fed remains committed to keeping monetary policy loose (even if reckless) risky assets appear destined to rise. But should we be so complacent?
This leads to the second word that matters, because it is arguably the only force that may end the monetary policy madness. This second word is inflation. According to the Fed, recent inflationary pressures are only “transitory.” While they may be right, keep in mind, this is the same Fed (granted, with a different FOMC Chair) who said, “We believe the effect of the troubles in the subprime sector will be limited and we do not expect significant spillovers to the rest of the economy or to the financial system," Bernanke, 2007.
So, what about the very real question, what if it we end up with inflation pressures that last longer than “transitory”? Remember the 1970s? I started in the business in the late ‘80s, when inflation was still a big economic headwind. President Regan said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
In 1988, when I started in this business, homeowners were borrowing money at 14% variable interest rates. Consider what a sharp increase in interest rates could do to the housing market, let alone the impact of the rising cost of living for the 55 million retirees today.
If inflation persists, the Fed’s policy of “doing whatever it takes” to support the economy and financial markets with zero interest rates and copious asset purchases would likely be forced to come to an end. So, be mindful and do not underestimate the risks. The market may leave the Fed with no choice but to react to inflationary pressures, which mean potentially swiftly rising interest rates. The more rapidly any such sustained inflation pressures take hold, the more abruptly the Fed could be forced to act, which could be a shock to the markets. How do you suppose the capital markets would react under such a scenario? Perhaps the word “ugly” does not even begin to describe it.
Of course, there are countertrends serving as tailwinds, pushing the markets forward; therefore, we must also recognize the potential upside. Indeed, there’s plenty of upside potential to address, and if you want to wear rose-colored glasses, you could find sufficient justification to be “all in” right now. Nonetheless, the Fed and inflation are, in my humble opinion, by far the most significant downside risk facing investors. That said, just because we identify this as a risk does not mean it is going to happen.
Also, I think it’s important to remember that any economic upset is likely to be temporary. Just as when there’s a major traffic accident, the freeway isn’t permanently shut down, the economy will surely eventually recover. But everyone may be brought to an immediate stop, such as when there is a major crash on the freeway. Rest assured, some will get hurt (especially those with the riskiest and/or leveraged portfolios), but for most, the traffic flow will bottleneck, causing delays and aggravation, but just as drivers intuitively find detours, investors will navigate through a calamity. Eventually everyone will get back on their merry way, just as we do after a traffic incident, and it’s important to keep that in mind because, likewise, I am confident the same will be true in the event of a sustained inflationary cycle. Investors and consumers have a history of being quite resilient and have demonstrated the ability to adapt. The concern, though, is how long it might take the markets to acclimate to a new and very different type of economic environment. We have not experienced inflation risks for many decades so the impact may largely depend upon fiscal and monetary policies.
I am also somewhat concerned that the swift market rebound last year may have given some (specifically, inexperienced) investors the illusion that market upsets are fleeting. Most Millennials have never directly experienced the financial losses from a major upset such as the Financial Crisis or the Dot Com bust. Keep in mind, the S&P declined for three consecutive years from 2000-2002 and the entire decade of the 2000s was essentially flat for the S&P 500 because of these two calamities. Many have long forgotten the pain of risky assets and yet, to only embrace the reward is a danger to everyone.
Regardless, money will flow where it is treated best so I’m sure there will be no shortfall of opportunities in the event of a market upset. The key is to be positioned so you can be nimble, quick and able to pursue such opportunities. Additionally, investors should be able to answer the question: How will a major market drop impact my financial goals? How will a market drop of 20-40% affect my retirement plans? Perhaps now is the time to stress-test your portfolio, especially if you are approaching retirement.
At Longevity Capital Management, we believe it is important to be sure you are invested in a manner that will best provide for the flexibility to navigate through such a situation. This is particularly true if you are seeking to generate income from your portfolio. We are always prepared for a market upset, particularly since they tend to occur unexpectedly.
Are you prepared?
Right now, I think most of us can agree that “traffic” (the stock market) is moving very fast, perhaps beyond a healthy speed. Furthermore, when the freeways are getting heavier, the risk of an accident increases. There are more investors today and, of greater concern, more speculators being drawn to the US equity market, which means the means the risks of an “accident” are steadily increasing. Of course, if traffic continues to flow smoothly, we may have nothing to worry about.
And that brings me to the good news as we enter the second half of 2021. Despite the Fed’s relentless monetary spending, inflationary pressures are suddenly cooling. While this may be short-lived, a number of indicators foreshadowed this recent change in inflationary pressure so we may see inflation risks diminish in the coming months.
One indicator, for example, is the 10-Year U.S. Treasury yield. It had previously spiked from 0.52% in early August 2020 to 1.74% by the end of March 2021, raising big flags of inflation concerns. However, yields have since fallen to 1.49% over the second quarter. Similarly, while the U.S. Treasury yield curve (which has an uncanny track record of predicting future recessions when it inverts) was dramatically steepening (an indicator of future inflation risks), it has suddenly reversed course and flattened. Granted, this trajectory can also swiftly change direction based on investor behavior, however as we enter the second half of 2021, these indicators suggest the markets are no longer worried about a sustained inflation outbreak, at least at this time. Instead, they are increasingly suggesting a robust economic recovery scenario. While that may prove to be temporary, the upside still appears favorable.
There are certainly trends that are moving positively, but scrutinizing the data, on the flip side, we are seeing a hint that the market may be eventually returning to a sluggish economic growth environment, not unlike what we experienced post-financial crisis. After all, the numerous realities we face such as rising taxes, blistering housing prices, a transitioning job market with Boomers retiring in unprecedented numbers (and many ill prepared for the costs of retirement, by the way), along with massive federal debt, a social security system running insolvent, and rising wages, certainly don’t point toward great economic health in the years ahead. Does the term “stagflation” ring a bell? I may write more about that in future blogs.
For now, though, as the pandemic continues to abate, the consensus outlook for the U.S. economy remains quite favorable. U.S. real GDP for 2021 is projected to end at a very healthy 6.0%. We are seeing projections of slower but still favorable growth for 2022 at 4.6% and despite that it is anticipated by 2023, we will be slowing down slightly, there is still plenty of optimism over the outlook to 20231. If we experience economic normalization, assuming consumer spending stabilizes in the months ahead, I might feel more confident about the next few years. Once the re-opening comes to pass, the consensus believes the economy will return to normal levels. But in all my years of experience, I cannot say this is a time where “normal” is in my vocabulary, so I’m not sharing in that sentiment at this time.
As Sir John Templeton once said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”
Nevertheless, things do appear to be moving in a positive direction. The US economy gained 850,000 jobs in June according to the US Bureau of Labor Statistics, beating Bloomberg survey estimates for a 720,000 job gain. And although the job participation rate is still concerning, we are seeing huge pent-up demand. It is possible we could underestimate job growth magnitude and duration. The International Monetary Fund (IMF) expects 6.4% U.S. GDP growth for 2021, which is more than double their January estimate of 3.1%, after U.S. household income growth soared to a record 21.1% this March.
The recovery has come down to whether there has been enough stimulus to sustain us through the shutdowns. Indeed, many U.S. consumers have been stashing cash, and they have already begun to turbocharge the recovery. Aided by stimulus checks and a recovering job market, personal savings rates soared to 21% of disposable income in the first quarter of 2021. But consumers have already reported plans to use some of their stash to take long-delayed vacations or simply get out of the house and go out to eat. I just took my family to Florida for a short vacation and despite the limited attendance in the Disney parks, restaurants were booked solid. In and around the parks, wait times, even with reservations, were over an hour in some cases. It is reported that bookings for domestic air travel as well as restaurant reservations (such as those placed through OpenTable) are rebounding strongly.
Let’s face it, we like experiences and connectedness with others, so it makes sense that travel and dining out are roaring back. But that’s to be expected and the markets anticipated this, so investors must ask, have companies become even stronger because of COVID?’
For sure, many businesses have taken initiatives to drive growth. For instance, cruise lines have established strict protocols to limit the spread of illness when sailing resumes and companies like Hilton are buying more properties and streamlining operations. In food service, restaurant operators adopted pickup services, online ordering and contactless payments. Examples are everywhere. Retailers like Target, Costco and Home Depot are ramping up their online operations to take on Amazon. And General Motors and Volkswagen are challenging Tesla in electric vehicles. Some companies have definitely used the crisis to innovate and improve, but not all. So the key is to seek to invest in those that are positioned to surpass the competition after the reopening. As for more growth-oriented stocks, shares of many leading digital businesses soared in 2020 but have languished in 2021. But that does not mean they are ill-poised for long-term growth. We do see some opportunities arising for patient investors. And since we measure our success by the long-term progress of companies rather than by the month-to-month movement of their stocks, we are taking on some positions at this time.
There are other areas that, regardless of what happens with inflation or economic cyclical changes, are likely to rise above in the next expansion. For instance, digital payment technology, which accounted for 9% of all total U.S. payments in 2019, increased 66% in 2020. It now accounts for 15% of all payments, which means there’s a lot of room to grow2. I don’t see that trend regressing. Telemedicine, or online appointments, accounted for a fraction of total doctor visits prior to the pandemic, but in the early months of 2020, about 20% of all doctor visits were via teleconference. Doctors can see more patients and work from anywhere with telemedicine.3 While I’m not personally a big fan of telemedicine, the aging population coupled with a shortfall of physicians suggests it is here to stay. It is estimated the US will face a shortage of up to 100,000 physicians by 2030, according to study commissioned by the American Association of Medical Colleges.
We see many of these Covid-19 behavioral shifts to be long lasting. Contactless purchases, ecommerce, digital payments, virtual meetings, telemedicine, remote working and more is likely here to stay. Growth may slow a bit in some areas, but I think it’s highly unlikely we’ll see a reverse of these trends. Furthermore, many streaming companies are releasing new movies through their services at the same time they are in general release. As people physically return to theaters, do you think this practice is going to stop? I don’t think so. I think it’s likely to pick up speed. Disney made $35.5 million on its opening weekend of Mulan from Disney+ subscribers, and that’s all profit since they didn’t have to pay distribution fees4.
Carry Onward, Cautiously
Still, the markets may be expecting more than what might be realistic; a trend we have seen many times during past booms. Do you recall the frenzy and ridiculous expectations in the growth of the world wide web back in 1999? Eventually, the internet and smart technology has reigned, but it took nearly twenty years to develop and expand its dominance and, essentially “catch up” to investor expectations. While Covid-19 certainly accelerated the adoption of many technologies that may have otherwise taken years to embrace, I believe we will have some catching up to do in the decades ahead. And that means profitability expectations may not be met. After the dust settles with this re-opening, we will likely have a better view of where progress, success and sustainability will meet.
Putting all of this together, while the threat of rising inflation and a shift toward tightening monetary policy from the Fed loom as the most significant risks confronting investors, I believe such risks may remain in check for 2021, provided current trends hold. Inflation pressures appear to be moderating, which could provide the Fed the flexibility to keep their foot fully on the monetary gas pedal for the time being. As such, risky assets including stocks, regardless of their high valuations, are viewed as favorable as we enter the second half of the year. But it might also be time to look at the international markets, as there appears to be more attractive valuations ex-US.
It is worth noting that the S&P 500 Index remains on a blistering uptrend since the start of 2018, thanks in large part to the Fed intervention. I fully believe that had the Fed not responded so aggressively to the pandemic, we would be in a far different (and not very good) place today. So, despite my concerns, I applaud the Fed action. I believe they did what was necessary, even if not necessarily a good thing for us in the long run. That said, I am not for further spending at this time. I would like to see the $40 billion monthly MBS purchasing cease. After all, do we really still need this with home prices rising at a blistering pace in many markets?
The S&P 500 uptrend appears to remain firmly intact as a result of an abundance of support to keep stocks moving to the upside. Naturally, we should always be prepared for a correction, especially in light of the current valuations. Any less-than-staller news could cause investors who are already concerned about an overheated market to retreat. However, I also see any such correction as a potential buying opportunity, depending on the underlying market conditions at the time. And of course, please always consider your goals, risk tolerance and time horizon before investing.
Our theme for the remainder of the year is “carry onward,” albeit with caution. The capital markets are confronted with a clearly defined major downside risk, however, I am of the opinion that as long as this risk remains in check (and it appears that it will be, at least for now), the underlying backdrop remains positive. Despite their increasingly rich valuations, US stocks appear to be the favored bet short-term. My advice: Don’t lose sight of the risks, look beyond the US and be sure you have a smart defense, especially a hedge against inflation, built into your portfolio.
It is probably time to think “out of the box.”
Having strong thought leadership to pilot you through the markets may prove to be invaluable in the years ahead. This is not, in my opinion, the time to navigate the markets on your own unless you have extensive experience, wide-spread knowledge of the markets, plenty of time to be attentive as well as access to important research and resources. If you are working with a professional, be sure your advisor’s approach is aligned to your philosophy and be confident he or she has their hands all in on the pulse of the economy. For those in or near retirement, now is not the time for mediocre leadership.
As always, if there is anything we can do for you, please don’t hesitate to contact us to schedule a complimentary consultation.
1 The Conference Board Economic Forecast for the US Economy. 2The Nilson Report. 3Epic Health Research Network. 4MSN.com
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.
Government bonds and Treasury bills are guaranteed by the US government as to their timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.
International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities.