April Investment Comments
Government intervention has made it more difficult to read and predict economic tea leaves. Record low interest rates not only allowed homeowners to refinance their mortgages, but companies also refinanced their debt and increased their borrowings. This extended into “junk bonds” where yields edged below 4% before rising recently. Such a rate used to be reserved for only the most creditworthy companies, which were recently able to borrow for less than 1% on a short-term basis and less than 2% on a long-term basis.
Statistics for unemployment, retail sales, and personal income must now be interpreted in the context of stimulus payments and COVID-related restrictions on businesses. Retail sales fell a stunning 3% in the month of February compared to January. However, January was up 7.6% from December on a seasonally-adjusted basis that takes into account normal patterns like holiday spending. Government statisticians struggled to keep up, as the January surge was originally reported as a 5.3% gain.
The runup and decline were largely attributable to $600 stimulus payments that went out in early January. Rather than looking at monthly trends, we need to look longer term to gain an understanding. Over the past three months, retail sales were up a healthy 6% from the prior year.
The number of new jobs in February was reported as 379,000, a sharp increase from recent trends. However, the improvement mostly came from re-opened restaurants and bars in many states, which had weighed down results in previous months. Excluding “leisure and hospitality” jobs, the February increase of 124,000 was moderately lower than January and December. The decline is largely due to poor weather which reduced construction work even though homebuilding has been on the upswing.
Home prices surged 10.4% in 2020 on rising demand and diminished supply; the supply of homes for sale was down 23% from the prior year-end. Government influence is in evidence here as well due to the impact of much lower interest rates on affordability, leading to rising demand.
Industrial production dropped abruptly in February due to weather disruptions and a shortage of semiconductors that has plagued the auto industry in recent months. Analysts blame the shortage on surging demand for technology equipment in the work-from-home era.
The issue is where do we go from here and how do we measure our progress? The recently-enacted $1.9 trillion American Rescue Plan will put more money in people’s pockets, in fact almost every household. The government estimates 160 million payments will be sent, vastly exceeding the 10 million jobs lost compared to pre-pandemic levels.
Money sent to the 150 million people who didn’t lose their jobs will create a perfect storm, arriving as warmer weather and accelerating vaccine distribution would have already stoked demand. As Scott Brown, chief economist for Raymond James Financial, phrased it, “People are likely to go nuts, we think, in terms of wanting to get out there and do stuff.” Economists call this “pent-up demand.” Despite government warnings that people are hurting financially, savings rates are broadly higher and cash balances are bulging as people with jobs have money, but few big-ticket opportunities to spend it. In short order this is going to get very interesting.
We may not have a precedent for a sudden, mass uncoiling of a wound-up economic spring. There was a similar uncoiling after World War II as Americans let loose following a long, damaging war preceded by a long, damaging Depression. However, the sudden drop in production of military equipment following WWII led to an immediate recession, rendering comparisons to today less helpful.
Many investors have begun to worry about inflation. Yields on 10-year bonds surged to 1.7% from 0.91% at the beginning of the year. While rising yields can portend rising inflation, yields on Treasuries remain below inflation. Zero or negative “real yields” (after-inflation) do not suggest concerns about accelerating inflation. Yet, government influence renders these tea leaves almost meaningless.
The Federal Reserve is buying about $1 trillion of Treasury bonds annually, funding about 40% of the budget deficit in Fiscal 2020. The Fed has its thumb on the scale of interest rates, so how do we determine the true market-clearing yield? We can’t, and this is troubling because Treasury yields serve as the reference rate for most other interest rates, including mortgage rates and corporate bonds. False signals are sent throughout the economy.
Fed Chairman Jerome Powell acknowledges that inflation could rise temporarily due to the anticipated burst of spending this Spring, but that it shouldn’t reach “troubling levels.” Let us hope he’s right, but like many situations over the past 12 or so months, this too is “unprecedented.”
It is said, “the stock market runs from uncertainty.” This implies renewed volatility, but the spending surge will increase profits broadly and investors like rising profits! Perhaps this explains why the market is at an all-time high despite numerous sources of uncertainty acknowledged by most investors. But we must not freeze in fear. Not deciding is still a decision—a default decision to accept the status quo. It seems prudent to hold on to some cash in case great opportunities emerge, but to remain largely invested as long-term stock prices follow earnings and earnings are likely to be favorable.
Scott D. Horsburgh, CFA