August Investment Comments
The economic recovery continues, but the pace of the recovery is slowing. First quarter GDP was estimated at $22.1 trillion annualized, surpassing its pre-pandemic high of $21.7 trillion. Reclaiming our economy’s full potential might take a long time, however. GDP has rebounded sharply but remains approximately 2% below its pre-pandemic growth path. Gains have not been distributed equally, and inflation is squeezing the budgets of consumers left behind by the post-COVID recovery so far. Where we go from here is a bit of a mystery.
Employment statistics have recently plateaued at a level that would have been considered very unsatisfactory before the pandemic. June’s Bureau of Labor Statistics report showed the unemployment rate ticked slightly higher versus May at 5.9%, with labor force participation also about flat at 61.6%. Before the pandemic, unemployment averaged about 4% and participation about 63%. Wages were a bright spot in June, up 1%. Those who remain engaged in the workforce are being rewarded with paychecks growing faster than the cost of living, which is also increasing at a rate that would have caused major alarm before the pandemic.
The June CPI report showed a 0.9% monthly increase. This increase was broadly distributed, as volatile food and energy increased at the same pace as the less volatile “core” categories. Interest rates shifted modestly higher on the release.
Oil and gas prices have marched steadily higher in 2021 and impact consumers twice, immediately through fuel bills and then slowly through retail price increases. The breakneck pace of commodity inflation elsewhere has calmed down. June saw meaningful declines in the prices of copper and lumber, two key industrial inputs. Both remain at historically high levels, however. Many soft commodities have behaved similarly, easing from historically extreme levels.
So it goes with housing as well. Home prices have appreciated rapidly but recently flinched, with new and existing home sales declining sharply in May. With prices estimated to be up more than 20% year-over-year, the University of Michigan Consumer Survey shows that over 60% of consumers currently think it is a bad time to buy a house. Along with commodities, what happens to home prices from here may tip the answer to whether price inflation is a transitory phenomenon or a structural problem.
The Federal Reserve, like other central banks around the world, is betting on the former—transitory—and is content to give short-term price inflation a long leash. This could prove wise, or it could prove naive. We would normally expect investors to respond to the risk of inflation by demanding higher interest rates on bonds, but the bond market has been hypnotized by a combination of central bank intervention and investor optimism about, presumably, future disinflation. We are tempted to call it “blind” optimism.
When central bankers were decrying inflation running stubbornly under 2% in the past, investors looked past their rhetoric and focused on the data. Now they are ignoring the data and focusing on the rhetoric. Investor affection for fixed future payouts has reached an extreme that looks downright unhealthy. Junk bonds are currently priced to yield under 5%, less than the prevailing rate of inflation. Considering that junk bonds have historically defaulted at a rate close to 4% annually, it will take a lot of future disinflation, or outright deflation, for investors to make a positive return from these levels. The yield on 10-year Treasuries is a paltry 1.4%. What makes the low yield on junk bonds even more alarming is that the 4% average default rate is only an average. If future defaults are higher than average—flip a coin—then junk bonds could produce negative gross returns even before the impact of inflation. At least the small coupon on Treasuries is money good.
Republicans have agreed in principle to a $1.2 trillion infrastructure bill. Democrats would like to spend multiples of this amount, but the risk, however remote, of runaway inflation, combined with the sensitive nature of the post-COVID recovery, is crimping support for a bigger bill. Funding a bill through higher deficits risks breaking the spell of low interest rates, and a tax increase could hurt economic growth. It is hard to imagine financial markets accepting either of those alternatives graciously, although we note that fiscal deficits have already greatly surpassed the levels that we, or most economists, would have viewed as extreme.
Meanwhile, the stock market marches ever higher. After five positive months in a row through June and a strong start to July, the S&P 500 is up more than 17% year to date. High stock prices are consistent with low interest rates, and equities have the added advantage of being a good inflation hedge historically, with the caveat that they have tended to appreciate before the inflationary liftoff but have struggled while inflation rages. Heading into a second quarter “earnings season” that laps the absolute depths of the 2020 pandemic, we expect supply chain inflation and labor shortages—which is wage inflation by another name—to be persistent themes. Keep an eye on gross margins. Companies who fail to pass along price increases are particularly vulnerable right now. On the other hand, companies whose competitive strength allows them to transform increasing costs into faster-increasing profits will be highly prized.
The investor’s job is not to see the future. It is to provide against future risks, whatever may come. Equities should offer positive long-term returns, net of inflation. Bonds? Maybe not. The rational conclusion is to reduce the role of bonds in the investment allocation while watching closely to make sure that one’s stock picks can at least tread water in an inflationary environment.
Miles Putnam, CFA