The economy experienced its strongest period of growth since 1983 through the second quarter this year. Yet the surge in momentum behind rising stock prices and bond yields off the pandemic lows a little over a year ago began to ebb. Stock and bond markets treaded water as they began to discount new information about the outlook, such as: the possibility that a new, more virulent, variant of COVID-19 may emerge; how much consumers will spend the savings they built up during the crisis; the persistence of bottlenecks that are disrupting supply chains; and the chances of additional fiscal stimulus legislation that would make clearer when and how taxes would increase.
The most significant new development over the quarter was greater uncertainty about the course of future monetary policy. Since the crisis began, the Federal Reserve (the Fed) conditioned markets to believe that they would meet the uncertainty of the economic outlook with certainty that monetary conditions would remain very loose for an exceptionally long period of time. Yet, at its June meeting, the Fed conceded that they may now have to raise interest rates in 2023, sooner than they had thought, because they had upgraded their inflation forecasts for this and next year. In the three months ending in May, core consumer prices (i.e., excluding food and energy) rose at an annualized rate of 8.3%, the highest since the early 1980s when the Fed was raising interest rates significantly in a war against a pernicious inflation psychology.
Markets are now beginning to assess whether this burst of inflation will be temporary, or more permanent, forcing the Fed to remove the punchbowl from the party just as it appeared to be really warming up. The Fed remains of the view that inflation pressures will subside quickly once the supply-chain bottlenecks caused by dislocations from economies opening back up at different times after the Great Lockdown are resolved. They are also quick to point out that year-on-year increases overstate the magnitude of the surge due to the extreme low experienced at the onset of the coronavirus pandemic last year. Yet, even if inflation is measured over the last two years to reduce the statistical outlier of the coronavirus crash and recovery, the trend is clear: a steady rise in the rate of inflation above 2%. Bond market investors now expect the inflation rate to average close to 2.5% over the next ten years, the highest it has been in over a decade.
It is not inflation, but inflation expectations, that matter.
Just how much longer will the Fed tolerate a booming economy generating a burst of above-average inflation? Much of the ascent in bond and stock prices over the last forty years has been underwritten by the Fed’s credible commitment to keep inflation expectations anchored at 2%. As the lesson of the 1970s shows, once an inflationary psychology sets in and a self-reinforcing spiral in wage growth sets in, only much higher interest rates will put the genie back in the bottle again.
Concerns about persistent inflation are driven by the unprecedented and coordinated fiscal and monetary policy response to bring relief to a pandemic-stricken world. After spending nearly one-fifth of GDP on six consecutive fiscal stimulus packages, the previous and current administrations have put back three times as much income into the economy as the COVID-19 pandemic took out. If inflation is “always and everywhere a monetary phenomenon1” with too much money chasing too few goods and services, it is disconcerting to realize that the Fed has financed this fiscal largesse by allowing the money supply to rise by 30% and its balance sheet of bonds to increase by 90% since the start of 2020.
As discussed in previous quarterly letters, the Fed and Treasury had learned from their halting, and inconsistent, “too little, too late” response to the Great Financial Crisis in 2008 with a “go big or go home, shock and awe” response to the economic fallout from the Great Lockdown in 2020. Yet have they gone from underestimating to overreacting? Their big bet now is clearly to create such a high-pressure economy that the unemployment rate will fall quickly in the immediate aftermath of the pandemic, especially after stimulus checks wear off and low-income workers are incentivized to find employment again. A temporary surge in inflation may be a side effect worth risking, not least because that helps to put record debt levels on a more sustainable trajectory in real terms.
Yet this administration is determined to do even more. Just as the economy was boosted by perhaps the greatest stimulus of all – reopening allowing the huge pent-up demand for services to be unleashed – it announced it had reached a bipartisan deal to spend another $1 trillion on an infrastructure spending package. Additionally, it seems determined to follow through on an additional multi-trillion-dollar spending package, which it hopes to pass by reconciliation realizing that bipartisan support for that will be difficult to achieve. Many of the more extreme increases in taxes proposed to pay for all this stimulus by the current administration are likely to be watered down as result.
Of course, the natural non-inflationary “speed limit” for the economy is determined by productivity growth. Helpfully, there are already signs that productivity growth has ticked up as a result of the many new technologies that have been adopted by corporate America since the pandemic began, allowing them to do more with less, ranging from virtual communication, to automation, the digitization of the payments system, eCommerce, and even artificial intelligence. Productivity growth will have to continue to increase significantly for this inflation scare to subside and long-term interest rates to remain contained. This will make the Fed’s job easier in calibrating its monetary policy stance so that it does not make the mistake of either prematurely snuffing out the recovery on the one hand, nor allowing inflation expectations to become unmoored on the other.
Investment Policy Changes
Our investment process has already led us to position portfolios for the potential of a more persistent rise in inflation:
- We remain fully invested. Inflation erodes the purchasing power of cash, and while it may seem prudent to stay on the sidelines during times of uncertainty, staying invested is crucial during times of inflation. After immunizing two years’ worth of spending net of portfolio yield in cash reserves, we recommend averaging significant additions to portfolios into markets over a period of six months.
- We are at the low end of our ranges to fixed income and at the high end of our ranges to stocks. Inflation typically drives interest rates higher, causing the price of bonds to fall. Stocks, however, can benefit as earnings tend to rise under modest inflation periods, as described in our primer on inflation. Recall that our process measures the valuation of stocks relative to bonds, not just stock valuations in and of themselves. So, while equity valuations may be expensive on both a cyclically-adjusted price-to-earnings (CAPE) and a trailing one-year basis owing to artificially depressed earnings during the pandemic, earnings growth and dividend yields today are still more than off-setting higher interest rates, ensuring that stock markets remain modestly inexpensive relative to fixed income.
- Tilting equity exposure toward Value stocks. Rising prices and interest rates are a tailwind to profitability for sectors, such as industrials, materials, energy, and financials. A tilt towards these Value areas also lowers the duration of portfolio's equity exposure: these sectors typically are high yielding, meaning they tend to return cash to investors more quickly through dividends and share repurchases. When interest rates rise, this is far less risky than holding stocks in the more Growth-oriented area of the stock market whose values are determined mostly by their terminal value, where an increase in the discount rate has a direct and immediate impact on the present value of a company’s stock price. In this way, higher-yielding stocks help to offset the compression of multiples that accompanies higher inflation. As we suspected in our last quarterly update, our discipline objectively confirmed that a new Value bull market had begun during the second quarter.
We have sharpened our exposure to Value by supplementing our core Value exposure with a tilt towards an index with “purer” Value characteristics – those securities that score well on the typical characteristics of book-, dividend-, and sales-to-price, as well as poorly on the growth factors, such as trend top- and bottom-line growth and momentum. For us, passive implementation always requires active due diligence.
- Diversify equity exposure into international emerging markets. Sustained inflation can lead to a devaluing of the U.S. dollar against other currencies. While the momentum in international stocks has stalled recently, we continue to emphasize a position in emerging market equities, which stand to benefit from a falling dollar.
- Emphasize private capital allocations to real estate, infrastructure, and credit. Real estate and infrastructure tend to perform well in inflationary periods as increases in rent or land directly increase the cash flow of these assets. After first allocating to this area several years ago, we are currently assessing how to take further advantage of the continued need for infrastructure spending around the globe during inflationary times.
Within credit, senior secured loans set their interest rate as a spread over a benchmark interest rate. Inflationary periods will cause the benchmark rate to increase, therefore increasing the interest investors earn on that loan. Appetite for these higher-yielding income-producing investments has remained strong as our allocation to Monroe’s private debt fund nears its closing for new subscriptions.
Several of our private equity managers have taken advantage of the robust underlying economy with early exits from several of their investments. Fulcrum, our growth equity manager, continues to perform ahead of expectations as a recent exit from Summit Spine & Joint Centers and subsequent distribution has investors in their 2016 fund now with more capital returned than initially invested.
In short, the spring has brought policy uncertainty to “the wall of worry” that markets must continue to climb, and the remaining summer months are likely to bring more volatility as the markets seek clarity on tax increases and the pace of monetary policy tightening. Our discipline has called for us to remain constructive with an emphasis on areas that may benefit from a rising inflation as we approach the fall. Between now and then, as always, we will keep you apprised of our views through our monthly market commentaries.
Please do not hesitate to call if we can answer any question you may have.
We are very grateful for the trust and confidence you place in our team and process. Thank you.
1 Professor Milton Friedman won the Nobel Memorial Prize in Economic Sciences for his understanding of price dynamics in the labor market and his general contributions to monetary theory.