During the 2nd quarter, the economy continued its recovery from the economic shutdowns of 2020. Consumer spending, which makes up roughly 70% of US economic activity, has been strong. The job market has been in good shape, with the main challenge being employers filling open positions. It seems every business has “now hiring” signs posted. Banks are flush with capital. Many corporations are in an improved position compared to the beginning of 2020. While the pandemic was a challenge for most businesses, the support provided by the Federal Government and Federal Reserve gave opportunity for companies to borrow additional money, extend credit maturities, and lower overall interest costs. With the economy seeing huge gains from government stimulus, companies are looking to report high earnings from the Second Quarter.
Within the last few weeks of the quarter, economic data started to deteriorate. It’s not a collapse, but things are not looking as promising as they once were. Several financial institutions have downgraded their economic growth expectations for later this year and into next year. There has also been a surge in COVID cases domestically and internationally as the Delta variant of COVID aggressively spreads. If global governments react with the same lockdown measures as they did in 2020, this will also put pressure on the economy. In addition, several of the protective measures implemented by the government are set to expire soon. The increased unemployment benefits are scheduled to cease in September, and the continuation of the eviction ban is in question. These could also have a damaging effect on the economy as lower income families deal with higher costs and less cash flow.
Questions still abound about the long-term health of the US Economy. The accommodative actions of the Federal Government and the Federal Reserve gave corporations the opportunity to retrench and restructure their debt, an opportunity they welcomed with open arms. US corporations issued more debt in 2020 than any previous year. While this was a boon in the recovery, as the economy cycles, many businesses will likely find themselves over-leveraged. All these gains have been achieved by unprecedented government support. Granted, this support was necessary in the wake of lockdowns. Without government support, economic recovery would have taken years, if it ever recovered at all. But this is now the second consecutive recession where massive government stimulus was necessary for recovery, and each step has required greater measures to be taken in support of the economy. In the process, the government has taken on more debt and may have created an economy reliant on low interest rates and easy monetary policy.
Inflation, Inflation Everywhere
Anyone notice prices going up lately? That’s a bit of a rhetorical question. I think at this point, everyone has noticed the increased cost of stuff (that’s technical jargon): used cars, houses, lumber, clothes, food, gas…it seems like everything has become more expensive the last few months. That’s not just perception. Inflation has arrived. The 12-month inflation rate in April, May, and June was 4.2%, 5.0%, and 5.4%, respectively. That’s more than twice the average over the last 10 or so years. Prices are going up, and we are all seeing it.
The question being openly debated in the financial news is, how long will this higher level of inflation last? If you listen to the talking heads out there, there are a few contrasting viewpoints. Leading one side of the argument is the Federal Reserve, who sees this period of high inflation as “transitory.” They state that this is the result of coming out of a period of lower inflation and congested supply chains, temporary issues they believe will eventually work themselves out as the economy transitions from closed to fully open. The counter argument is that we are witnessing sustained high inflation due to unprecedented direct government stimulus into the economy and the ongoing support of the Federal Reserve.
Each side of the argument has its merits. Inflation was barely existent in 2020 and was historically low in the period between the Financial Crisis of 2008 and the 2020 pandemic. If you look at inflation in that broader context, the high inflation figures experienced during the 2nd quarter could be partially attributed to a “base-rate effect.” Several industries, like the travel industry, dropped prices significantly in 2020 and are now increasing prices aggressively as demand has returned. The bottlenecks in the supply chain are largely the result of businesses decreasing inventory and production during the pandemic and then having to manage a sudden spike in consumer spending and government earmarking as the economy re-opened. Plus, the shipping and transportation industry can’t seem to get enough employees. Goods and materials are sitting in ports with no one to unload them or transport them to their destination. In short, there’s a mismatch between supply and demand right now. Arguably, the numbers also support this argument that inflation is more of a result of these short-term factors as opposed to a long-term trend: if you remove the certain components of CPI related to re-opening (i.e. hotel & air travel, computer chip shortages, used car prices, etc), the inflation surge is not much of a surge.
The counter-argument is somewhat compelling as well. Money supply (the amount of dollars in the financial system) increased by 25% in 2020 because of the massive stimulus efforts by the Federal Government and the Federal Reserve. Banks are flooded with deposits from corporations and individuals who have basically stashed their stimulus dollars. In fact, some banks are having to re-work their capital structure because they have so much cash in deposits. If that money starts getting into the economy, the mismatch between supply and demand could persist.
The difference between those two positions comes down to whether or not the high inflation rate will be sustained. Price increases in some areas where inflation is really hot, such as used cars and housing, will likely temper as consumers begin to balk at the rising prices. Supply chain issues will eventually work out, as it is within businesses’ financial interest to quickly move base goods and products and as pent-up demand from the pandemic fades. If forward looking economic indicators are correctly showing a decrease in growth, that should also have a taming effect on inflation as well. As these economic forces work out, what we see as the most likely outcome is inflation settling in a slightly higher range than in the last decade as the deflationary impacts of globalization and decreasing working-age populations begins to counter-act inflationary pressures.
The path to that end may be volatile, and we also could be flat wrong. We’ve often remarked on economists’ inability to accurately predict inflation, and while it’s a nice ornament in the office, our crystal ball does not help us see any clearer than theirs. There are a number of unknowns that could continue to push inflation higher. Another stimulus package from the Federal Government may threaten to overheat the economy and add fuel to inflation. In addition, the savings amassed through stimulus could make its way into the system if consumers at large begin to expect higher sustained inflation. If people believe they will have to pay a higher price for a good or service if they wait, they are more likely to spend now to avoid paying more later. This can create a feedback loop…the consumer spends because pricing is going up, companies respond to the demand by increasing prices, and consumers again spend because pricing continues to go up.
So, we must move forward with a watchful eye towards inflation. Regardless of what happens with inflation, there are still some immutable facts. Good companies will continue to make money, and hard assets will retain value. We will continue to look for those kinds of positions and manage our bond exposures to react well in a rising interest rate environment.
During the 2nd quarter, the US stock market rose to some new high-water marks. Honestly, we continue to scratch our heads in wonder about the performance of the market as it continues its steady upward climb. Prices are optimistic and seem to be ignoring any future risks. It appears that a large volume of stimulus money has landed in financial market pushing arguably overstretched valuations higher and driving an increase in speculative behavior. In the last few months, shares of several companies whose business models have been seemingly left behind by market trends, like GameStop and Blackberry, have been revived by day-trading retail investors crusading against hedge funds who had shorted the shares. The price chart of lumber from April to the end of June looks like an outline of the Matterhorn. It went from $840 per thousand board feet in mid-April, peaked at around $1,700 in mid-May, and ended June at $716. Bitcoin started the year at around $20,000, ran up to just over $60,000, and is now sitting at around $32,000 and is trending upwards.
This isn’t normal market behavior (although Bitcoin can go Wild-West at any moment), and prices don’t move this much purely based on fundamentals. It’s hard to explain a 100% increase and then a 70% drop in the price of lumber over the course of 2 months solely based on supply and demand. Logjams of that magnitude don’t pile and then break free that quickly. This was textbook speculative market behavior.
Times like this require an increased degree of caution and an eye on long-term valuations. Benjamin Graham, the often-coined father of value investing, believed one of the biggest challenges to investors was recognizing when the market had turned from investing money to speculating in money. There is a difference between the two. Investing is buying an asset for its value and long-term cash generating qualities whereas speculating is betting on future market movement (there is room for nuance here that we won’t get into). Speculation isn’t all bad. There is room for speculation in a portfolio. How much is dependent on the investor. But it is important to acknowledge when you are making a speculative bet and often in markets like we are experiencing the crossover from investing to speculation can be subtle. As the market continues to climb, it’s easy to ignore the fundamentals, ignore the mounting risks, create justifications for higher and higher valuations, and put your faith in the everlasting bull market, may it never die.
While that approach may work for a time, it can be detriment to long-term returns. It is a well-supported argument that the biggest indicator of future returns is current valuation. That’s why most of our focus will continue to be on the fundamentals: buying good companies at good prices or owning funds that focus on the same. There are some remaining corners of the market where those can still be found. They’re not going to space or talking about creating things like the metaverse, but they will generate cash, a lot of it. And we get to own that cash generation for a reasonable price.
Looking farther out, we do see a lot of innovation on the horizon. The medical industry, in particular, is witnessing technological change that has been previously unseen. Technological advances in energy, transportation, and the way we work are also taking place. While we see a lot of opportunities to invest in these markets, they seem priced for perfection at this moment. We will continue to look for opportunities to invest capital at an acceptable level of risk.