August 2021 Commentary

Jack Brown, CFA

We suspect inflation will be above average for the next couple years ~ perhaps in the 2% to 5% range.  The inflationary factors we believe are present are:

  • Stimulative Federal Reserve (monetary) policies,
  • Stimulative fiscal spending policies,
  • Large amount of savings built up in money-market, savings, and checking accounts,
  • Supply-chain bottlenecks,
  • Accelerated spending as the economy re-opens.

While the intensity of these factors will change over the next several months, we believe these factors will remain largely in place – helping to drive consumer expectations towards an inflationary mindset that incentivizes buying “now” before prices increase further.

On the other hand, the forces that limit inflation remain in place. Specifically, if the rapid pace of technological improvements continues, consumers ultimately get a “bigger bang for the buck.” Second, high levels of global trading and production capabilities tend to keep prices in check. Finally, the Federal Reserve has plenty of tools at their disposal to slow down spending – halting the inflationary mindset.

Currently, however, the Federal Reserve has the exact opposite approach which is to increase the inflationary mindset. The three main policies driving this approach have been 1) keeping overnight “Fed Funds” rate near 0%, 2) flooding the market with money by buying bonds, and 3) communicating to the public that they will allow inflation to rise above the 2% target for some time before taking action.

The problem with this policy is it ensures that “cash is trash.” In the chart below, we compare inflation (as measured by Core CPI – the Consumer Price Index excluding food and energy prices) represented by the dark blue line to the 3-month Treasury Bill (the “T-Bill”) represented by the red line.

T-Bills tend to be heavily influenced by Fed policy and are a good proxy to measure what savers receive, in general, from money market funds and other cash substitutes at banks and in investment accounts. Since 2009, inflation (the blue line) has been higher than T-Bills (red line) indicating investors holding cash have indeed been losing out to inflation. Surprisingly, this is not normal. Prior to 2009, investors would typically receive money market rates, CD rates, or other cash products that would more than offset inflation.

Today, the disadvantage of holding cash appears to be near record levels; enticing savers to take risks beyond the safety of cash or similar investments. Additionally, with an ascending inflationary mindset, investors and consumers are also incentivized to accelerate spending.

Many of the same factors driving inflation are also pro-growth, economically speaking, with the consensus view being the economy will continue to grow at a healthy clip for some time. As this growth and inflation view spreads among consumers, businesses, and investors, a typical byproduct would be rising long-term bond rates.

Below, we look at Nominal Growth Domestic Product (“Nominal GDP”) (blue line) which includes economic growth and inflation and compare it to long-term bond yields as represented by 10-year Treasury bonds (red line). While the relationship between these two lines is far from perfect, there does appear to be a significant one. In fact, higher levels of nominal GDP seem to be associated with higher long-term bond yields. Consistent with consensus, our view is nominal GDP will rise. Given the preceding observation, we further believe long-term yields, coming off record low levels, will also rise over the next couple years – perhaps more consistent with the 2000 to 2020 average (~3%).

While rising rates would provide some headwinds for investors who hold interest-rate sensitive bonds, they will continue to receive stable income (all else equal) and the opportunity to reinvest at higher rates.

Stocks would most likely be able to handle a modest rise in long-term bond yields to the 3% range. Specifically, if there remain plenty of blue-chip companies with competing dividends, income seeking investors would not be overly motivated to swap out of stocks. Further, we believe a 3% long-term bond yield is reasonable for the market to handle if stock market valuations do not get too ahead of themselves (i.e. the forward price-to-earnings ratio of the market remains near 20 or lower; $1 of earnings for $20 in stocks or a 5% earnings yield).

Speaking of stocks and inflation…what is the history of stock market performance and inflation? The common assumption is “it is bad.” However, we conclude “it is not clear.”

In the chart below, each dot represents a coordinate matching the stock market return to the corresponding level of inflation for each of the last 100 years. What you might observe is there are 17 years when inflation is above 5%; 8 of those years generated negative stock market returns while 9 years provided positive returns. As a result, the evidence is slightly more positive than negative though the sample size may be inadequate to draw any concrete conclusions.

On the other hand, when inflation is 5% or below, the stock market returns appear to be positive on average. Consequently, while we believe inflation will generally be 5% or below for the next few years, we do not believe inflation will be the top risk for the stock market.

Source: Robert Shiller, Standard & Poor’s.

As always, there are several risks to market returns. However, two of the major ones, the economy and the financial system, are low risks as they each appear to be on solid ground. On the other hand, certain valuation metrics are extended. The Shiller CAPE ratio, for example, is a price-to-earnings measure for the stock market with one adjustment – earnings are represented by the inflation-adjusted average of the prior 10-years of earnings. So while the price of the market is current, the earnings are an average of the past.

The Shiller CAPE ratio is showing us that today’s market is expensive relative to history. We believe this needs to be considered as an outlier but is indeed relevant. Our approach to minimizing the valuation risk is by adhering to our valuation centric approach to both growth and traditional value investing. Being willing to avoid buying (and consistently sell) investments that appear to be unreasonably expensive, we believe investors have and will continue to benefit around periods of market consolidation driven by valuation concerns.

Today, we remain strategically neutral to the stock and bond markets. In other words, as an investor, your long-term asset allocation plan remains important. As the stock market has run up, rebalancing may require some selling of stocks to get back in line with your strategic allocation. However, a modest overweight to stocks may make sense assuming your portfolio is not sacrificing excessive downside risk in favor of tax avoidance. Meaning, if you have holdings that are overvalued but also carrying high tax implications if you were to sell, accepting the trade-off that comes with trimming these positions makes sense in our opinion.