Would you like to ride in my beautiful balloon
Would you like to ride in my beautiful balloon
We could float among the stars together, you and I
For we can fly we can fly
Up, up and away
My beautiful, my beautiful balloon
The world’s a nicer place in my beautiful balloon
It wears a nicer face in my beautiful balloon
We can sing a song and sail along the silver sky
For we can fly we can fly…
The lyrics to Jimmy Webb’s classic song, made famous by the 5th Dimension seemed like an appropriate way to lift our midyear outlook off the ground.
Global risk assets including equities, real estate and industrial commodities continued their ascent higher in the second quarter, buoyed by a surging global economic recovery, continued progress against Covid, easy money, and lots and lots of fiscal stimulus.
As Chart I below shows, U.S. stocks continued to lead global equity markets, up 15.3% through June 30th. International and Emerging Markets were up half as much, but still turned in respectable returns of 9.2% and 7.5%, respectively. Economically sensitive commodities including metals and grains, were up over 20%. Interestingly, precious metals, a traditional hedge against inflation, were down 5.7%. This suggests that commodity prices are being driven more by a current excess of demand relative to supply rather than a significant concern about inflation.
Bonds, on the other hand have had a difficult year, with most global bond indices in negative territory. Only high-yield bonds have managed to eke out a small gain.
Bonds have faced the double threat of rising interest and inflation rates, which makes them worth less in both nominal and real terms. Sovereign bond yields in much of the developed world are even lower than in the U.S. So while bonds are perceived as a safe asset, they are almost guaranteed to lose value over time. This especially applies to medium and longer-maturity Government bonds.
Looking under the hood of the U.S. stock market, smaller and medium sized stocks outperformed larger stocks, and in each category, “value” oriented stocks outperformed more “growth” oriented stocks. (Chart 2) This makes sense as value-oriented stocks are more closely tied to the economic recovery. They dramatically underperformed growth-oriented stocks during the Pandemic and are now having their day in the sun.
We can see this more clearly if we look at U.S. stock market performance by sector. (Chart 3) More economically sensitive sectors such as Basic Materials, Financial Services, Energy and Industrials have generally outpaced last year’s Covid winners like Technology and Healthcare.
Global Growth:
Stepping back from the markets to look at the economy, global economic growth is recovering sharply.
Most developed world economies have made significant progress in vaccinating their populations and overall infection and hospitalization rates are low. This has allowed them to re-open and return to some semblance of normal activity. We expect the U.S. to return to its historical growth trendline by the end of this year, (Chart 4) and Europe to follow close behind.
Some of this resurgence reflects pent-up demand for things that were foregone during Covid like travel, dining out, weddings, and concerts. This demand will ultimately be satisfied and things will drift back towards a new equilibrium, not too different from how things were before the Pandemic.
Some of this resurgence is more enduring, reflecting massive amounts of fiscal stimulus coursing through the U.S. and the rest of the global economy. This stimulus should take another few quarters to work its way through the system, providing an ongoing boost to economic growth through the rest of this year before it starts to taper off.
The passing of a $1.2 trillion bipartisan infrastructure bill and potentially the $1.8 trillion American Families Plan Bill, would provide an additional boost to long-term economic growth as well as to longer-term inflationary pressures.
We have also seen a sharp rise in the demand for labor. According to the Bureau of Labor Statistics most recent JOLTS (Job Openings and Labor Turnover Survey), there are over 9 million current job openings, more than any time in the past 20 years. (Chart 5) Competition for skilled workers is fierce, making it hard to fill open positions and creating upward pressure on wages.
Inflation:
In addition to rising wages, we are also seeing significant upward pressure on prices as demand for goods and services exceeds supply. These pressures are currently being exacerbated not only by the abundance of demand outlined above, but also significant shortages in supply.
The global economy is large and complex and if you put it in a coma for a year, it doesn’t just spring back to life in a day. The pandemic impacted vast sections of the economy: entire industries were shuttered, supply chains were disrupted, companies scaled back operations, furloughed or fired workers and closed their doors, sometimes for good. Workers who were impacted looked for work in other industries, and others opted to stay home to take care of children and/or collect temporary unemployment benefits.
We think that a lot of these imbalances are temporary and will correct themselves in the coming 6-12 months. Consumers will satisfy their pent-up demands, the supply of goods and services will increase to meet demand, people will re-enter the work force as schools re-open and temporary benefits expire.
That being said, we do believe that the longer term trend is towards rising levels of inflation. We do not, at the moment think that this will lead to severe inflation like we experienced in the 1970’s, but the inflationary risks are more to the upside than the downside and one should not be complacent about them.
Barring a severe setback in the fight against Covid, the global economy should have a significant tailwind supporting strong growth at least through the rest of this year and perhaps into 2022. After that, we expect a change in the weather and a number of current tailwinds will start to become headwinds.
First, just like giving a kid an entire box of candy bars, after a period of hyperactivity, it’s natural for the child to slow down and need a nap. Similarly, if you give the economy the fiscal equivalent of a few trillion candy bars, it’s natural for the economy to slow and need an economic nap, otherwise known as a recession.
Second, interest rates, which have been in a secular decline for four decades are now starting to rise and we think this trend will persist. As the economy improves, and employment and inflation rates hit their established targets, the Federal Reserve will begin to taper asset purchases and then start to raise short term rates. Meanwhile, investors will start to demand higher long term interest rates as compensation for rising inflation rates and investment risks. Higher interest rates increase the cost of capital for investment, decrease the amount of overall investment and slow the rate of economic growth. This doesn’t mean that growth will stop, but if low and declining rates have been a tailwind, rising rates are definitely a headwind.
Third, tax rates for corporations and individuals are rising. The United States and most of the 130 members of the Organization for Economic Cooperation and Development have backed an agreement for a minimum global corporate tax rate of at least 15%. In the U.S. there are a number of new tax proposals being discussed. While we do not think that most current tax proposals being discussed will pass, we do think that corporate and personal income tax rates are likely to rise modestly in the coming years.
Fourth, after several decades of globalization, the world appears to be moving backwards towards de-globalization. This does not mean that countries won’t trade with one another or that companies won’t do business all over the world, but it does mean that global supply chains will likely become more localized, global trade will likely become more restricted and regulated, and costs of doing business will rise.
None of these factors mean that the global economy will come to a screeching halt, but they are all examples of former tailwinds that now appear to be shifting into headwinds. They won’t really have much impact this year, but in the coming years, they will likely create a frictional drag on economic growth.
Investment Outlook:
While our economic outlook is quite rosy, our investment outlook is more guarded for the simple reason that a lot of good news and high hopes are already reflected in current prices. With the economy booming, life returning to normal, and real estate and financial markets floating together among the stars, the world does seem like a nicer place.
But, the beautiful balloon of financial assets is already soaring well above normal cruising altitude. We see modest additional upside, at least in the near term, and meaningful downside should conditions change for the worse.
Looking forward, expected returns across most asset classes are near the low end of their historical ranges and not very attractive. This doesn’t mean that markets can’t and won’t drift higher, but it does mean that it is a good time to maintain a more defensive posture. Corrections are never fun, but they are inevitable and they do provide opportunities to reinvest at more attractive valuation levels; typically at times when the world seems like a less nicer place.
The U.S. stock market is expensive relative to the rest of the world, but in the U.S., some areas like financial and industrial stocks still offer reasonable value. Europe and Emerging Markets are considerably less expensive than the U.S. overall and have more potential upside as their economies recover.
Commodities should continue to benefit from the economic recovery, although not uniformly. Transportation accounts for close to 60% of global oil production and so, despite the current surge in oil prices, we think that fossil fuels face a long term headwind from the electrification of vehicles. Meanwhile electric vehicles consume four times as much copper and other specialty metals as a typical gasoline-powered vehicle, suggesting a tailwind for metal demand, regardless of inflation. We also think that commodities, including metals and gold, can offer a good hedge against inflation and can play a valuable role in diversified portfolios.
Global real estate, and especially private real estate, including multi-family housing, infrastructure and commercial, still looks reasonably attractive.
Perhaps the least attractive asset from a valuation standpoint are medium to longer-term government bonds. Consider that in an environment where inflation is running around 3.8%, and a 10-Year U.S. Treasury bond offers a nominal yield of only 1.4%, this equates to a real (inflation-adjusted) annual yield of -2.35%. (Chart 6) In much of the rest of the developed world, real yields are even lower. Relative to this, stocks almost look like a bargain.
Putting it all together, as we look to the second half of the year, our baseline outlook is for a continuation of a strong economic recovery in the U.S. and elsewhere in the world that may even surpass expectations to the upside. This should lift financial markets gradually higher, but it would not surprise us to see more turbulence as investors digest incremental data and news for better and worse.
The greatest near-term concerns would be a meaningful rise in Covid infection and hospitalization rates as the Delta variant of Covid spreads. Thus far, it seems to be having its greatest impact on non-vaccinated adults and is spreading most rapidly throughout the developing world where vaccination rates are much lower, including South America and Africa. Meanwhile vaccine manufacturers are on track to produce over 10 billion doses of Covid vaccine by the end of this year, which should be enough to thwart the long-term growth of the virus as long as the vaccines remain effective. If their effectiveness declined, or a new, more vaccine-resistant strain emerges, this would significantly impact markets.
Other concerns include higher than expected inflation readings, an acceleration of the Federal Reserve’s timeline to raise short-term rates and tighten monetary policy, or a sharp rise in longer term interest rates. We do not think these things will happen, but they are certainly possible.
On another front, if it looked like a more radical set of tax and regulatory proposals might actually get passed into law, that would certainly suck a lot of air out of the market. As we noted earlier, we don’t currently see this as a probable outcome. With a very closely divided government, passing any major legislation will be difficult. While we think that there is some appetite to raise corporate and capital gains taxes a bit, larger changes do not currently enjoy sufficient support even among Democrats to pass the House or Senate.
Most of these concerns are well known. In our experience, it is not the monster that you know about in the closet that gets you, but the one you didn’t expect that was hiding under your bed. We also know that over time, economies and markets tend to triumph over monsters and have an inherent tendency towards growth and appreciation.
Based on our outlook, we think that it is important to maintain a long-term perspective, focused on areas of secular growth, while also maintaining a global focus and a higher level of diversification among and within major asset classes.
While we continue to believe in technology and innovation as areas of strategic long-term focus, we have also been tactically tilting client portfolios towards more value-oriented sectors that are benefitting from the recovery. We have also been increasing exposure to Europe relative to the U.S.
We continue to own gold and some other commodities as an inflation hedge and have been adding private real estate to client portfolios where appropriate.
Although bonds are unattractive, they do provide a defensive bulwark and ballast in portfolios. They also offer a place to park excess cash while we wait for attractive opportunities to put capital to work. Within our bond allocations, we have focused on more conservative total return and income-oriented strategies that have tended to be less sensitive to changes in interest rates, or deteriorations in credit markets. In the fixed income markets in particular, we think it is important to be highly diversified and flexible.
As always, we continue to invest with a global focus; balancing investments targeted at areas of long-term growth and innovation with more defensive equity, alternative and fixed income strategies aimed at mitigating volatility and risk.
Please let us know if you have any questions and/or if there is anything we can help you with relating to your financial life. And, if we can ever be of any help to a family member or friend, we always welcome referrals from our clients.
Jurika, Mills & Keifer
July, 2021