While the economy rebounds and fears of inflation abound, we continue to watch those indicators we believe will help us and our clients make well informed decisions as to the direction and allocation of their investments. We do not try to predict markets, but rather strive to be ready vs. trying to be right. With that in mind here are some key data that we track daily as we monitor and help our clients manage their portfolios:
Earnings: These are some of the strongest earnings U.S. companies have seen in almost 40 years. To put that in contrast, in 2019 the earnings of the S&P 500 was $162. In 2020, during the middle of the pandemic, that shrank to $142. Look at 2021: Current run rates are $200. Fidelity Investments, in a recent investment professional webinar shared those S&P earnings for 2021 might even hit $225.
Stock prices are mostly based upon earnings. This might help explain the return of the market year to date and over the past year.
Free Cash Flow: That is money that a company has left after paying its bills, debts, its dividends, and other things. Free Cash Flow for many sectors (Energy in particular) is reaching significant highs.
Market Corrections: Corrections occur in the stock market, the bond market, the real estate market, and the commodity markets. We are aware and want our clients to be reminded that this can always be a possibility. One such risk is on the rise: Should the Fed wish to start tightening by decreasing its monthly asset purchases of over $120 billion dollars. That is what has been called tapering and, in the past, the markets have experienced the so called “taper tantrum” where most asset classes experienced a sell off when the Fed makes shifts like this.
Inflation: Like many advisors, we watch these number closely. We have some specifics to share with you beyond the stated CPI and PPI numbers. CPI, the Consumer Price Index, was reported this past Thursday for the month of May. It showed the year over year inflation rate at 5%. PPI (the Producers Price Index) was reported this past week and came in at 6.60% – May 2020 to May 2021. Both numbers show inflation potentially running at twice of what is known as “The Expected Inflation Rate.” That rate is the rate at which most institutional investors expect as the actual long-term rate of inflation. That number is available daily. However, it needs to be computed by looking at two factors: a) the U.S. Treasury 10-year note yield and b) the U.S. Treasury 10-Year Inflation Protected Notes Spread. The difference between the two is the expected inflation rate. That is the result of the pricing that the market puts on those Treasuries based upon what they think the inflation figure really is.
Note: The Federal Reserve more closely watches the movement in an index called the Personal Consumption Expenditures (PCE) index according to Fidelity Institutional, in its June 2021 report on Fixed Income. The PCE is published by the U.S. Department of Commerce. That next reading will be June 25. For now, that number is 3.1% for April which increased substantially from March when it stood at 1.9%.
At this writing, the 10-year U.S. Treasury was yielding 1.45% and the U.S. Treasury 10-Year TIP Spread was -.985%. So, the difference between the two is 2.435%. That is the rate the markets expect the true rate of inflation to be. That is obviously off the stated rate of the CPI and even the PCE. Why might this be so?
Many economists, investors and the Federal Reserve think the current CPI and perhaps the PCE are transitory in nature – the result of the economy rebounding from the lows realized just one year ago in the middle of the pandemic. They also point out that the CPI numbers are distorted by just a few things: Used cars, airline prices, gasoline and food. Add to that the numerous gaps in supply as a lot of manufacturing capacity had been reduced or shuddered during the pandemic.
“2.35%. That is the rate the markets expect the true rate of inflation to be.”
As a result, the markets have shrugged off the potentially ominous CPI numbers believing that the real inflation picture is the expected rate. The market is signaling that there are not too many dollars chasing too few goods which is the classic definition of inflation. We are in a different spot from this. We think that monetary inflation – the growth of the money supply as having much greater impact than temporary supply gaps.
There are several things to consider: 1) The Federal Reserve’s balance sheet sits at $7.95 trillion dollars. That is up from $4.16 trillion dollars at the start of the pandemic. The balance sheet was $2.2 trillion dollars in November of 2008 during the Great Recession. Just two months before that it was at $925 billion dollars. In other words, the Fed’s balance sheet has almost doubled in the past year and is up tenfold since just prior to the Great Recession. The balance sheet is simply the amount of money the Federal Reserve has injected into the financial system by way of buying bonds on the open market When they buy bonds, they use newly produced U.S. dollars to buy those, thus increasing the supply of money. That means a tremendous amount of liquidity. It is liquidity that supports and raises the prices of assets be they stocks, bonds, real estate, or the cost of borrowing and so on. 2) Federal deficit spending. We are approaching a record deficit of $4 trillion dollars. The U.S. government has added to supporting the economy by way of its own spending on stimulus and other programs. That means even more money into the system. 3) Labor shortages – as the economy continues to emerge and grow the number of job openings has caught up with the number of unemployed workers yet employers across the country from restaurants to construction cannot hire the labor to meet the increase in demand. 4) according to Fidelity Institutional, liquid savings are now at $4 trillion dollars, up substantially. Also, the U.S. savings rate is over 14.1% according to Tradingeconomics.com and it remains high (it was less than 10% at the start of the pandemic). You might see that as a lot of money on the sidelines, which is waiting to be spent on dining out, traveling, vacations, leisure and other things as the economy reopens.
Liquidity is the opposite of constrained credit. During the Great Depression, and what brought about the Great Recession can in part be blamed on the lack of liquidity and the lack of credit. That makes demand go off the proverbial cliff, prices deflate, and a recession or depression ensues. Many market pundits think once the supply imbalances are worked through that we will return to continued deflation. Their reasoning is not because of a lack of credit or liquidity but rather due to technology and a shrinking population. They think this time it is different. We do not agree.
The demand for housing has been unprecedented. This is more a result of the liquidity that is out there versus demand, in our opinion. If the Fed balance sheet had not doubled or the deficit spending not occurring, housing and other asset prices would not be supported at current levels. We think the only thing that will cause the housing market to cool, or even slowdown will be the reduction in Federal Reserve monetary injections.
So, what are the takeaways for clients? First, to review strategies and allocations and look to see if you have the diversification, you need or want should you be of the same belief that monetary inflation will indeed impact the expected inflation rate. There are several strategies to consider where inflation resilient or inflation resistant investment are concerned. Equity (stock) investments in Energy, Financials, Materials, Industrials, Commodities and Real Estate. Investments into small and medium sized companies (or funds that invest into those) is advisable as well. Investing in emerging and developed foreign stocks (or funds) for a portion of your allocation as well.
Second, review fixed income holdings. For those that have investment grade corporate or long-term maturities? You may consider adding short term inflation protected bonds, like TIPS to your portfolio.
Third, consider the real rate of return on your investments. That is the return you are getting less a) the expected inflation rate and b) the nominal (stated) inflation rate. As an example, if you have a bond paying 3%, its real return would be .565% after the expected rate of inflation or -2% with the nominal or stated rate of inflation. The same can be said for stocks, or growth investments and real estate. Look at your return and subtract out both inflation rates and make any needed adjustments accordingly.
When managing your investments and financial affairs we encourage investors to review and think about what changes they need or want and then to make those over time, not necessarily overnight. At The First Wealth Management and Raymond James, our focus is on actively monitoring and over actively managing our clients’ investments. We appreciate the old saying that at first you concentrate to build wealth and then you diversify to preserve it.
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