It has been a very good start to the year. Stocks are surging higher and the economy is booming. Earnings have largely supported the massive rally that we saw in 2020. And while we continue to have concerns over valuations, we still feel the easiest path forward is up.
This outlook offers our views on the labor market, inflation, fed policy, lingering COVID risks, stocks, bonds, real estate and structured notes. We summarize key points below for those who would prefer not to read the whole thing as it is lengthier than our normal commentaries. As always, the team at Adams Wealth Advisors is happy to help you navigate the markets and are here to answer any questions you may have on how this outlook impacts your portfolio.
We are seeing a strong recovery across the board; this is reflected in economic data and stock prices as shown below.
The S&P 500 is up 15.3% through the first half of the year
GDP is growing at the fastest pace in over 30 years
6.8% in Q1 2021 Expectations are to be 9.8% in Q2 and 6.5% for 2021
Over 3 million jobs have been added to the economy and unemployment has fallen to 5.9%
There are mounting concerns over a labor shortage
Inflation and Fed policy will be important macroeconomic issues for the remainder of the year
Inflation came in at 5.4% YoY in June, which is the highest reading in over 10 years
While rate hikes are likely a couple years out, Fed asset purchases will likely begin to taper this year.
We would expect at least a little volatility around Fed tapering
Covid is unlikely to be much of a story in the US
However, the Southeastern United States may struggle more than the rest of the country
Globally, Covid is still a very real risk, especially in less developed countries
We would expect stocks to remain on their upward trend, but the pace of gains has to subside at some point
It is a challenging environment for bond investors and we do not see that changing anytime soon
Real estate has been on a tear, but we are becoming concerned about the potential for a bubble.
Structured notes have become less attractive in a low volatility environment
This only applies to new notes, our existing book is quite strong
Volatility around tapering and/or tax reform could inject some value into the space.
There has been increasing focus on labor shortages in the United States. Some of the shortages can be put in the “good problem” category. A robust recovery has led to very strong demand that businesses were not adequately staffed to handle. However, generous unemployment benefits are undoubtedly contributing to the shortage.
The impact of unemployment benefits is hard to quantify, but researchers at JP Morgan show the impact to be negligible (Paper available at this link). At least to some extent, businesses find themselves competing not just with each other, but also generous unemployment benefits. Obviously, with high enough wages unemployment benefits become relatively unattractive and bring many workers back into the labor force. Growth in profit margins probably give most businesses room to increase labor costs, but at least to some degree businesses may be playing the long game here. Federal benefits are set to expire in September, at which point labor loses a substantial amount of leverage. While this waiting game causes short term pain, labor costs are hard to reduce, as people are generally unwilling to take pay cuts, which leaves layoffs as the only real option. There is no doubt that unemployment benefits are keeping the unemployment rate higher, but it is not the most significant factor. Schools and childcare facilities being closed probably have a larger impact on the labor force. As would-be working parents are forced to be at home with their children. Barring a major setback from the Delta variant of coronavirus, schools should be fully reopened in the fall. Reopening schools paired with the expiration of unemployment benefits should dramatically alleviate the shortage. As shown in the chart, job growth has been strong and we expect that trend to remain in place throughout 2021 and likely well into 2022.
The mix of massive fiscal stimulus and highly accommodative monetary policy has rightfully led to concerns over inflation. June’s headline CPI was up 0.9% MoM, which is above May’s 0.6% monthly pace and the consensus of 0.5%. This makes June’s CPI change the fastest monthly rise since 2008. June data also showed a jaw-dropping 5.4% YoY inflation rate; a rate that has not been seen in over a decade. This is higher than the consensus rate of 4.9% and May’s 5.0% rate. This release noted a big impact from used car/truck prices (largest monthly increase on record), higher energy prices, and accelerating food-price rises.
On a long-term basis the Fed targets 2.0% inflation. Policymakers have generally agreed that the high rate seen in the first half of this year has been “transitory inflation”. Given massive supply chain disruptions, a lumber industry that was not prepared for a boom in housing and a host of other issues, the Fed’s position certainly has merit. Most economist are forecasting a return to normal rates of inflation in 2022.
However, there are less transitory inflation pressures that are worth keeping an eye on. While lumber prices may be an extreme example, commodity prices have risen sharply.
Prices in the commodity space have been subdued really since the Great Recession of 2008. Prior to that, insatiable Chinese demand boosted commodities across the board, most notably pushing oil to over $172 per barrel. Shortly after the peak, oil tanked nearly 70% and mostly declined for the next decade. The 10-year boom followed by a 10-year bust is common for commodities as they tend to work in much longer cycles. There is some thought that we may be on the early stages of the next commodity super-cycle, which means very low inflation over the past 10+ years would be difficult to repeat.
Fed policy has been incredibly accommodative since the shutdowns began in March of 2020. The monetary response paired an aggressive fiscal response which definitely supported the economy through a truly unprecedented event. The policy moves allowed the economy to avoid a liquidity crisis, which prevents banks from lending, companies from refinancing and eventually bankruptcies. This is not to say the crisis was easy for businesses, but by avoiding a massive wave of bankruptcies, the economy was well positioned for a vigorous rebound, which we are currently enjoying. Given the strength and speed of the recovery, the Fed will need to pivot from supporting growth, liquidity, and employment, in order to prevent the economy from overheating.
The first step in reducing monetary support will come from a reduction of asset purchases, also known as quantitative easing, by the Federal Reserve. This is often referred to as tapering. Over the past 12 months, the Federal Reserve has purchased about 36% of the $2.3 trillion of debt issued by the US Treasury. The Fed also has been purchasing $40 billion of mortgage-backed securities per month since the start of the crisis.
These purchases have undoubtedly kept interest rates low in the face of increasing inflation. Stocks and bonds prefer easy monetary policy and are prone to bouts of volatility as monetary policy shifts towards a less accommodative stance. These bouts of volatility are aptly called taper-tantrums. At the end of the day, tighter Fed policy is an indication of a stronger economy, so we will happily ride out any taper-tantrums and even buy into them, should they become severe enough. In our opinion, the Fed is much more comfortable erring on the side of being over accommodative than overly tight. This is also not the first time the Fed or markets have had to deal with tapering. The 2021/2022 taper-tantrums may be less severe than those of 2013. In our opinion, the bigger risk is that the Fed underestimates inflationary pressures by overly attributing them to transitory factors and then realizes it is too late. The Fed is very capable of reigning inflation in, and markets are perfectly capable of weathering rate-hike cycles, but it will be far less orderly if the Fed is playing catch-up. The early 1980s suffered deep recessions as the Fed wrangled in excessive inflation. To be clear, we do not think this is the base case. Demographics, the lack of a unionized labor force, globalization and automation are strong deflationary forces. Given the structural tilt towards deflation, there is considerable wiggle room to correct for overly dovish monetary policy.
Active COVID cases in the US have been dropping dramatically over the past few months, but the new Delta variant could cause another spike in cases. The variant originated in India and led to a massive spike in COVID-19 cases in May, overwhelming India’s healthcare system.
The reason behind the large increase in cases is because of the variant’s higher reproduction rate. The Delta variant has an estimated reproduction rate of 6.5, much higher than the original COVID-19 reproduction rate that was closer to 1. According to the CDC in the past two weeks 51.7% of the new COVID cases in the US have been linked to the Delta variant. The higher reproduction rate has also caused epidemiologists to change their target for herd immunity. Originally, they were targeting 70% of the US population to be vaccinated or have been infected to achieve herd immunity, but due to the higher reproduction rate, the hurdle for herd immunity may be closer to 85%. Currently, it is estimated that around 70% of the US population have been vaccinated or have been infected with COVID. In general, the US is well positioned to deal with the variant. The lack of herd immunity means that a spike in cases is very likely with the Delta variant. The US is short of herd immunity, but the vaccination rate in the US is enough to offer some protection. The healthcare system should be able to handle the increased case load with minimal disruption. However, the Southeastern United States is in the worst position with a large at-risk population and relatively low vaccination rates.
Even with the Delta variant, we would not expect Covid to have much effect on the US economy. Globally, we expect to see countries with low vaccination rates, like Brazil and Japan, to continue to struggle with containing the spread of the Delta variant. We live in a connected world and the stock market reflects that. While the US is in a great position, Covid is not completely done impacting the market, and obviously much worse, the lives of so many people.
It has been a fantastic first half of the year for stocks. The S&P 500 has risen 15.2% in 2021 and a staggering 96.1% since the lows of March of 2020. We think conditions lend themselves to more gains in the market, but expect bouts of volatility stemming from inflation concerns and Fed policy. Stocks are great inflation hedges in the long term and the Fed is far more likely to err on the side of lower rates than higher. We would look at any volatility, stemming from Fed policy expectations and/or inflation concerns, as buying opportunities.
Heading into the year, we thought the easiest path for stocks was higher, but have been surprised by the magnitude of the gains. The rally has been broad-based, but there has been a change in leadership with the types of stocks most favored.
Energy stocks have led the way due to rising oil prices. While we do not think oil prices have to come down, we are not overly excited about the energy sector. US shale has been slow to ramp up production, which means there is plenty of potential supply once there is belief that oil prices can hold these levels. OPEC has become increasingly dysfunctional and has far less ability to impact the price than it has in the past. It is difficult to say what the fair price of oil is. Historically, we are well within a normal range with room to the upside, but we are not that far removed from a negative price. The inherent volatility in energy paired with the potential for an increase in supply of oil makes us shy away from this sector.
Financials lagged the initial rally but have been the second strongest performing sector year-to-date. Trailing only energy, which has benefited from a massive rally in oil prices. Financials’ performance has primarily been driven by an increase in interest rates. Banks are fundamentally strong from a balance sheet perspective, but from a stock perspective we think that the rally has mostly played itself out. Interest rates have already rolled over, with the 10-year treasury yield at a four-month low at the time of writing. PPP loans were a one-time cash cow for the banks, but overall loans are below their pre-covid trend. The long-term revenue picture looks challenging to us for financials and would expect their leadership in the market to be relegated to short-lived spikes in interest rates from taper-tantrums and/or inflation fears.
Conversely, technology shares have lagged the market after leading it out of the crisis. Valuations in this sector are exceedingly high, which can make them more sensitive to interest rates. The link between rates and growth stocks is tepid but seems to be the reason for the slump in technology in the beginning of the year. Despite high valuations, we still have an optimistic outlook on the tech sector as the long-term growth prospects are very bright. Valuations are not particularly useful in timing the market but are certainly a risk worth monitoring. High valuations do not in-and-of-themselves create market pullbacks, but can lead to more severe pullbacks. The 2001 recession was not a deep recession, but brutal for stock investors due to the very lofty valuations that existed in the market. Valuation concerns are not limited to tech stocks. Tech has been delivering on high expectations, which reinforces high valuations. We expect tech stocks to continue to do well and at least catch up to the broader market in the second half of the year.
Heading into 2021 we expected inflation and low rates to pressure the dollar and offer a tailwind to international equities, especially emerging markets. This thesis has not consistently played out. Emerging markets enjoyed a strong couple of months to start the year, but large EM economies like India and Brazil have really struggled to contain coronavirus. Brazil has made some progress on the vaccination front despite the vaccination effort being plagued with corruption. India faces a serious challenge on the vaccination front with only about 5% of the nation’s 1.4 billion people vaccinated. Chinese stocks have suffered a pullback after a strong first six weeks of the year, but have given all of it back. China has become increasingly aggressive toward offshore listed Chinese companies. DiDi Global (DIDI) shares plummeted this week after it was announced the company will be subject to a cybersecurity review from Beijing. Relations between China and the US, the world’s two largest economies, continue to worsen with no reprieve from a change in US leadership.
Outside of China, returns have been better, but still not enough to keep pace with US stocks. Despite the aforementioned coronavirus issues in Brazil, Latin American equities are quickly closing the gap with a 21% rally since early March.
We think that Latin America could prove to be a good long-term trade and has plenty of room to continue its current rally, but political instability and waning Chinese commodity demand could prove to be difficult to overcome. Overall, we still like emerging markets, especially outside of China. Valuations are more reasonable in the space, demographics are much more favorable than in the developed world, and commodity prices should continue to be a tailwind.
International Developed market stocks have lagged the US as well. European equities outpaced the US until mid-June, but that lead has now completely evaporated. Japan has been flat for the year. The world’s third largest economy has dramatically lagged its developed counterparts in vaccinations and is well behind in reopening. The already delayed Olympic games in Tokyo are likely to not even have spectators as Tokyo remains under lock down, which are expected to remain in place beyond the games. Japan may be the worst of the bunch, but the reopening trade has come in fits and starts for all developed international equities. Many large European economies remain under lock downs and have made worse progress with vaccinations than the US. In Germany, the largest European economy, the population is only 39% vaccinated, France and Italy are only 34% vaccinated. The UK is the outlier across the pond with about 51% of its population vaccinated.
Developed international equities are not particularly attractive to us at this point. A modest allocation makes sense to diversify away from the US dollar without being overly exposed to emerging markets. It is possible the reopening trade gains steam and proves us wrong, but in general we feel emerging markets and US equities have more upside left.
Inflation is typically not a problem for the stock market. However, it is a huge concern for bonds, which are already trading at negative real rates. The real rate is the interest rate of a bond minus expected inflation. We are very concerned about investing in long term bonds and low yields forcing would-be low-risk investors out on the risk spectrum. It is very difficult to make a case for US Treasuries outside of an offset to equity risk. The 30-year US treasury bond is yielding about 2%, which is the Fed’s long term inflation target. Zero real return over 30 years is unfortunately the best the treasury market has to offer right now. However, bonds are likely not in a bubble that will pop, as the Fed can prevent a rapid increase in yields fairly easily, but more importantly, US Treasuries are still attractive when compared to other developed countries debt. The 1.3% yield on a 10-year US treasury is very unappealing until you compare it to a 0.6% yield in the UK, about a 0% yield in Japan and a negative 0.3% yield in Germany. While we do not see catastrophic downside risks in Treasuries, there is nothing compelling about them as an investment.
Investment grade (IG) corporate debt offers some real return, but not much. Compared to treasuries, IG bonds are attractive, but we prefer pushing out a bit farther on the risk spectrum to high-yield bonds, which offer higher yields. Credit spreads, the yield of corporate bonds minus a treasury bond with the same maturity, are historically low, which limits upside in corporate debt. However, spreads are not at all-time lows and typically tighten as rates increase, cushioning the blow from higher rates. We would expect credit spreads to tighten as the economy continues to improve. High yield bonds will benefit from this tightening the most but come with higher risk of default. We think the strong economy will keep default rates relatively low, making high yield more attractive than IG and both far more attractive than treasuries.
Real estate has performed very well this year and is the third strongest performing sector year-to-date. This is somewhat surprising because real estate is typically sensitive to rising rates. Under normal conditions, it is rare to see financials and real estate not on opposite ends of the performance spectrum due to their diametric reaction to changing interest rates. High unemployment and de-urbanization were expected to cause rents to tumble at the start. Shutdowns crushed already struggling box stores. The picture was pretty bleak for real estate not too long ago. 2021 has seen dramatically rising rents, strong consumer spending and a reopening that has not suffered many setbacks.
This reduction of uncertainty in the real estate space allowed the asset class to shrug off headwinds from higher rates en route to strong gains. The Case-Shiller US National Home Price Index has increase 15% since the start of the recession. That is a much faster pace than it was increasing prior to the recession. A shortage of new homes will continue to be a tailwind for home prices for some time. Unemployment will continue to improve, but the improvement will occur generally in lower paying jobs. This will likely support rents, especially in multi-housing, but will be less of a tailwind in higher priced homes. In general, valuations have become unattractive. The yield on the Dow Jones US Select REIT Index currently sits just under 3%, which is very low historically. Price to free funds from operations remains reasonable.
Real estate, specifically non-commercial real estate, is very prone to speculative bubbles. A contributing factor to this boom-bust cycle comes from easy access to cheap leverage and a misunderstanding of the risks in real estate for many non-sophisticated investors. The lack of liquidity in the market means prices are not updated frequently and there is a perception of very little volatility in prices. When looking at publicly traded REITs, there is not much of a difference in volatility in real estate compared to the broader market. Looking at the Case-Shiller Index, we can see that the price of homes are not very volatile.
However, very few investors pay for the house in full; leverage dramatically increases volatility. The 2006-2012 draw down saw the median home price fall about 28%. While stocks recovered much faster than home prices, the peak-to-trough drawdown was 57% percent, about double the decline in the median home price. The stock market moved to new highs by 2013, but it was not until 2017 that median home prices recovered. Now, if an investor put 20% down on the median home price of about $184,000 in June 2006 that would be a down payment of $36,800. By 2012 that same median house price was down 27% to about $134,000 a price decline of $50,000. Mortgage rates were about 6.8% in 2006, so in 2012 there would be about $137,189 left on the loan. The value of the outstanding loan would exceed the value of the house by about $3,189. The decline when incorporating leverage would be 109%, a much worse decline than is even possible in the stock market. Leverage cuts both ways, so the same investment over the past year would have returned about 75%. However, employing the same degree of leverage in the S&P 500, would have resulted in a gain of 92%. Too often we see people looking at the stability in home prices, which is already exaggerated due to the lack of liquidity, and comparing it to their levered returns. You can’t have your cake and eat it too, without leverage, housing is generally a more stable asset class than stocks, but with lower expected returns. With leverage housing returns quickly catch up to equity returns, but with similar if not higher levels of risk.
This is not to say real estate does not have a role in a portfolio, but it is important to properly weigh the risks when comparing real estate to other asset classes. Low rates, an improving economy and increased household formation certainly give real estate the ability to continue higher. However, high valuations and the potential for increasing interest rates makes us more neutral on it relative to equities. Structured Notes Structured notes are a very heterogeneous asset class; in fact, it may even be a stretch to refer to them as an asset class at all. In general, higher volatility leads to better terms for notes. The VIX, a measure of implied volatility in the S&P 500 has fallen below its historical average.
Because of this, we have generally seen either lower yields offered or more complex baskets with higher potential for severe draw downs. We have strict requirements for the purchasing of notes and we have seen a dramatic decline in the number of deals that pass our screening. We would expect this to persist until something sparks volatility in the market. Taper-tantrums and/or tax-reform legislation may inject some value into this space. In the meantime, we will continue to follow our strategy and invest only in notes that meet our standards.
– Cormac Murphy, CFA – Chief Investment Officer & Director Of Research