Here comes the sun. Across the country, Americans are enjoying summer and the relaxation of Covid restrictions. The optimistic mood extends to very positive economic trends. With widespread vaccination and low case counts, the economy is rebounding strongly and on track for annual GDP growth of 6-8%, the best rate experienced in many years. Pent-up U.S. demand, fueled by federal stimulus and pandemic-sparked savings, is feeding the economy. Tremendous job growth is also expected with the reopening of the economy.
Inflationary pressures are a potential side effect of this good economic news. Consumer prices were up 5% from May a year ago, the biggest jump in inflation in nearly 13 years. This spike may have been exaggerated by weakness in prices a year ago as demand for many goods and services dropped in tandem with lockdowns. Inflation risks are demanding our careful attention and the key question is whether inflationary trends will prove to be transitory. Labor costs will be a key variable to monitor. Given the shortage of skilled labor, we expect upward pressure on wages. This is noteworthy because wage inflation tends to be sticky and may lead to more persistent general price inflation.
In the U.S., the twin trade and budget deficits are over 20% of GDP – a peacetime record. It appears that large budget deficits have been legitimized globally. Historically, however, there have been consequences to sustaining too large a deficit, including a weaker currency or higher interest rates to defend the currency. Investors must consider whether the U.S. can wean itself off extraordinary economic stimulus and artificially suppressed interest rates. We are keeping a close eye on trends in the U.S. Dollar, as a weaker currency will only serve to reinforce the inflationary pressures already present.
Interestingly, in the face of higher inflation, longer-term interest rates have recently backed off from the surging yields experienced in the first quarter of this year. Additionally, the Federal Reserve has said they will not raise short-term interest rates for the near term. These conditions seem to be supporting lofty equity market valuations. The price-to-earnings ratio (a measure of valuation) of the median stock is now higher than the levels reached in the dot-com bubble at the turn of the millennium.
Historically, during the later stages of a bull market cycle, investors are lured into extrapolating the positive conditions that have been supporting the trend well into the future. For example, corporate earnings growth is quite robust and low bond yields seem a poor alternative to surging stock prices. Expecting these trends to persist, investors bid up stocks to sometimes unreasonable levels; the risks of economic recession, price inflation, or higher interest rates are generally not factored into stock prices. Retail investors are particularly susceptible to the allure of positive trends and the prospects of getting rich quick. Accordingly, individual investors and day-traders—who started participating in the markets on a meaningful scale during the pandemic—are playing a larger role in the day-to-day trading in the stock market.
With interest rates low and stock prices high, investors need to be realistic about forward looking returns. High stock prices can provide an opportunity to rebalance, potentially improving or stabilizing future returns. In the current environment, we recommend sticking with high quality, growing businesses. We believe certain stocks can be suitable investments in an inflationary era (if it comes about), given a strong purchase price discipline. On the fixed income side, with current rates, it does not make sense to lend money for longer periods of time (investing in bonds is lending). We are focusing investment in shorter-term bonds and looking for opportunities to lock in higher yields when the return justifies the risk. If inflation proves to be persistent, our patience will pay off for our clients with better returns to follow.
Beyond market and economic conditions, we are also monitoring the legislative landscape, with particular attention to possible material changes to the tax code. We look forward to discussing the investment opportunity set within the context of our clients' unique circumstances and objectives.
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.
