1. Taking Stock: Reviewing our 2021 Outlook
Mid-year is a great time to take stock of the major themes highlighted in our Economic and Market Outlook published in January. What has worked? What hasn’t worked? What has changed?
As we wrote in January, we believed that “accommodative monetary policy, more fiscal stimulus, a benign power transition in Washington, the return of corporate earnings, and the return of economic activity” would result in “value and small-cap outperformance, a weak dollar, a strong China, and higher, but still historically low, interest rates.”
Thus far, our assessment of major market drivers, and resulting asset class performance, has been largely correct. That said, the landscape is constantly changing, therefore we must be vigilant in assessing and reassessing our portfolios relative to the prevailing market environment. Here, we will focus our discussion on the most critical elements impacting our portfolio positioning.
Our Most Important Call
Within BMT’s equity asset allocation, our most significant deviations from the market benchmark are our overweights to mid and small-cap stocks along with our tilt toward value. The value tilt includes large underweights to big 2020 winners – Amazon, Apple, Facebook, Google, Netflix, Tesla to name a few. The rationale for this positioning, as well as our current views, are summarized below.
What we Missed – China
After the sharpest post-COVID economic recovery anywhere in the world, we anticipated that China would be a powerful growth engine this year, despite some efforts by Chinese officials to tighten monetary and fiscal policy. We believed China’s strength would further enable the recovery of export-oriented economies across Europe and Japan, leading to strong equity market performance. Although emerging and developed international stock returns have been solid in 2021, they have trailed U.S. markets. We underestimated how aggressive Chinese policymakers would be in terms of pulling back stimulus and therefore overestimated the economic strength of the Chinese economy this year. Using the growth rate of Total Social Financing as a broad measure of credit and liquidity growth, we can see a sharp deceleration beginning in early 2021. BCA Research calculates a proprietary measure of economic activity, which should begin to slow if history is an accurate guide.
A combination of credit growth deceleration and slower exports may lead to a contraction in corporate profits in the next 12 months. This has the potential to also impact developed market corporate profitability to some degree.
With that in mind, we must also consider certain offsetting factors, especially within developed international markets. Economic reopening continues to accelerate in many European countries, as evidenced by manufacturing PMI data reaching its highest level in many years. Combined with still attractive relative valuations when compared to the U.S., we will maintain a neutral allocation to international stocks. We will continue to watch the unfolding headwinds from China, as this is not something we anticipated.
Looking Ahead – stick with small-cap and value in 2021
Most importantly, we would say that there is still room for small cap and value stocks to outperform large cap and growth stocks. Given that these are our most significant asset allocation tilts, size and style performance will be a major factor driving our relative returns. We believe our positioning is supported by a few key variables. For example:
First, historically small-cap earnings growth has been highly levered to economic growth. In rough terms, the exposure of small-cap earnings to nominal GDP growth is somewhere around 3x that of the large-cap. This is particularly relevant because estimates for future GDP growth continue to be exceptional, especially when compared to the last 10 years.
Small caps also are currently trading at the most favorable free cash flow yield spread to large caps since the Financial Crisis, and valuations remain attractive.
Lastly, interest rates and credit spreads tend to be important variables driving style-factor performance. Of late, 10-year interest rates have declined while credit spreads have tightened. This is a mixed message for equity markets – lower yields often signal slower growth while tighter credit spreads often mean the opposite. This recent behavior is unlikely to last very long. Based on historical returns, value does best when rates are rising and credit spreads are tightening. This is our outlook for the remainder of 2021.
2. As Good as it Gets? Investing at All-Time Highs
Economic data, stock market performance…how could it get any better?
- The Organization for Economic Co-operation and Development (OECD) forecasts 6.9% gross domestic product growth in the United States for 2021. This would be the biggest annual increase since 1984.
- At 64.7, the Purchasing Manager’s Manufacturing index reached its highest level since 1983.
- A year following the March 2020 S&P 500 low, stocks were up 75%. That was the largest twelve-month gain in history dating back to 1950. Stocks were recovering off a low base, but impressive, nonetheless.
At this stage, many investors are wondering what do to with new cash. Can things possibly improve from here? Should a better entry point be targeted?
A note on dollar-cost averaging (DCA)
First and foremost, we will always advocate for investing throughout the market cycle. Consistently timing pullbacks to put money to work is a losing proposition in the long run, and usually leads to investing at higher prices. The reason for this is quite simple – the market tends to rise over time. To quantify this, from January 1871 through December 2020 U.S. stocks returned an average of 0.025% per day, including non-market days and weekends. Due to this simple fact, dollar cost averaging usually means you are buying in at higher, not lower, average prices. Frustratingly, the minority of cases where DCA does outperform lump sum investing (when the market is falling) are precisely the times in which sticking with DCA can be most difficult. Investors are emotional, and it is always uncomfortable to buy into a market that is going down…even if that was the plan.
Strong performance usually leads to strong performance
It is always hard to invest new cash after a big market run. However, the data would not support this behavioral bias. For example, the average return for the S&P 500 three years after a twelve-month rally greater than 50% is 42%. The average return over the next five years is 65%. Simply said, strong performance has historically been followed by strong performance.
A look under the surface of today’s market provides additional evidence to support this optimistic view. In mid-April, 97% of S&P 500 stocks were trading above their own 200-day moving price averages. This represents a broad market advance, with almost all stocks participating. It is exceedingly rare to see a market that strong, with only three other readings above 95% over the last forty years – May 1983, January 2004, and October 2009. One would be correct to assume that such a strong reading may indicate a market that is “overbought,” but that is not the full picture.
In each of these historical examples, a correction or lengthy pause followed, but these periods also represented the early innings of very strong multi-year bull markets. Perhaps bearish in the very near-term, but the momentum and breadth of the current stock market advance is positive when considering a multi-year investment horizon.
Strong Economic Data = Strong Earnings
Many investors are concerned that economic data is as good as it gets, therefore catalysts for additional stock market gains will be scarce. Our view on this subject is simple – the pandemic recovery may have reached its peak, but that does not necessitate an immediate deterioration in economic conditions. Data will remain strong for at least the next twelve months, supporting asset prices and cyclical market leadership. Therefore, we will continue to tilt our portfolios toward mid/small-cap and value stocks. We will of course maintain exposure to growth and technology companies but will remain underweight relative to the benchmark.1
We will often use the Institute of Supply Management Purchasing Manager’s Index (PMI) to help track the economic cycle and the likely behavior of financial markets. This data series has a strong track record of accurately indicating the current phase of the business cycle and trends in what asset classes and sectors perform best. We expect PMI readings to remain elevated, which indicates sustained earnings growth, benign financial conditions, and a higher likelihood of cyclical leadership.
We use several variables to help us forecast the direction of PMI given its high correlation to both earnings and stock prices themselves. One of the most powerful signals we have found is the change in interest rates over the previous two years. An increase or decrease in interest rates works its way through the economy over time and leads to changes in PMI by about 18-months. As seen in the chart below, the economy should continue to have a strong interest rate tailwind for at least another year.
Earnings are key at this phase in the cycle
We believe the economy is in the expansion phase of the business cycle and that we will remain there for some time. In this phase, earnings growth is critical for stocks. Persistent economic growth, as forecasted by persistently high leading indicators like PMI, will support earnings growth as we move into 2022.
3. Semiconductors – Investing Amid the Shortage
The global semiconductor industry has been strained over the past year to keep up with large fluctuations in demand. The Covid-19 pandemic initially drove some, such as the automotive industry, to cut back future orders as a recovery was expected to take multiple years. Chip producers did not stockpile car electronic parts in anticipation of future orders but instead opted to shift manufacturing to areas of surging demand. As working from home and social distancing lockdowns became commonplace in March 2020, products such as smartphones, laptops, desktops, and video-game consoles all started to see supply shortages. Producers of these goods started to place additional orders just as others, such as the automotive industry, were canceling theirs. Despite all odds, much of the global economy persevered throughout the pandemic, and the increased demand coupled with previously canceled orders being reinstated created a situation where semiconductor manufacturers were struggling to keep up. These producers are investing in increased capacity but the investment cycle for semiconductors can take anywhere from 18 to 36 months, resulting in no true short-term solution. The supply shortage for semiconductors is likely not going to be solved in 2022 and will likely bleed into 2023. While there is an industry-wide supply issue, the most severe instances are centered around less advanced chips which have seen decreased manufacturing bandwidth in recent years as producers have been shifting capacity to higher-margin, top-of-the-line chips.
This is where the industry stood at the end of 2020, but two events in February and March of 2021 have introduced even more strain to an already stressed supply chain. In February, a large Samsung factory in Austin, Texas was shut down due to a severe winter storm which resulted in widespread power outages. The factory did not resume full capacity manufacturing for approximately a month, during which it lost out on the production of ~100,000 wafers used as the basis of semiconductor production. Additionally, in March 2021, a factory owned by Renesas Electronics located outside of Tokyo, Japan experienced a fire in which a large portion of its cleanroom facilities was destroyed. It is estimated that Renesas is responsible for over 65% of all 300mm chips which are widely used in infotainment systems. While the organization has multiple production facilities, the fire has greatly reduced the volume at which they can distribute needed components. These developments in addition to the previously mentioned supply chain pressures have had an outsized impact on the auto industry as modern vehicles use less advanced semiconductors throughout. As a result, Ford, Volkswagen, Honda, and many others have had to reduce or temporarily pause production during the first two quarters of 2021.
Rise of the Foundries
Gordon Moore, a co-founder of Intel, publicized his opinion in 1965 that the number of transistors on an integrated circuit will double every year. He initially believed that this trend would occur for about a decade but later revised his hypothesis in 1975 to have the number of transistors double every two years. This framework, later called Moore’s Law, has been instrumental in long-term planning within the semiconductor industry and became somewhat of a self-fulfilling prophecy in terms of development cycles. In addition to the well-known first law, Moore’s second law is an observation related to semiconductor producers. It states that while the number of transistors and therefore computing power doubles every two years, the cost of a semiconductor chip fabrication plant doubles every four years. As the price of computing power continues to fall, the associated costs with fab manufacturing will likely continue to increase despite improvements and optimizations by producers. From the 1970s to the mid-2000s, the dominant industry model was an Integrated Device Manufacturer (IDM) like Intel where the design and manufacturing would take place in-house. However, as the second law became more of a reality and costs started to increase, specialized chip manufacturers called foundries emerged and started to take market share away from IDMs. Many chip designers did not want to make the large capital investment necessary for in-house semiconductor production and became known as fabless companies. This trend has continued to accelerate with large foundries dominating the industry. Taiwan Semiconductor Manufacturing Corporation (TSMC) and Samsung are currently the only two foundries offering services to produce top-of-the-line chips making up ~84% and ~16% of the market respectively. Intel is the only IDM still on the cutting edge of chip design, but the company has been struggling to keep up with the manufacturing prowess of the foundry duopoly.
Consolidation, Regionalization, & Expansion
The extreme concentration within the industry has allowed for an impressive amount of efficiency, but it could come at the cost of future supply shortages. For example, the vast majority of TSMC facilities are within Taiwan, a notable geopolitical flashpoint between the United States and China. Taiwan is a self-proclaimed independent country with its own democratic process, but China believes it to be its own territory, currently acting as a rogue state. If TSMC’s Taiwan facilities were ever compromised, the world would likely face an extreme semiconductor shortage that would make the current situation seem mild. The company is aware of this issue and has been attempting to diversify its geographic footprint but many of its largest clients were against the cost increase that decentralizing would incur. However, this sentiment has recently changed due to the premature unification of Hong Kong into Mainland China. Many now see disruption as a realistic threat and urge TSMC to build more state-of-the-art facilities closer to their end-customers in a process dubbed regionalization. TSMC recently started construction on a new factory in Arizona worth over $35BN USD and is not alone. Intel is also expanding its foundry footprint in the United States, committing over $20BN USD to build two new facilities also located in Arizona. If regionalization is successful, we find it likely that future shortages will be less extreme, and not reach across the globe. Soon, we may see a global semiconductor supply chain that is geographically diverse with every region having its own dedicated facilities. In the spirit of this trend, TSMC and Samsung have committed to spending ~$80-$100BN USD each over the next three years to grow manufacturing capacity. Intel also announced plans to open its foundry capacity to fabless companies in need of manufacturing in a bid to become a hybrid of an IDM and foundry. While these actions do not help the current shortage, we believe that the steps TSMC, Intel, and Samsung are taking to increase production capacity will benefit the industry for the long term.
Looking to the Future
The current shortage highlights just how integral semiconductors have become within the current business environment. Additionally, the projected growth of AI, VR, 5G, mobile devices, automotive technology, and cloud computing will likely lead to substantially higher secular demand for semiconductors. We believe that some within the industry are positioned to take advantage of this growing importance and will achieve long-term outperformance. As previously discussed, TSMC is systematically crucial and has shown no signs of slowing development for the most advanced chips. While TSMC is a leader in the cutting edge, the realm of integrated circuits is comprised of many attractive sub-industries. Analog Devices Inc. (ADI) is one of the most innovative suppliers of semiconductor devices to the automotive, energy generation, and healthcare sectors. One of the most exciting developments is the adoption of electric cars, as the ADI manufactures various products that improve efficiency and increase driving range. Skyworks Solutions Inc. operates in another sub-industry that focuses on enabling wireless connectivity in a wide variety of end uses. While SWKS is currently concentrated within consumer handheld electronics, we believe the company will be able to grow and diversify its business as more devices become wirelessly connected. TSMC, ADI, and SWKS are just a few examples of what has been integrated into the BMT Custom Equity Portfolios and Equity Separately Managed Accounts (SMA), all of which will allow our clients to capitalize on the continued advancement of computing technology.
4. ESG Investing – Fad or Future?
ESG investing has gradually evolved over time. Pax World Funds launched a socially responsible mutual fund in 1971, which was the first investment strategy formally designed to include ethical values into the investment decision-making process. Over the next couple of decades, socially conscious investment strategies began to emerge that incorporated exclusionary screens or filters, which entails avoiding companies that produce products or services (tobacco, firearms, etc.) deemed to negatively impact society. In the 1980s, the Comprehensive Anti-Apartheid Act, which prohibited new investments in South Africa, as well as the Exxon Valdez oil spill set the stage for increased awareness of social and environmental causes. In 1990, the Domini 400 Social Index was launched, which was the first benchmark used to gauge the performance of stocks that pass certain social/ethical standards. By 1994, there were approximately 25 socially responsible mutual funds, with roughly $2 billion in assets under management.2
Over the next 25 years, the definition of socially conscious, or ESG investing began to expand. Some investment firms started to rely less on exclusionary screens and began to quantify risks, based on various environmental (climate change, pollution, deforestation, etc.), social (diversity, human rights, labor standard, etc.), and governance (board composition, executive compensation, etc.) criteria. The assessment of ESG factors and risks is often done in conjunction with conventional, bottom-up security analysis, as opposed to being a separate and distinct component of the investment process. Many socially conscious-oriented investment firms, given their size and scale, also began taking an active approach when engaging corporate management teams about various ESG-related topics. During the past decade, the term “sustainable investing” has become more prominent and is centered on creating long-term value by bolstering relationships with all corporate stakeholders (employees, customers, suppliers, communities, governments, etc.), not just shareholders. The idea is that companies who operate with these issues in mind will be able to maintain and grow their business for a longer period of time versus the average company. Impact investing, another permutation has gotten more traction in recent years. This approach not only focuses on evaluating companies through an ESG and stakeholder lens but also considers the net societal benefits of the goods or services produced. There is even a subset of products that emphasize specific themes (i.e., climate change, diversity, renewable energy, etc.).
A Growing Trend
In response to investor demand, there has been a proliferation of ESG-oriented investment strategies, numbering in the hundreds, with a wide range of goals and objectives as highlighted above. Based on data compiled by US SIF (“Sustainable Investment Forum), sustainable, responsible, and impact assets under management are north of $17 trillion, representing roughly 1 out of every 3 dollars in assets under professional management in the United States. Widespread adoption of ESG investments is not strictly a U.S. phenomenon. According to some estimates, the total value of global investment strategies with ESG mandates will exceed $50 trillion by 2024.
A confluence of events ranging from the COVID-19 pandemic to broad social unrest across the United States, as well as a renewed focus on climate change given shifting policy priorities in Washington, helped foster increased demand for ESG-oriented investment mandates in 2020 and 2021. On June 17, 2021, the House of Representatives passed the ESG Disclosure Simplification Act of 2021, which if ratified by the Senate, would require publicly traded companies to disclose various ESG-related data and metrics. Furthermore, leading ESG indices have continued to deliver favorable returns relative to the broad market across different geographic regions – a fact not missed by investors looking to deploy capital.
An ESG Bubble?
Any time an asset class delivers strong relative performance, followed by a surge in asset flows and increased media attention, we always worry about the potential formation of a bubble – almost all of which invariably deflate. In our opinion, there are segments of the ESG landscape such as the renewable energy industry, that look richly valued or have experienced extremely high price momentum. The chart below highlights a few renewable energy ETFs that have significantly outperformed the broad market as well as a more diversified universe of highly rated ESG stocks over the past couple of years.
However, to say that there is a massive asset bubble brewing in the entire ESG space is an exaggeration in our opinion, and candidly, somewhat misleading. Based on data compiled by Empirical Research Partners, stocks deemed “ESG Leaders”, or stocks more widely held by various global ESG investment strategies, do have a more pronounced bias toward growth (as opposed to value). So, if growth underperforms value, are ESG investments destined to significantly trail the broad market? While we don’t know for sure, we think the opportunity set of stocks and third-party investment solutions is robust enough to build ESG-oriented portfolios without outsized factor tilts.
For example, BMT’s new Mission Aligned investing program has created a diversified portfolio targeting themes such as equal rights, climate change, and broad environmental impact (among others). We have done with without drastic size or style exposure differences when compared to our more traditional portfolios. Therefore, we are able to invest via an ESG lens without sacrificing the exposure diversification that is core to our process.
In addition, over the long term, some of the investment industry’s leading ESG benchmarks (highlighted in the table below), have reasonable returns, correlations, and volatility when compared to more traditional Core, Value, and Growth benchmarks.
In sum, we don’t think the interest surrounding ESG products is fleeting. While the rapid growth of sustainable investing may level off to some degree, we think it’s likely that ESG-oriented strategies will constitute an even larger percentage of the total value of investable assets as time progresses.
5. Investing in Big Ideas – The Advent of Molecular Medicine
Following the initiation of the Thematic Equity Fund managed by Chevy Chase Trust Investment Advisors (CCT) in our BMT Custom Equity Portfolios, we have received several inquiries into the strategy’s underlying themes. Clients have been particularly interested in the “Advent of Molecular Medicine” theme, a topic we dive into in more detail below. As a refresher, the Global Thematic Equity Fund looks for investment opportunities driven by secular trends that are expected to play out over a multi-year time horizon. Chevy Chase believes there are powerful secular trends driven by economic, demographic, and technological changes that are powerful enough to positively influence the financial performance of companies across multiple industries.
Molecular Medicine – What is it?
Molecular Medicine studies the inner workings of genes, proteins, and other cellular molecules and how they can be used to diagnose and treat disease. Molecular medicine can be a very broad topic and for our purposes, will focus on genomic medicine which seeks to use findings in the study of our genes and the entire human genome to provide better clinical care to patients. The main catalyst for this new area of medicine was the Human Genome Project (HGP), launched in 1990 by the U.S. Government. The Project’s goal was to determine the base pairs that make up human DNA (deoxyribonucleic acid) as well as mapping all the genes of the human genome from a physical and functional standpoint. After 13 years, HGP was completed in 2003 and was an overwhelming success as its entire sequencing of the human genome has advanced the usage of genetics to understand and manage various diseases. While molecular and genomic medicine remains “young” by medical standards, it is providing great promise to one day solving many deadly diseases.
Why is it important?
The practice of medicine is evolving because of the breakthroughs in genomic science. Historically, clinical care required a physician to make many judgments about a patient’s condition through symptoms, anatomy, and their own experience. Today, physicians are increasingly using a person’s molecular and genetic information to improve diagnosis and treatment. Many human ailments have some basis in our genes, but their study has been limited until the completion of the HGP. Genetic variation accounts for physical differences like height and hair color. These variations also have medical consequences such as susceptibility to diseases like cancer, diabetes, cardiovascular disease, and Alzheimer’s disease. An individual’s genetic makeup can impact their response to certain drug treatments. The evolution of the treatment of cancer is a great example of how genomic data is shaping care. Historically, if diagnosed with cancer, a patient would have surgery to remove a tumor, followed by chemotherapy or radiation to try to kill cancer, which unfortunately killed healthy cells as well. Today, cancer cells as well as your genes can be examined to better match your and your cancer’s specific genetic makeup to determine the best course of treatment and whether certain drugs will be effective. For example, two drugs Erbitux© and Vectibix© are used for the treatment of advanced colorectal cancers, however, they do not work if a patient has mutations in the KRAS gene. As a result, doctors can sequence the cancer cells to check for mutations to better tailor treatment for success. The ultimate vision is to make the practice of medicine more precise and personalized by tailoring treatment to a patient’s particular genetic makeup. Furthermore, diagnostic tests are being developed to test for signs of cancer in your blood through a liquid biopsy in comparison to current tissue biopsies that are more expensive, invasive, and often catch diseases too late in their progression. COVID-19 has provided a boost to genomics and the importance of genetic sequencing. National health agencies used genomic sequencing to study and follow COVID’s mutation and spread. Genetic sequencing also allowed for the rapid development of vaccines and therapies. Moderna’s vaccine, one of the first in the U.S., was developed from COVID sequencing data and enabled the company to ship doses to clinical trial in 42 days without ever having the virus onsite.3 While it remains early days in the study and application of genomic medicine, there is great promise that it can save lives and reduce the long-term cost of health care.
How we are investing
Through our investment in the CCT fund, our core holding within the “Advent of Molecular Medicine” theme is Illumina, Inc. (ILMN), the global leader in solutions for genetic sequencing. This company produces sequencing and microarray systems, consumables, and analysis tools that are accelerating and simplifying genetic analysis. For the medical community to advance its knowledge and use of the human genome in treating disease it must have a cost-effective way of studying genetic data. This has been Illumina’s core mission, to enable the collection and study of genomic data through the continued reduction in cost and time to sequence the human genome. Illumina, whose equipment has generated 90% of the world’s sequencing data has helped to reduce the cost to sequence the human genome from $95 million in 2001 to under $700 in 2020.
By empowering genetic analysis and facilitating a deeper understanding of genetic function and variation, ILMN’s tools advance disease research, drug development, and the creation of molecular diagnostic tests. This fundamental shift in health care with a greater emphasis on preventative and predictive medicine will usher in a new era of precision of health care.
CryoPort, Inc. (CYRX)
As pharmaceutical companies develop more biologics, cell and gene therapies, there is a growing need for a more specialized logistics network. These therapies which involve the shipment of live cells require very cold and precise temperature control as well as timely delivery. Many cell therapies need to be shipped at cryogenic temperatures (minus 196 degrees Celsius) to prevent degradation of the cells. For example, samples used to develop CAR-T therapies must be kept below minus 136 degrees Celsius and a stable range of 2 to 8 degrees. Logistics are further complicated as many use a patient’s own cells transported to a lab, then back to the patient for infusion. CryoPort is the answer to these complications. The company provides specialty temperature-controlled supply chain solutions to the life sciences industry. Its focus is on serving the cell and gene therapy (C>) market which has these unique supply chain challenges. The C> market is expected to grow from $4.3 billion in 2019 to over $33.1 billion by 2024, driving robust demand for specialized logistics. The company has a strong competitive position as it is integrated into 491 clinical trials, providing a sticky revenue base when treatments become commercialized.
Guardant Health, Inc. (GH)
As mentioned previously, there is great promise in using genetic data for diagnostics and in particular prevention and early detection. Guardant Health has developed proprietary blood-based tests it hopes can be used for early cancer detection. The company believes it can overcome cancer through the collection of molecular information at all stages through a routine blood draw, also known as liquid biopsy. Liquid biopsy uses bodily fluids to look for genetic material from tumors and is less invasive and lower risk than a typical tissue biopsy. Guardant hopes to capitalize on a $70 billion market of cancer therapy selection, recurrence monitoring, and early cancer screening. The Guardant360 test is a molecular diagnostic test measuring 74 cancer-related genes and the Guardant360 CDx was the first comprehensive liquid biopsy test approved by the U.S. Food and Drug Administration (FDA), measuring 55 cancer-related genes.
As mentioned, the world is much closer to the beginning than the end of its development of molecular medicine, but the potential impact is very large. We remain confident in Chevy Chase’s approach to investing in the “enablers,” and while the holdings may change over time, the theme appears primed for success over the long term.
Recent inflation data has been exceptionally high over the past few months.
In May, consumer prices increased 0.6%, the second-largest advance over the past decade, while rising 5.0% over the past year. When excluding food and energy costs, core CPI increased 0.7% in May and 3.8% over the past year, the highest since June 1992.
The headlines are certainly attention grabbers but, in our view, not the beginning of a longer-term inflationary trend.
Today’s higher inflation, which we believe is partly due to base effects, pent-up demand, significant savings, and demand/supply imbalances will likely adjust lower as the impact from the unusual shutting down/reopening of the U.S. economy fades. Consistent with this view, inflation expectations have remained well-anchored near historical levels, an indication the recent inflation spikes will be partly transitory. With this in mind, we expect the Fed will be patient before adjusting monetary policy to ensure that any inflationary trend is sustainable.
Below, we review what we believe to be the key factors driving the current jump in inflation, while also covering the reasons we believe inflation pressures will ease moving into 2022.
When U.S. economic activity was most depressed during the economic lockdowns, consumer prices dropped for three consecutive months beginning in March 2020 through May 2020.
When measuring today’s year-over-year price increases, the comparison period is one of abnormally low inflation driven by economic lockdowns and business closures. These base effects will eventually fade away as the most depressed months drop off from the 12-month period and the annual data is less exposed to pandemic-related price pressures.
Pent up demand
Sectors most exposed to the lockdown are now seeing a notable bounce-back in activity. For example, after months of shelving travel plans, vacations are back on the calendars. Coinciding with the extra foot traffic at airports and hotels, prices have also increased. In April alone, prices for hotels/motels increased roughly 9% while airfare jumped by more than 10%. We would view this inflationary spike as more temporary as demands begin to normalize.
Bottlenecks and supply/demand imbalances
The reopening left some suppliers on their heels, creating demand/supply imbalances across different economic sectors. Bottlenecks are evident as demand outstrips supply and price pressures build.
For example, used cars have recently felt upward price pressures, partly due to bottlenecks associated with the production of new cars. After reducing inventory last year, car rental firms were working with an empty parking lot when customers began lining up again. After chip shortages limited the availability of new cars, car rental firms turned to the used car market to restore inventory. Increased prices have been notable in both the rental car and used car markets due to supply constraints. As bottlenecks improve and supply is better positioned to catch up with demand, price inflation is expected to fade. Lumber prices (down about 50% from their peak) may be a good indication of what’s ahead.
Lumber has been in high demand as individuals focus on home additions and remodeling. Supply hasn’t kept up, partly impacted by sawmill shutdowns during the early period of the pandemic. More recently, after reaching a record high of $1,686 on May 7, lumber prices dropped by nearly 50% and closed under $800 on June 28. High prices softened demand as suppliers were still building inventory. Although each product is different, lumber’s recent price activity provides some insight into how other products with similar reopening patterns may evolve.
Today’s higher prices have not significantly influenced consumers’ expectations for future prices. This is important. When there is an expectation for significantly higher future prices it can lead to a self-fulfilling prophecy – in anticipation of higher prices, consumers fill up their shopping carts with today’s, lower-priced items. Higher demand, influences prices higher. Businesses raise prices and the cost of living increases. Workers turn to employers for pay raises. To support margins, companies increase prices which ends the cycle.
Based on the data, we don’t see this scenario as likely. Expected annual inflation beginning five years from now was at 2.24% on June 11 based on Treasury Inflation-Protected Securities (TIPS) breakeven inflation compensation data. Not alarming at all. In fact, the rate is below the five-year averages leading up to and following the prior recession that began on 12/31/2007.
Investment Implications and the Fed
We certainly acknowledge today’s inflation is abnormally high, but it is also explainable. Differentiating between transitory and sustainable inflation will be key when determining long-term implications. For the reasons stated above, we believe the recent spike is temporary.
The Fed also sees today’s inflationary spike as partly transitory and has communicated this on numerous occasions. Monetary policy will likely remain accommodative until a sustainable inflationary trend emerges. Until then, the Fed will be patient before withdrawing policy, consistent with Fed communications. Today’s low short-term rates will be with us for a while longer. According to the Summary of Economic Projections, the federal funds target range is expected to remain near 0.00% at least through the end of next year – another 18 months or so.
Considering that the Fed has yet to announce any tapering of its $120 billion monthly bond purchases, even 18 months presents a tight window for the first rate hike. We expect the Fed to fully wind down its purchases before any consideration is given to altering the Fed Funds rate. Tapering discussions may be at their early stages, but actual changes to monthly purchases are probably more of a late this year or early 2022 occurrence considering the labor market still needs time to reach “substantial improvement.”
Time will certainly help resolve the transitory/sustainable inflation debate. For now, we believe there are compelling reasons today’s high inflation data will prove to be more transitory. If so, this will likely keep downward pressure on interest rates, particularly at shorter maturities. Although investors are speculating that a more hawkish Fed will soon emerge, we are not convinced that their policy path will be accelerated by presently higher inflation.
7. It’s Raining SPACs and Doges
From fringe cryptocurrencies to internet-driven “meme stocks”, 2021 has provided a persistent undercurrent of unusual market activity. For those investors that choose to speculate, extreme volatility and the potential of permanent capital loss are risks that should be well understood. Although prices are usually not governed by fundamentals in the near term, we believe that an investment’s true value is always revealed…eventually.
Special Purpose Acquisition Companies (SPACs)
SPACs are shell companies that raise money and list on an exchange with the sole intent of merging with a private firm to take it public. SPACs have two years to make a deal or they must hand back the cash to investors. Over the past year, abundant capital looking for a home has led to an extraordinary amount of private companies going public. While much of this activity has still been done through traditional initial public offerings (IPOs), SPACs, which have been around since the early 1990s, have grown in popularity as the rules and regulations for SPACs (vs. IPOs) make going public much more efficient.
While SPACs will always be a viable option when taking a company public, the recent explosion in volume is not sustainable. We believe a key near term risk is that as the large number of recently raised SPACs approach their 2-year acquisition deadline, SPAC sponsors (the management team that forms the SPAC) may be motivated to make deals that are less than desirable in order to get their outsized incentive payments. Not all SPACs are bad (not by a longshot) …but they’re not all good either. Be selective and always conduct proper due diligence.
While there is no official definition of a meme stock, it tends to be a stock that has a high amount of short interest, starts trading on high volume based on social media mentions, and has a sharp rise in price for essentially no fundamental reason.
AMC Entertainment (AMC), the largest movie theatre chain in the country, is the most recent meme stock to garner attention and abandon trading based on fundamentals. The company has taken advantage of the stock going from under $2/share in January to over $70/share on June 2 by issuing 20 million new shares. Evidencing the current mania, the company issued the following warning in the prospectus for the recent share offering:
“Within the last seven business days, the market price of our Class A common stock has fluctuated from an intra-day low of $12.18 on May 24, 2021 to an intra-day high of $72.62 on June 2, 2021, and we have made no disclosure regarding a change to our underlying business during that period, other than with respect to an additional financing.
We believe that the recent volatility and our current market prices reflect market and trading dynamics unrelated to our underlying business, or macro or industry fundamentals, and we do not know how long these dynamics will last. Under the circumstances, we caution you against investing in our Class A common stock, unless you are prepared to incur the risk of losing all or a substantial portion of your investment.”
The company has gone from having 100 million shares outstanding with a market cap of under $1 billion at the end of 2019 to a company with 500 million shares outstanding and a market cap of over $25 billion. All this while sales are not expected to return to 2019 levels until at least 2024.
While the disconnect between meme stocks’ performance and underlying fundamentals has admittedly lasted much longer than we would have expected, we continue to believe that eventually, share prices will reflect the underlying fundamentals of these companies. When the music stops, make sure you have a chair.
Cryptocurrencies are another area of the market that has received a lot of attention and has seen significant price movements in both directions. Bitcoin has gone from under $10,000 at the end of 2020 to over $60,000 in April of this year. In the last two months, the price has fallen below $30,000. We wrote extensively about our views on Bitcoin in a March publication (https://www.bmt.com/bitcoin-what-you-should-know-before-investing/).
Our view is that Bitcoin faces real hurdles to becoming a widely adopted medium of exchange, but that it may be an attractive store of wealth (as with gold) as its fixed supply cannot be devalued by central bank money printing. There will likely continue to be price volatility due to the many unknowns, but there is a clear case for longer-term value. There are also areas of the cryptocurrency market that are purely being driven by speculation, Dogecoin being the clear example.
8. More Spending and More Taxes
By the time you read this, the fiscal policy discussion will likely have changed and changed again. Look no further than the initial infrastructure proposal. The American Jobs Plan (AJP) was released on March 31, 2021, calling for an additional $2.2 trillion in federal spending during the next decade. Now a two-stage package seems to be the way forward, with a smaller bipartisan agreement being tied to a much larger second bill which would be passed along party lines through budget reconciliation. However, there is still widespread disagreement about the price tag of the larger bill, as well as how to pay for it. And lest you think the disagreement is purely down party lines, it most assuredly is not.
Watered Down Tax Hikes and Market Impact
Amid all the policy debate, we believe the question now is not whether taxes are going to go up, but by how much. From there we need to understand how an increase in taxes might impact the economy and financial markets. We believe that President Biden’s original plan for tax hikes needs to be significantly watered down to gain majority support among Democrats. For example, Senator Joe Manchin (D., W.Va.), a key swing vote in the Senate, has signaled he might be willing to support a broader spending package via a reconciliation bill that included raising the corporate tax rate, but only to 25% and taxes on capital gains to 28% versus 39.6% in President Biden’s original proposal. This seems like a feasible outcome, in our view. We expect a tax increase of this magnitude to result in a 5-6% decline in S&P 500 earnings.
For now, investors are likely to shrug off the near-term impact of higher taxes, given strong economic growth and continued support from accommodative monetary policy. Looking back to 2017, analysts did not begin to reflect the benefits of the Tax Cuts and Jobs Act in their 2018 EPS estimates until after the bill was signed.
Although tax increases may impact the magnitude of market advances in 2022, we believe the bull market will endure. Consensus estimates still point to earnings growth of 15% for S&P 500 companies in 2022, so it would take an unrealistically large tax increase to keep corporate profits from continuing to grow. The IMF’s latest economic projections forecast U.S. real GDP growing by 3.5% in 2022, a full percentage point faster than their January forecast. Given the strong correlation between equity returns and economic growth, the equity bull market will likely survive a tax increase.
9. Oil Prices Keep Rising – Is a new commodity “super-cycle” emerging and should investors adjust portfolio allocations?
Understanding the Last Commodity Boom
Commodity super-cycles are infrequent and typically occur when there is a structural shift in demand, a long-lasting curtailment of supply, and an element of speculative fervor by investors as the final stages of the bull market play out. A case could be made that the last commodity super-cycle began during the late innings of the 1990’s “Dot Com Bubble” and peaked right before the “Great Financial Crisis” wreaked havoc on the global economy. The last commodity market boom coincided with the rapid industrialization within certain emerging market counties, especially China. In 1999, China’s annualized GDP growth rate was under 8%. Six years after China was admitted into the World Trade Organization (“WTO”) in 2001, its annualized GDP growth surpassed 14%. China’s transition (highlighted in orange) from an agrarian society to an industrial powerhouse over the last 40 years is captured in the chart below.
China’s economic transformation caused a significant increase in demand for raw materials necessary to urbanize a society. S&P GSCI (Goldman Sachs Commodities Index), which is comprised of the most liquid, production-based commodity futures contracts for energy, agriculture, industrial metals, livestock, and precious metals, rose rapidly during the early to mid-2000s. Oil prices over this period experienced more than a 10-fold increase.
What’s Ahead for Commodity Prices
After recovering from the lows during the depths of the Great Financial Crisis, commodity prices have been trending downward given a period of tepid global economic growth, less demand from China, and increased supply resulting from technological innovation within the energy complex.
As of today, the worst of COVID-19 seems to be in the rearview mirror as vaccinations administered to the global populace continue to increase. Economic growth has accelerated from depressed levels while fiscal and monetary policy has remained quite accommodative. All these factors have led to significantly higher prices for risk assets, including commodities. Does the rapid rise in commodity prices signify a post-pandemic recovery, or do they suggest the start of a new secular trend?
Without the benefit of hindsight, it’s nearly impossible to answer this question. However, the proclamations circulating around the financial media about the dawn of a new commodity super-cycle seem a bit sensational in our opinion. We do acknowledge that the macroeconomic environment has created a tailwind for commodity prices in the near term; however, we are skeptical about whether the factors typically associated with super-cycles are in place. In the past, these events were driven by prolonged U.S. dollar weakness and a structural shift in demand.
Assessing Secular Trends
Countries such as India, Brazil, Nigeria, or Indonesia could undergo economic transformations that are often accompanied by massive infrastructure-related investments, like China more than a decade ago. However, there are demographic challenges for many developed countries, as well as China, that could have a deflationary effect on commodity prices over the long run. First, the dependency ratio, as illustrated in the chart below, is projected to rise over the next several decades. When this number is rising, the size of the global workforce is shrinking in comparison to the rest of the population. This in turn typically leads to weaker growth, and potentially a persistent headwind for commodity prices.
In addition, some estimates indicate that China accounts for more than half the world’s steel production and has been a major contributor to oil demand growth. China’s population (along with India) is expected to dramatically decline over the next several decades.4
While there are near-term catalysts that could cause commodity price inflation, we are skeptical of the long-term impacts. In terms of energy prices (oil, natural gas), U.S. and OPEC producers have spare capacity, which will likely result in an uptick in supply if prices continue to climb.5 It is also likely that demand for fossil fuels will wane over time given the persistent global focus on renewable energy and climate change. Industrial commodities, such as timber and copper, have gotten a boost from the strong housing market. We think that the housing market will start to stabilize and even level off once fiscal and monetary authorities begin to remove accommodative policies put in place due to COVID-19. Furthermore, cryptocurrencies have garnered investor attention and appear to have quelled demand for precious metals, like gold and silver.
Finally, the increased popularity of ESG investing and innovations in response to climate change may lead to strong secular demand for industrial commodities, such as copper, nickel, and certain rare earth minerals. However, we don’t think a super-cycle, which benefits a wide range of commodities, is a likely outcome. Therefore, we believe investors should avoid making drastic changes to their portfolio allocations based on conjecture that a new commodity super-cycle is about to begin.
10. Real Estate in the Aftermath of the Pandemic
The real estate market has seen significant changes over the last 18-months. Some sectors are continuing to struggle, while others are flourishing in a new era of remote connectivity and accelerating e-commerce trends. While much is uncertain, we believe that broad real estate exposure will be beneficial for investors over the long term.
Residential Real Estate – Strength Personified
The residential sector has been on fire – rising prices, rising rents, and a rush to buy and build have created a frenzied dynamic in this corner of the real estate market. Though COVID-related policies and an accommodative Fed are playing a part, some drivers of the market have been lurking below the surface for years, perhaps serving has persistent support. For example, chronic underbuilding since the Great Recession has led to a low housing supply – 2021 began with nearly 52% fewer available homes on the market versus the prior year. The simple supply/demand imbalance will likely persist for some time, providing a level of fundamental support even as certain stimulus measures begin to wane.
Other factors can of course be linked more directly to COVID: lumber shortages resulting from mill closures and restrictions on imports sent the price of lumber skyrocketing ~400% from April 2020 to April 2021. Although this has added $36,000 on average to the cost of building a new home, and around $119 to average monthly rent, demand is robust.
Apartment housing has also been counterintuitively strong. Though disaster was predicted for residential rental properties as prohibitions on eviction were introduced, rent collection in 2020 only dipped between 1-2%, showing a much more resilient market than was previously thought. In addition, rent growth stayed steady through the pandemic. As coastal urban areas such as NYC and San Francisco saw rent declines around 8%, sunbelt and coastal suburban areas drove a net increase in overall rent growth to 3.9%. The combination of these factors – unimpacted rent collection and rent growth – led many apartment REITs to increase their distributions in 2020.
We think an important dynamic in the rental market is the trend of “high-income” renters increasing significantly over the last decade. Whether through convenience, location, lack of single-family home supply, or changes in the family structure, households earning over $75,000 have been renting at increasing rates, and the construction of new apartments has catered largely to this demographic. Apartments in this demographic tend to experience more stability, with households below this income threshold being twice as likely to fall behind on rent in 2020. As this “high-income” demographic continues to take on a greater share of the market, it adds to the resiliency and profitability we have already seen in the last year.
Commercial Office Space – Not as Bad as Feared, but the Trend is Clear
How do corporate reopening plans affect the need for office space? Is work from home the new standard? Is conventional in-person retail shopping a thing of the past? Over the next few years, businesses will have to answer these questions and evaluate their physical footprints.
During the pandemic, many companies preserved their physical office space even with employees working from home. With restrictions being removed and employees starting to return to the office, these companies are making long-term strategic office space plans. These decisions will have a significant impact on the owners of this segment of commercial real estate. A survey from the American Institute of CPAs conducted in Q1 2021 showed increases in businesses planning a 10% to 49% reduction to office space compared to Q3 of 2020. Some companies being locked into long-term leases may explain, in part, the “No Change” responses. As these leases expire companies will reevaluate their physical space.
Surveys from BCA Research found differences between employer and employee preferences for working from home. Employees responded with a recommended workweek of 55% work-from-home while employers planned for only 22% (one day a week) work from home. The future will likely fall somewhere in between, forcing companies to reevaluate their real estate needs in order to retain top talent. We see the departure from the office as less dramatic than previously expected, but we believe that in the coming years the need for physical office space will certainly be reduced.
This is our view because, in part, the slow shift away from the office was already in place prior to the COVID pandemic: 17% of Americans already worked from home 5 days a week, a number that had slowly grown over the last decade as technology made remote work possible. According to the Bureau of Economic Analysis, office properties represented 6% of private structures in 2000 which then reduced to 5.6% by 2019. This reflects the net reduction in new office space, which is often difficult to fill for property owners. The good news is that office property owners were in a better financial position entering the COVID pandemic compared to pre-Global Financial Crisis. Office, industrial, and apartment REITs had lower debt ratios entering COVID compared to pre-Global Financial Crisis, while interest coverage ratios for the entire REIT industry were higher entering 2020 compared to 2008.
Retail and the E-Commerce Tidal Wave
Other pre-existing trends were also accelerated by the pandemic. Retail store vacancies have been on the rise for over a decade as retailers shift from traditional brick and mortar locations in favor of online sales. Data from the US Census Bureau shows the increasing percentage of e-commerce sales as a percentage of total retail sales over the past 10 years.
COVID-19 restrictions accelerated this trend as customers moved online to fill their grocery, clothing, and household supply needs without venturing out of the house. Many of these customers will make the permanent switch to online shopping. This trend has had a significant effect on department stores and traditional malls. Restaurants and bars have increased sales by 71% over the past ten years, while department store sales have declined by 29% during that same period. Many department stores have shifted their use of space to storage facilities and distribution centers.
Industrial distribution centers and storage facilities will be a vital component of the online retail supply chain. We see these industrial centers as a complement to a traditional retail storefront. Retailers are offering more purchase options online such as curbside delivery and in-store pickup. Larger retailers are looking to decrease shipping times, or implement same-day shipping. This added convenience necessitates support for additional distribution centers located closer to the consumer. Industrial REITs continue to benefit, having higher occupancy rates than REITs overall while new industrial centers are continuously being built. In 2019 Industrial REITs had net operating income growth of 8.8% compared to the negative growth of retail and hotel/hospitality centers. We continue to see support for the industrial property sector as a vital component of the omnichannel distribution chain.
Diversification is Key
We believe that broad real estate exposure makes sense within the context of a diversified portfolio. We implement this through a diversified publicly traded Real Estate Investment Trust (REIT) ETF. Real estate has the lowest correlation to the overall equity market when compared to other S&P 500 sectors, therefore providing an extra layer of diversification along with higher dividend yields. While the few sectors we discussed above do not comprise the totality of our exposure to the asset class, they are examples of key areas affected by trends in how Americans live and work. It is worth noting that the REIT market has changed significantly over the years – in 2010 retail, offices, and residential made up 55% of the FTSE Russell index. Compared to 2020 those sectors have decreased to a 32% weight, while infrastructure, industrial, and data centers – areas which have experienced significant growth – now account for 38%. The real estate market is extremely heterogeneous, with certain subsectors benefitting from the pandemic while others suffer (at least in the near term). For that reason, having exposure is sensible, and being sufficiently diversified is critical.