COVID, INFLATION, and how to Navigate the Market

This market is a lot like a duck, it is calm on the surface but there is a lot of churning underneath.

Image: by Ruslan Khaydarov

As I write this on Thursday night (7/22), the S&P is up 16% YTD and just 1% below its all-time record high on 7/12.  However, there has been a violent rotation underneath this seemingly linear move higher in the S&P.  Versus their 52-week highs, the Russell 2000 index has fallen 7% and the 10-year treasury yield has gone from 1.78% to 1.28%.  The most recent advance in the S&P, however, has been driven by the S&P technology index which was up just 1% till May 12th and since then has advanced 17% in just over 2 months.

A few factors seem to be driving these moves including: 1) a surge in the Delta variant of Covid shutting down parts of the world again, such as no spectators being allowed at the Olympics; 2) peak growth concerns as we lap the worst of the Covid-19 shutdowns a year ago; 3) seemingly more belief in inflation being “transitory” as prices for certain commodities like lumber have gone lower; 4) 10-year Treasury yields retreating from a high of 1.78% to 1.28%.

Since their highs early this year, sectors that were outperforming YTD that were geared to economies reopening and higher inflation have sold off.  From their 52-week highs, the S&P energy sector is down 13% (up 29% YTD), the materials sector is down 9% (up 12% YTD), financial sector is down 6% (up 23% YTD) and the industrial sector is down 3% (up 16% YTD).

Our view remains that economies will slowly continue to re-open as more people get vaccinated and reach herd immunity.  The Olympics banning spectators was clearly a watershed event given it was already postponed.  Having said that, roughly 3.6 billion vaccine doses have been administered worldwide.  Our view has been that as the weather gets colder, much like other coronaviruses such as the flu, Covid will also see a pickup in cases.  We also believe, much like the flu, that every year we will be getting a Covid shot given coronaviruses are known for rapid mutation.  However, close to 30M vaccine doses are being given daily.  Given the desire for humans to interact with each other, we think we will eventually develop new ways of socializing despite the presence of Covid, whether it is wearing a mask at events or getting screened before entering venues.

We also believe that inflation will be more persistent than transitory.  Headline/Core CPI are at 5.4%/4.5%. These are the highest levels since Aug-08/Nov-91. Core PCE, the Fed’s preferred inflation metric, averaged 1.6% for the prior decade. Any concerns about inflation due to the easy money policies following the Global Financial Crisis (GFC) have been wrong.  Our view is that inflation today will be more persistent versus transitory.  While clearly some increases are transitory such us comparing oil prices to negative $35 last April, other inflation components like wage and rental price increases we think will be more persistent given structural changes.  

“Although incoming inflation data are somewhat elevated, a portion of the increase… appears to have been due to transitory factors.” (6/30/04 FOMC statement). However, what followed was 17 rate hikes over 2 years which took the Fed funds rate from 1.00% to 5.25% that ultimately culminated in the Global Financial Crisis as the Fed dealt with inflation that was persistent not transitory.  

We believe wage inflation is going to be the big problem going forward and these increases are persistent and feed through to the cost of final goods and services. Average hourly earnings were up 3-3.5% in the second half of 2019 as wage pressures started to build.  Currently, the Job Openings and Labor Turnover Survey (JOLTS) is 9.2M and compares to 9.3M people that are unemployed and an unemployment rate of 5.9%. It took over 8 years for the number of people unemployed and job opening to overlap following the global financial crisis versus just over a year following Covid.  Average hourly earnings are already up 3.6%.  We believe the unemployment rate will move down rapidly as generous extra unemployment benefits expire in September with over 20 states already starting the process before then.  These wage pressures are only going to get worse as we head towards the holidays when more seasonal workers get hired.

The rise in shelter prices is notable with owners' equivalent rent (OER) up 2.3% y/y and home prices up 15% y/y. April home prices, per the Case Shiller index, is up 15% y/y which is the highest since December of 2005.  Owners' equivalent rent (OER) is up 2.3% y/y and is 30-40% of most inflation metrics and larger than food and energy combined.  OER typically lags home prices by a year so we would expect pressure on rents to continue.

And the Fed looks increasingly behind the curve as the central banks of both Russia and Brazil have raised rates three times each while England joined Canada to become one of the two G7 central bank to start tapering.  Inflation has been relatively non-existent since the GFC (and arguably for 40 years) but now is picking up globally.  Russia, Brazil and Turkey, are among the 19 central banks that have raised their main interest rates so far this year.  In total there have been 29 rate hikes this year already.  Russia’s central bank said earlier this year, "the rapid recovery of demand and elevated inflationary pressure call for an earlier return to neutral monetary policy." 

We believe the Fed will signal the start of their own tapering process by the August Jackson Hole meeting. The Fed continues to reiterate their belief that inflation is “transitory”, but their dot plot has 2 rate hikes in 2023 and they need only 2 more votes for a rate hike in 2022. In our opinion, inflation data for the next several months will force them to change their stance by the Jackson Hole meeting. 

In 2011, 2015, 2018, and 2020, the stock market fell 10-20% over 1- 5 months during periods when monetary stimulus was flat to down.  

• In 2011, the Fed hinted at not expanding its asset purchase program just before a 19% drop in the S&P 500 over 5 months. 
• In 2015, talk of balance-sheet shrinkage preceded a 12% S&P decline in just a month. 
• In late 2018, a comment about the Fed balance sheet un-wind on “autopilot” plus the ongoing trade war coincided with a nearly 20% S&P drop in 3 months. 
• In 2020, the S&P dropped 10%, with 7% in just three trading days starting on 9/2. The Fed balance sheet had been flat to down since mid-June.

GDP growth will be the best in decades both in the US and globally in 2021 driving even more demand pressure on inflation. US GDP growth following the GFC from 2010 to 2019 averaged 2.3%.  This was the slowest recovery following a recession since World War II.  As a result, companies continued to cut back on capacity expansion to match the lower-than-expected growth.  In 2020 following the pandemic, capex was cut back particularly hard as many companies tried to survive the unprecedented drop in prices.  As a reminder, oil got to negative $35 dollars per barrel at one point.  However, US GDP growth is expected to be ~7% in 2021, the fastest since 1984 at 7.2%.  World GDP growth is expected to be 6%, the highest since 1976, after falling 3.3% in 2020.  We believe, this surge in GDP growth combined with low capital expenditures will lead to a persistent, not “transitory”, increase in inflation.

The Fed may need to act in a more disruptive manner than what they have done in the past.  Historically, the Fed has acted preemptively to fend off inflation.  With their new policy of waiting to see if inflation is present before acting, there is a real risk of having to reverse policy much more quickly than in the past.  If inflation turns out to be more persistent than transitory, a rapid tightening in policy might be needed. With valuations at record highs, this might cause a much sharper stock market correction than seen during past tightening cycles, which can lead to slower growth in the future.  This might not be a near-term concern, but it is important to monitor, as this can be a portfolio changing event in the long term.

Record valuations magnify the risk to the downside given the total market cap of the US stock market divided by GDP is at a record 1.9x versus 1.4x at the peak of the tech bubble and a 50-year average of 0.8x.  This incredible multiple expansion has been driven by the repression of interest rates by the Fed buying bonds. This has driven up valuations of the entire market but especially of technology stocks.  We would note that this ratio went from 0.84x in late 1972 to a low of 0.35x in late 1974 due to rising inflation.

It is estimated that by the end of Q1, there was also over $5.4 trillion (6% of global GDP) in excess consumer savings since the coronavirus pandemic began and the US has $2.6 trillion (12% of US GDP.) Given many activities have been halted during COVID-19, the US savings rate exploded to 34% in April 2020 from 7-8% prior to COVID-19. This is more than double the previous all-time high of 15% in 1975.  Currently, this rate is sitting at 12%. When global economies reopen, this excess savings is likely to be spent and drive a surge in demand and more persistent inflation.

There are many signs of a bubble, but bubbles can continue for longer than anyone suspects.  Meme stock prices, Bitcoin prices, a non-fungible token (NFT) by Beeple (an unknown artist just a few years ago) selling for over $60M are just some signs of excess in this market.  Former Federal Reserve Chairman Alan Greenspan famously talked about “irrational exuberance” in the financial markets.  Most forget this comment was in late 1996, and the S&P peaked in March of 2000 after having more than doubled from the time of his original statement.  When the current bubble eventually bursts, it will take all stocks down, not just the more speculative stocks that are being bid well beyond normal valuation metrics.

Amazon had revenues of $1.6B in 1999 which grew to $3.1B by 2001 but the stock however went from $106 at its peak in 1999 to $6 at its lows in 2001 when the bubble broke.  Roughly 4000 other internet related companies went out of business.  Some of the most exciting technologies of today such as artificial intelligence, bio-technology blockchain, crypto currencies, digital banking, electric vehicles, green energy and virtual reality, are likely to change the world much like e-commerce did in the late 1990s.  This does not mean that investments in this space cannot get crushed if history is any guide.

Our hope is that our shorts will outperform when this bubble breaks and enable us to cushion the portfolio against a correction much like in Q1 of 2020 during the emergence of COVID-19.  In addition, our longs are primarily stocks that have growth at a reasonable price (GARP) that we believe will decline much less during a market correction. Risk management for both our long and short positions is key in this environment.

In Summary
The drivers for the US stock market record highs remain the same:

1. The Fed balance sheet hit a new record of $8.2 trillion and is up 18% y/y after being up 77% last year.
2. Money supply is up 14% y/y (peaked at a record 27% in Feb) vs a peak of 10% during the GFC and 14% in the 1970s.
3. Vaccinations & progress towards herd immunity continue.
4. The macro data is strong with the best GDP growth in decades.
5. The employment picture continues to improve with weekly jobless claims near 400K for the first time since the Pandemic.
6. Excess savings during the pandemic will be spent adding fuel to the recovery.
7. More Federal government stimulus is expected. Looking forward, the Biden administration is trying to pass another $4-5 trillion in stimulus between the Infrastructure Plan and the American Families Plan.

However, history has not been kind to the market when the Fed balance sheet has shrunk in the past and we believe a 10-20% correction in the S&P before year-end is likely.

1. The market cap of the entire US stock market divided by GDP is at 1.9x compared to the peak of the tech bubble at 1.4x and 50 year average.
2. Inflation, driven by rising rents and higher wages, is more likely to be persistent than transitory.
3. Inflation along with higher taxes is likely to eat into future corporate earnings.
4. The Fed looks increasingly behind the curve compared to other Central banks that have already started tapering or raising rates.
5. The Jackson Hole Symposium in August could mark a major shift in the Fed’s policies.
6. World changing technology stocks with the highest valuations may suffer the most during a Fed induced sell-off much like after the tech bubble burst in 2000.

Through year end, we are managing the portfolio carefully with valuations & earnings expectations near record highs.  We are favorable to sectors geared towards re-opening ($XLE -energy, $GOOGL- advertising), higher inflation (financials-$JPM) and enterprise demand picking up in technology ($ORCL $CSCO) while consumer demand cools from pandemic highs.