After a long advance, stock markets are now experiencing a pullback from record levels. There appears to be increasing angst about inflation and coming tax increases creating fear among some that the market is due for a much more substantial sell off. We do not think a severe correction is on the immediate horizon, but a further pullback in the market is a very real possibility. We will continue to make some adjustments to portfolios as conditions warrant. The economy is recovering and there is a lot of cash and buying power in the global economy, and borrowing rates remain incredibly low. Here are some thoughts and comments based on how the outlook for the economy and investments may be changing.
The word is all over the headlines and if we are paying attention, we notice it in the prices we are paying at the grocery store and restaurants. It is an unusual day if we do not hear about higher house prices and the shortage of available houses for sale. There are help wanted signs up everywhere for jobs in lower paying positions such as retail or food service. Employers are likely going to have to pay higher wages to attract workers—more inflation. Commodities from agricultural goods, lumber, copper and other base metals are all hitting new 52-week highs. Clearly, inflation is picking up.
Yet, non-farm employment in April was still down by 8.2 million (5.4%) from the pre-pandemic level in February 2020. On May 11th, St. Louis Fed President James Bullard expressed some inflation concerns but only expects overall inflation to get to 2.5%-3.0% in 2021 and drop a bit in 2022. Combined with strong economic growth, this does not mean the stock market will fall apart. However, some areas become more attractive in this scenario.
With such strong market performance across the globe, we expect a short-term pullback. We believe growth stocks will continue their underperformance versus value stocks. We believe the dollar is likely to again weaken versus the Euro and despite political risk, emerging market stocks perhaps have a chance at being the best performing asset class. Bonds are not attractive at these rates. We have been making some adjustments and will continue to do so with these themes in mind.
It seems to be a good time to try and lock in some gains from growth stocks (particularly small-cap). Gold miners are an interesting defensive position. Even with a recent rally, gold is still 10% below its high reached last August. As opposed to holding gold, we tend to prefer mining stocks which track gold prices, but also deliver real cash flow and earnings. And speaking of “assets” which trade strictly on price, let’s talk about crypto.
Even with high stock prices and housing prices at a record, perhaps there is not a single better example of too much cash in the economy than cryptocurrency. While the asset class has certainly grown in value and influence over the past decade, these investments remain highly speculative, driven strictly by demand instead of any real intrinsic value. It would have been nice to buy $1000 of Dogecoin as a gag Christmas gift 5 months ago–it would have been worth $160,000 last week (although we hope no one bought it then since it has lost 33% so far this week!). Crypto currency has high volatility and perhaps can make a great trading vehicle for those so inclined and willing to tolerate large swings in value. Maybe, Bitcoin or Ethereum will be around for a long time and maybe demand will cause the values to go up from here, but there is still much uncertainly around what will happen going forward with this new asset class.
So, are we headed into a new sustained inflation cycle? One reasonable way to view this is to recognize the extraordinary decline in economic activity due to the pandemic. The drop off in demand led to lower supplies and inventories. With stimulus and increasing vaccination rates leading to a strong rebound in economic activity, not only are companies trying to catch up with current demand, but they are rebuilding inventory and supply lines. Demand for goods has surged leading to higher prices and shortages. One clear example that some of you might already have noticed is air travel and rental cars. Rental companies had to sell of their fleets to survive when travel collapsed and now there is a severe shortage of rental cars. Auto manufacturers would be running at capacity but now there is a shortage of computer chips affecting everything from toy manufacturers to cars to i-phones. This surge may be transitory. Once manufacturers catch up, demand will stabilize and relieve price pressures. Markets can do well in this environment. Also, demographics are believed to play a key role in demand and future inflation as major world economies continue to experience increased aging of their populations. Central banks have been fighting deflation for close to 15 years. This may not be a regime change.
Reading news these days can be a depressing endeavor. Many articles and opinion pieces have an apocalyptic air on taxes on both sides of the political spectrum. This is just a short reminder that what is being proposed is not current law and there will be some degree of compromise. We would expect that to include some corporate tax increases and some level of capital gains tax increase, which may include eliminating stepped-up basis on assets at death. There are some big unknowns which may affect certain sectors such as real estate as well as creating other planning opportunities related to taxes.
Here is what we can do and control. In taxable accounts, we can periodically realize tax losses be selling and replacing positions where prices have declined. We can also try and avoid realizing short-term capital gains on positions we sell. Tax reform may not change much, and it seems unlikely any increase would be substantial enough to alter the investment approach at this time.
In summary, we may be in for more pronounced swings as stimulus, tax policy, and inflation expectations work their way out over the next couple of months. While not expected, we are prepared to significantly alter portfolios if the economic outlook changes.