The S&P 500 return for the first 6 months of this year has been very strong. China followed by the U.S. were the first countries to recover from the global pandemic. Corporate earnings have come roaring back due to the success of the vaccines and the reopening of the economy. Stocks, being the discounting machines that they are, have risen in anticipation of the recovery. Also rising are interest rates and inflation. Bond yields rose dramatically during the first quarter which slowed the rise in growth stocks during the second quarter. We expect another step up in interest rates during the second half of 2021. This will put downward pressure on highly valued stocks and further depress bond prices. We maintain our position that valuations for growth stocks are stretched at current levels. We expect the dollar will weaken later in the year versus other major developed countries, as their economies continue to recovery and accelerate. The dollar weakness will encourage investors to shift funds to emerging markets and Europe providing a tailwind to their recovering markets. We have strategically increased our exposure to these areas across the portfolios.
At present, there is great debate as to whether the recent increase in inflation is transitory or permanent. This is important because the direction and level of interest rates is a key determinant in the pricing of a stock, bonds, and real estate. The prices of industrial and soft commodities along with food and energy are all up dramatically in the last 12 months.
Oil prices have increased by over 40% since January of this year. Some portion of the increase is due to the Biden administration’s policy to cease drilling on Federal lands for oil and gas. This has created a domestic shortage,
driving up the prices of oil to the benefit of OPEC. The policy was put in place to reduce pollution and address climate change. Unfortunately, it does neither because the policy does not change energy usage or demand for oil and gasoline, just the price.
There has been a record backlog of container ships waiting in U.S. ports to offload their goods from around the world. The number of ships awaiting access to port facilities is down from its peak, but it is still quite high. This decline indicates that supply lines are coming back online but many goods were not delivered due to supply lines being previously closed. This impacts business inventories, creating imbalances.
Lumber futures contract prices went from a historical average of $350 to a high of $1670 per thousand board feet, currently down below $800. Inflation in housing prices is reflecting the increased prices of lumber and other building materials. The chart below indicates that lumber prices have come off their highs as additional supply has reentered the marketplace.
Employee wages have increased but worker shortages persist. There are “help wanted” signs on storefronts across the country, approximately 10 million workers of the 30 million workers that were laid off have yet to return to work. Businesses have offered additional incentives and employment bonuses to attract workers but have seen mixed results. Many workers can make more money by not working and receiving additional benefits than returning to work. These additional unemployment benefits are scheduled to expire this coming September and the Federal Reserve has noted in their recent meetings that this may encourage more of the labor force to return to work.
Inflation cannot be both transitory and permanent has been the argument. One side of the argument thinks there is a huge supply chain inflation issue with inventories, commodity prices, and employee wages resulting from Covid shutting down large parts of the global economy and then a sputtering restart. Many goods consumers want are in short supply; because the domestic manufacturers had been shut down or the goods were imported from foreign manufacturers who were shut down or the products are sitting in a container ship waiting for entry into one of our ports. Many local distributors have also been closed during the pandemic and just recently reopened. We think there is a short-term or “transitory” bubble in inflation because of the stimulus provided by the government in the hands of the public, who are bidding up the price of goods where there is temporarily only limited supply. As the supply chains fill, supply will satisfy demand and prices will recede. For the long-term many of the components of inflation have been moving higher in small increments since 2013 and we expect that that will continue after the global economies get back to full strength.
The other side of the argument is that inflation is permanent and will rise from its previous low levels to a slowly rising but permanent condition after the current but temporary bulge in the high rate of inflation passes. In the chart below you will see many of the components of inflation. The down arrows indicate deflationary pressure, sideways arrows indicate neutral pressure while up arrows indicate inflationary pressure. From 2008 until 2013 we had a deflationary environment as a result of the real estate bust and the Great Recession. Since 2013 many components have moved to neutral or an inflationary bias and by 2017 we had beginnings of inflation (chart below).
Before COVID, wages, balance sheets, housing, etc. all began to improve if only a little at a time. In summary, we are going through a reopening supply problem that has created bottlenecks and increasing inflation rates which is short-term but there has been a change in the direction of long-term inflation which changed around 2013 and was just beginning to accelerate before the pandemic.
Good News for Seniors
According to the Senior Citizens League, the COLA (Cost of Living Adjustment) for Social Security payments will be increasing. Since inflation has increased during the last 12 months a higher COLA is in store. The League’s estimate for the increase is currently at 5.3% which is an increase from the previous estimate of 4.7%. The official announcement will be made this coming October. In recent years the COLA’s have had very little fizz, this one will be noticeable for seniors.
The Federal Reserve
All eyes are on the Federal Reserve as high inflation as measured by the CPI (consumer price index), and PPI (producer price index) report very high inflation numbers. The latest report shows there was a 5.0% increase in the CPI and a 6.6% increase in PPI in the last 12 months. In the past, the Fed was very quick to increase interest rates if inflation began to rise for fear it would take hold and continue to rise and get out of hand. Unfortunately, the quick-acting Fed would induce bear markets, recessions or cut short the growing strength of the economy by increasing interest rates to keep inflation in check. Inflation has not been a problem since the late 1970s and early 1980s, but the Fed has feared that inflation would reemerge and has used interest rates to manipulate the economy, thus putting a damper on economic growth in America. Now the Fed will be tested again.
Their position is to let inflation rise to over 2% on a sustainable basis, which we have not seen for many years. The Fed’s fear of runaway inflation will be tested by the high transitory inflation from reopening the economy and the massive monetary and fiscal stimulus. Today the 10-year U.S. Treasury bond should be yielding more than 3.0% rather than the 1.5% level it is currently trading. That is based on the growth of GDP and inflation. Investors are concerned that the Fed will act too quickly to transitory inflation readings by reducing stimulus. The Fed announced that they would be selling corporate bonds and ETF’s which they bought to provide liquidity during the sharp selloff last year. It only amounts to $14 billion, mostly junk bonds, but it is a sign the Fed thinks that there is
enough liquidity around and the economy has recovered enough, that some small companies can raise capital. Investors are keenly aware of the “Taper Tantrum” of 2013-14 when the Fed announced they would be reducing the monthly amount of stimulus they were providing and the market had a significant selloff. The market loves liquidity and when it slows or is removed investors respond negatively. Removing the punch bowl has negative effects on the markets. The Fed and other institutional investors fear the economy will slump back to the Obama era of low growth (less than 2%) after the economy reopens and the sugar high of the massive stimulus passes by 2023.
There was another time when interest rates were not in line with economic activity and that was during World War II and after. The Federal government was borrowing massive amounts of money to support the war and pegged the rate of interest below where market rates would indicate, to borrow money with less interest expense. The government’s hand in holding down interest rates lasted for 12 years even though the war only lasted 4 years. Currently, the Biden administration is proposing to borrow trillions of dollars and if interest rates were to significantly rise, the increased cost of high interest would be substantial. In summary, we think a lot of the increase in inflation is transitory but there was already a shift in long-term inflation at low levels that will build as a
synchronized global recovery evolves.
An EV and AV Evolution
Today EVs (electric vehicles) represent only 3% of the cars on the road in America. Even though EVs have been available for many years, their acceptance has been quite slow for three primary reasons; 1) cost (which has been government-subsidized), 2) battery life and range, and 3) slow charging times. This is all changing and fast. Due to technological investment by public corporations such as General Motors, Samsung, Tesla and other private entrepreneurs, longer battery life is offering greater mileage range, around 350 miles, and partial battery charging times are down to minutes rather than hours, full charges still take hours.
Government mandates on limitation and phase-out of internal combustion engines are helping to spur the transition from gasoline and diesel to electric vehicles. The UK is discussing a ban on new sales of internal
combustion cars by 2025. Germany is extending its cash bonuses for EV’s until 2025. Japan announced a phase-out date of 2035 and China is planning to move completely to EV’s autos by 2035. California has put a zero-emissions date for new cars and trucks of 2035. General Motors projects that 40% of their auto sales will be electric vehicles by
2025, only four years away!
Europe and China are moving very quickly to make the conversion to EV’s, see upper chart “EV Growth around the World” above. The chart below it depicts the global EV penetration for the next 30 years. This is going to reduce pollution and the demand for oil and gas worldwide significantly. We do not think there will be more new cars sold, just the opposite, but the new cars sold will be increasingly EV’s until eventually new internal combustion engines are phased out. Since the useful life of an auto can be 20 years gasoline stations will convert more to electric and less gas. Auto parts companies will have much lower sales because internal combustion engines have many more moving parts to wear out and break needing replacement.
The reason we expect lower auto sales overall is that driverless cars or AV’s (autonomous vehicles) and trucks coupled with EV’s, along with driverless ridesharing will develop a much larger share of the market. People in urban areas especially are more accustomed to taking a taxi, Uber/Lyft, and public transportation, such as buses, subways, and light rail, than people in the suburbs, but that will change. Cars are expensive to buy, maintain, fuel, park and insure. Most of the time they are just parked at home or at the office depreciating. Rather than own a car there will “transportation as a service” (TaaS), whereby you would simply order a Tesla for so much a month or mile to take you wherever you want to go on-demand. Studies forecast the cost of electric vehicles and their batteries are estimated to decline by 40%, as they become more widely used and produced. EV and AV trucking and freight companies could see their cost decline as much as 40% also, pressuring railroads for transport business. AVs, autonomous cars, and trucks, along with using EV’s will reduce pollution and overall transportation expenses. These changes will produce a big increase in the average consumer’s pocket.
From an investment point of view, companies that provide the next generation of batteries, battery software, and charging station look appealing. There are several new auto EV manufacturers around the world. We favor the established makers such as Toyota, General Motors, Volvo over the new companies. The established companies will sell EV’s but not necessarily more cars, where new EV companies must build the whole car, not just the engine. Additionally, the new manufactures will have to build new plants, marketing, and distribution, while the old companies already have in place facilities and may simply change out the engine.
Change is Here
The whole world is going through very rapid changes, accelerated by COVID-related shutdowns. We expect a global expansion with America, China, and Europe leading the way bringing all other countries into greater trading opportunities and innovation. In the past, when all the major economies of the world are out of recession at the same time, the expansion can last 8 to 10 years.