Is the World Normal Yet?
Compared to the first six months of 2020, the first half of 2021 has been a snooze. I think we are all fine with that! After COVID sent global economies and markets reeling through much of last year, we are finally returning to normalcy. Gross domestic product in the United States fell 3.5% last year, the largest yearly economic contraction since WWII. In 2021, the recovery is strong and the economy is on track to grow a staggering 7%. Still, the unemployment rate remains stubbornly high at 5.8% and many people and businesses are still struggling to reinvent themselves to prosper in a post-COVID world.
Financial markets are off to a solid start, with the S&P 500 and MSCI EAFE (international markets) Indexes both up double digits year-to-date, while the MSCI Emerging Markets Index is lagging with only about a 5% gain. With the recovery from the 2020 COVID-recession still underway, I expect modest gains from global stock markets throughout the rest of the year, barring some black swan event like COVID descending upon the world again. For those interested in diving deeper, let us discuss the economy and portfolio strategy.
Everyone is Talking About Inflation: Should We Be Scared?
“Inflation” is industry speak for broadly increasing prices. We have certainly experienced inflation over the last year, with the latest Consumer Price Index report indicating an inflation rate of 5.0% over the last twelve months. That inflation rate falls to 3.8% if you exclude food and energy – a standard practice due to how traditionally volatile these items are.
Below is a post from WELLth’s Facebook page highlighting the inflation rates of some key goods & services from May’s Consumer Price Index release.
Inflation has been highest for products which are in short supply due to the lingering effects of COVID. For instance, rental car companies sold off chunks of their fleets last year to have enough cash through lockdown. With people now travelling again, there are not enough cars for customers to rent. Of course, lots of demand and little supply (of rental cars in this case) mean higher prices.
More Money Chasing Fewer Goods
Also contributing to the pickup in inflation – median household income is higher than ever. Really! Yes, there are still many who are suffering financially from the effects of the pandemic, but for most, household cash flow is higher than ever. Personal income (adjusted for inflation) jumped 12.7% during the first quarter of this year – the largest quarterly increase since the data started to be collected in 1959. However, this increase can almost be entirely attributed to government stimulus, as personal income only grew by 0.2% in the first quarter if government payments to citizens, such as unemployment and stimulus checks, are removed. In the industry, we call these “transfer payments.” More info in the chart below:
The bottom line is that people are generally flush with cash right now and ready to spend. There is lots of demand for things like houses, cars, travel, etc. and there is a shortage of labor and materials for creating these goods and services. Lots of demand and not much supply mean prices go up.
But Any Inflation Should Only Be Temporary
The main supply and demand factors driving inflation right now are temporary. We can reasonably assume widespread stimulus will taper and global supply chains should normalize as well. It seems the Treasury market agrees with this hypothesis, as the implied inflation rate from this market over the next ten years is currently only around 2.25% per year. There is a group who thinks inflation will spike permanently because of current policy by both the Federal Reserve and the Biden administration, but current data suggests this scenario is unlikely. Specifically, any inflationary effects from excessive stimulus would need to compete with some very deflationary long-term trends (increasing labor productivity (lower labor costs), globalization, and an aging population).
Positioning: Why We’re Buying Boring Ol’ Banking
Technology stocks reigned supreme in 2020’s lockdown economy, with the S&P Information Technology Index climbing 43.9% last year. The “old world” industry of finance, facing borrowers in default and paltry demand for loans and credit, lagged, dropping 1.7% in 2020. This 45.6% gap in performance between these two sectors left financial companies undervalued and prime investing candidates for the post-COVID recovery. Through mid-June of this year, the S&P Financial Index is up 27.5% while technology is only up 9.2%.
From a valuation perspective, financial stocks could have continued upside from here. We use price/earnings ratios to measure valuation differences between sectors. Basically, this measurement shows how much investors are willing to pay for a dollar of earnings. And, based on this metric, financial stocks are still quite undervalued versus technology.
As a result, we have adjusted most portfolios to include more financial stocks. We invest in a specific fund (the ticker symbol is MTUM) which seeks to adapt to changes in stock sector leadership over time. This fund halved its allocation to technology and increased its financial holdings from 1.51% to 32.44% in May. Such large portfolio changes are typically rare for this fund, but they tend to occur during major regime changes in leadership. We believe this change will lead to strong fund performance through at least the remainder of 2021.
Politics and Economics: Taxes
Joe Biden’s American Family Plan seeks to increase taxes on individuals and families in the top 1% of wealth. The most controversial component of this proposal is the increase in the “capital gains” tax rate (this tax is assessed on investment profits) for those earning over $1,000,000 per year. Political views aside, any tax increase could be considered as a disincentive to savers/investors, as the overall return on investing money is reduced by higher taxes. Short term, I would consider this a positive to consumers, as increased tax revenue could be redistributed to “non-1%ers” (likely all of us). Longer term, most analyses would indicate lower savings/investing rates lead to lower long-term economic growth. Should Biden’s tax hikes pass, we hope elected officials deploy the increased tax revenues into productivity-enhancing projects which would offset the likely smaller pool of investments to fund future economic growth.
Final Thoughts: Thank You
WELLth Financial Planning went into business in January with a mission of promoting financial wellness through comprehensive financial planning and evidence-based investment management. If you’re reading this, you’re likely one of WELLth’s first clients. I want to sincerely thank you for supporting this vision as well as reaffirm my dedication to help you become your best financial self, now and for years to come.
As always, my phone line is open at (561) 972-8011 if you want to talk investing, planning, or just want to say hi. Have a fantastic summer!
-Chris Diodato, CFA, CMT, CFP®