September Market Commentary
As we close in on the end of the 3rd quarter of 2021 and head toward the 4th quarter, many questions abound. The prospect of a sustained inflationary environment is one obstacle that the economy may have to tackle. Another issue investors are grappling with is the threat of rising interest rates. Further, just as COVID seemed to be heading toward the rearview mirror, the Delta variant appeared and has wreaked havoc on any return to normal that may have been predicted. Investors, and the population in general, may be better suited to cease using terms like “the post-COVID world” and “return to normal” and start adding terms like “living alongside COVID” to their vernacular. In addition, investors must also deal with the prospect of a more challenging return environment as valuations continue to climb. Where does one begin?
Well, as it relates to the inflation question, here at Wolf Group Capital Advisors, we tend to fall somewhat outside of consensus and believe that the inflationary environment will not be as transitory as many have forecasted. We do not think the United States will be in a sustained inflationary environment for many years. However, we also believe that inflation will likely not fall back below 2% by the end of the year. The Consumer Price Index for All Urban Consumers (CPI-U) has been running above 5% for the 12 months ending in May, June and July.
The recent level of inflation has been in excess of expectations. We believe we could see more of the same in the coming months. The difference between now and the time period after the Great Financial Crisis is that the dollars the Fed is injecting into the economy are actually finding their way into the hands of consumers.
When looking back at 2008-2009, the Fed also engaged in quantitative easing (many refer to this as “printing a lot of money”). At the same time though, the regulations and restrictions on banks were greatly increased. This meant that despite banks having much more money to lend, they did not end up lending it to individuals or businesses because their reserve requirements were much greater. While this recent level of greater than 5% inflation may not sustain itself for years, we believe we may see inflation north of 3% into next calendar year.
Generally speaking, most market participants tend to view inflation similarly to Aunt Sally’s extended visit over the holidays, an unwelcomed nuisance. While sustained, runaway inflation should be viewed skeptically, inflation of the more contained variety could be a welcomed relief for many Americans. From the perspective of the average employee, if wage inflation occurs, it could help give labor a bit more leverage in their quest to be compensated more appropriately for their skill sets. This could also help a higher percentage of the global population participate more fully in the continued economic growth around the globe and narrow the ever-widening wealth gap. This is not to say that double digit inflation is not a risk but more that 3-4% inflation (especially if mid-single digit wage growth can occur) could have some ancillary benefits to the global economy that may not be fully appreciated at the current time.
One does not need to look much further for other risks to markets and the economy. By just about every measure, stock valuations are higher than historical averages. This has been the case for some time though and is perhaps more reasonable than at first glance based on the favorable environment that currently exists for equities (low interest rates, high corporate earnings, etc.). Valuations must always be viewed in context of the prevailing market and economic landscape. We do not view valuations in a vacuum and believe that while valuations are higher than historical averages there are numerous reasons that justify those relatively rich valuations.
In addition to relatively high valuations, the usual contingent of outstanding risks still exist. Those include a policy mistake by the Fed, an unforeseen geopolitical event, and/or political agendas causing turmoil. In his recent memo, Joe Amato, President and Chief Investment Officer at Neuberger Berman, writes about political risk and more specifically, the upcoming budget bill. Amato states, “…the budget bill has the potential to surprise the market on the stimulus package’s size, its scope, and the balance of funding among borrowing, capital gains tax, corporation tax and personal tax.”
While the above quote contains a lot of scary unknowns, Amato and his colleagues believe the budget issue will ultimately be resolved in amicable fashion and that, “the demands of electoral politics will result in a smaller budget, which ultimately translates into tax hikes at the more modest, balanced and market friendly end of the scale.”
Another risk that has been talked about for years but has not yet rattled equity markets is China’s mystifying mounting debt problem. Perhaps it will eventually be seen in the public eye (after bubbling below the surface for many years). Depending on the severity of the actual debt load, it has potential to not just negatively impact the economy in China at the local level but, to radiate throughout the global financial markets.
After digesting the above paragraphs and taking a moment to reflect on them, a reasonable reader could surmise that there is a litany of reasons why one should not invest in the stock market. While that conclusion may seem intuitive, we do not view it through that same lens.
As regular readers of our market commentaries understand, our viewpoint consists of being confident that continued investment is the most sensible approach as markets increase more than they decrease and predicting the timing of when a downturn may occur is a fool’s errand. Those investors who lessened their equity exposure ahead of (or during) the fiscal cliff of 2013, the taper tantrum of 2015, the 2016 Presidential election, and the global pandemic of 2020 know just how difficult it is to time markets.
Also, when one attempts to time the market, he or she must get two decisions correct. When one sells ahead of some sort of anticipated decline, when and how should one know to become fully invested again? Getting one side of the market timing equation correct is excessively difficult. Getting them both correct? Nearly impossible.
There have always been many reasons not to invest and there will always be numerous reasons not to invest. Rarely do good investments feel comfortable. These many ever-present risks are the reason why equity investors earn outsized profits over the long term. That is, investors get compensated for taking these risks. This compensation occurs through the equity risk premium. The equity risk premium tends to average 4-7% above inflation over the long-term. The timing of when one invests typically determines whether the equity risk premium one earns is closer to 4% or 7% above inflation.
This is not to say that financial markets will move in a straight line upward for years at a time, which is why investing in stocks is not for everyone. Some simply cannot handle the price paid to achieve higher returns, which is volatility. However, for those that can remain invested despite the uncertainty, the reward is often greater than one could earn through most other forms of investment.
With that in mind, we continue to recommend that our clients own a diversified portfolio of stocks, bonds, cash and real assets. The portfolio they own should consist of a basket of assets they feel comfortable holding, regardless of the underlying market conditions and the expected returns associated with that environment.
Written by Charles Verruggio, Chief Investment Officer