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Financial Market Update | June 2021

Should You Be Afraid of Inflation?

The focus in news reports and markets in the past weeks was on inflation. The headline U.S. Consumer Price Index (CPI) number in May came in at 4.2% on a 12-month basis, which was higher than most people expected.

To place this in context, April 2020 was when the global pandemic-induced recession bottomed. Since then money growth has exploded in the U.S. and to a lesser degree, in the other major developed economies. The increase in the money supply has been largely driven by stimulus checks flooding into household bank accounts and increased precautionary savings by corporations.

Why Is The Market So Concerned With Inflation Data?

Inflation is definitely better for the economy than deflation. It will stimulate consumers to spend or invest more. Employees can ask for higher wages, companies can generate higher revenues.

Inflation combined with low-interest rates is generally positive for risk assets like equities and real estate.

The fear factor is that sustained inflation can threaten economic stability and to avoid that happening central banks will step in and tighten monetary policy by raising interest rates. And this can have a negative impact on asset prices and that is obviously what investors are concerned about.

What is interesting to note is that bank lending has not accelerated in line with the sharp increase in broad money growth, however. After briefly jumping at the outset of the pandemic, U.S. bank loans outstanding have been shrinking. The subdued pace of bank lending will mitigate inflationary pressures in the near term. However, inflation could still eventually rise in a sustained manner once the U.S. economy begins to overheat.

It is possible that the Gross Domestic Product (GDP) growth in the second quarter will again surprise to the upside. One indicator for that is that the US Trade deficit number came in much lower than expected, which points to increased economic activity. Global economic activity is rapidly gaining back what was lost during the pandemic. While at the same time still millions of people are out of work. If jobs growth stays strong this will only add to GDP growth in the coming quarters.

Speaking of jobs growth. There was a lot of attention to the fact that the April jobs data in the U.S. came in much lower than expected. Immediately there were many news reports talking about stagflation, which refers to low economic growth combined with higher inflation. Subsequently, the May jobs data came in higher but still lower than expected. In our opinion, this shows that the U.S. economy is recovering but there is no reason for the Fed to make any changes to its policy any time soon.

Our base-case scenario is to expect strong growth and accommodative monetary policy. Strong growth is assured as long as the virus doesn’t come roaring back, and the Fed still isn’t even talking about tapering its asset purchases, much less hiking the fed funds rate. Which means our risk-friendly asset allocation recommendations remain unchanged.

The risk for markets is to get caught up in short-term thinking, especially in a period where there is not much other news. The next earnings season will only start in mid-July, the pandemic is subsiding in every country that is actively vaccinating, and there will be no new stimulus plan announcements. And we are getting closer to the summer period which is traditionally a period where we see trading volume in the markets, which can create additional volatility. Despite this, markets were very calm during May. The bond market does not seem to be too concerned about inflation pressures yet and bond yields came down. The equity market traded in a narrow range and ended slightly positive for the month, which was the fourth positive month in a row for equity markets.

An important issue to watch will be new spending legislation. We think it is likely there will be a bipartisan infrastructure bill. In the end, Republicans will join Democrats since all want spending in their states and localities. Although we think the economic impact of Biden’s infrastructure bill will be limited in the short term as spending will be spread out over 8 years. If it passes it could have an impact on the Fed’s policy, as it would be counterproductive to tighten monetary policy at the same time the government is loosening fiscal policy.

Another argument why we think the Fed will not deviate from its stated plan to stay put is that Chairman’s Powell term ends early next year, and Powell and other candidates would be seeking to stay aligned with President Biden’s ideas.

The “Transitory” Debate

Most investors would agree that 3-4 months of higher consumer price increases would not be, in and of themselves, economically significant or investment relevant. But the question of whether even a temporary period of high inflation could persist over a 12-month or multi-year time horizon has become prominent in the marketplace, with some investors believing that it has high odds of supporting higher prices in a way that becomes self-reinforcing among consumers and firms.

A shift in the market narrative from a relatively benign longer-term inflation outlook to a belief that a more durable uptrend is developing, could trigger a taper tantrum-like surge in bond yields, with negative knock-on effects for risk asset markets. For now, the Fed is sticking with its view that any uptick in core inflation will be transitory, despite upgrading its own economic forecast. From an investment perspective, the outlook for inflation is important mostly because of its implications for Fed policy, and thus interest rates and equity valuation multiples.

We do expect inflation to rise significantly over the long haul. However, our view is that it will take another 2 to 3 years before we see structural inflation. As the example of the 1960s illustrates, a long period of overheating is often necessary to push up inflation in a sustained manner. The U.S. unemployment rate reached its full employment level in 1962. However, it was not until 1966, when the unemployment rate was two full percentage points below equilibrium, that inflation finally took off.

Also, the official core Consumer Price Index (CPI) likely overstates underlying inflationary pressures. The pandemic threw all sorts of prices out of whack. One needs more refined measures of inflation such as the Dallas Fed’s trimmed mean Personal Consumption Expenditures (PCE) indicator, which only rose a modest 1.8% in April. Similarly, relatively clean measures of wage growth, such as the Atlanta Fed Wage Tracker, do not point to an imminent wage-price spiral. All this means that the Fed can afford to sustain an exceptionally easy monetary policy. That should keep growth at an above-trend pace and continue to support equity valuations.

Equity Markets

The U.S. and global stock markets have been stuck in a narrow range for more than a month now. Not only that, but the strong equity market gains of the last 12 months can actually be accounted for almost entirely in terms of rising earnings expectations, which is exactly what all the textbooks say should happen. Markets seldom behave so perfectly in line with theory as they have done over the last year. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of slowing earnings momentum. Net revisions remain positive, and positive earnings surprises have risen to their strongest levels on record.

US GDP grew at 6.4% in the first quarter, powered by 10.7% growth in consumption. The six largest companies in the S&P 500 reported first-quarter earnings that exceeded expectations by an average of 41%, and the Fed remained resolutely dovish.

Within a global equity portfolio, there has been a modest uptick in global ex-U.S. equity performance, led by European stocks. Europe, which has badly lagged the economic performance of the U.S. in the last 6 months, is primed for its best period of growth since 2017 and should close the growth gap with the U.S. Moreover, the euro area has the potential to provide more positive economic surprises ahead, in comparison to the already roaring U.S. economy, especially as it has more exposure to the strengthening global trade cycle.

A resilient Chinese economy should support other emerging markets. Progress on the pandemic front should also help. The United Nations estimates that as many as 15 billion vaccine doses could be produced by the second half of 2021, enough to inoculate most of the world’s population. The shortages of vaccines in emerging markets could turn into a surplus by the end of this year, something that market participants do not seem to fully appreciate. The rotation in growth momentum from the U.S. to the rest of the world could put downward pressure on the U.S. dollar. A weaker dollar, in turn, usually coincides with the outperformance of international stock markets.

Bond Markets

The U.S. 10-Year Treasury yield has traded sideways since mid-March. The strengthening economy in combination with the improving jobs markets should keep upwards pressure on bond yield in the next 12 months. Although we expect the rise to be more modest, we still favor a short duration stance within a fixed-income portfolio. Although our view is that inflation pressures will abate in the coming months, we keep exposure to Treasury Inflation-Protected Securities (TIPS) as a core hedge position in the portfolio.

Another key portfolio hedge is local currency emerging market government bonds. Two key drivers of Emerging Markets (EM) bond returns will offer a constructive backdrop in the year ahead. The U.S. dollar will likely soften in the face of strong global growth conditions, with economic momentum now firming up in lagging major economies such as the euro area.

In the meantime, rising U.S. Treasury yields are typically associated with spread narrowing for EM debt. In the case of EM local currency-denominated debt, there is plenty of room for nominal spreads to tighten, and real yields are already positive with plenty of room to fall as global inflationary pressures build up. Strong global trade momentum and firm commodity prices, along with a relatively high nominal yield and generally undervalued currencies, are additional tailwinds for emerging market bonds.

Digital Assets

Cryptocurrencies experienced a ‘flash crash’ in May with the whole crypto market falling by more than 50% in a few days’ time. There are many reasons cited in the media, including Elon Musk’s tweets, but the main reason is an old-fashioned one: Cryptocurrencies are being used as an investment asset and a speculative bubble was building up, which was bound to correct at some point.

We do not think this is the end of cryptocurrencies as the underlying technology is potentially disruptive for a large part of the financial ecosystem. Interest in digital assets is growing among private and institutional investors. We do believe in the potential of cryptocurrencies, but we do not believe there will be room for that many of them. Therefore, we prefer to only invest in the largest ones and that constitutes an original technology like Bitcoin and Ethereum.

PLEASE READ THIS WARNING: This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

*Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.  There are risks associated with these types of investments and include but are not limited to the following:  Typically no secondary market exists for the security listed above.  Potential difficulty discerning between routine interest payments and principal repayment.  Redemption price of a REIT may be worth more or less than the original price paid.  Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.  Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.  This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein.  The offering is made only by the Prospectus.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

By

Financial Update | May 2021

Listen to the audio version or read the full overview below.

Strategies for a Sustained Asset Bubble

In the past month we have seen strong first-quarter corporate earnings, a sharp decline in Covid infections in the U.S., the announcement of President Biden’s American Families Plan, and a dovish Fed statement, all of which are supportive of equity markets.

In February and March, we witnessed a sharp upward move in long-term U.S. bond yields, temporarily causing a sell-off in global equity markets and especially growth stocks.

In April we saw bond yields retracting, which triggered a healthy gain in equity markets, supported by very solid first-quarter corporate earnings. Of all the S&P 500 companies that have reported so far, earnings were on average 3% higher than the average analyst forecast.

Looking forward, we remain confident about equity markets. We still see ingredients for a strong recovery in the global economy, and although we believe there might be longer-term inflationary forces at work, fears for higher inflation in the short term are overblown.

Developed economies continue to transition towards a post-pandemic state. Europe has further to go, but it is lagging the US at a constant rate and is thus merely delayed – not on a different path. This ongoing transition is also reflected in the global macro data, which continues to surprise to the upside.

Despite elevated valuations, there is the potential for the Federal Reserve’s monetary policy to inflate a new speculative bubble. This bubble could run a lot longer than we think. Therefore, we continue to expect positive absolute returns from stocks over the coming 12 months and would recommend that investors remain overweight stocks versus bonds in a multi-asset portfolio.

Bond Yields

Whenever bond yields rise, you must remember that the bond market is trying to tell you something about the underlying economy. Rising bond yields are typically reflective of stronger economic growth. The ISM Manufacturing Index is at its highest level since 1983 – the world economy is in a strong recovery mode. Higher yields are consistent with the economy getting stronger. Under these circumstances, we would be more concerned if bond yields did not rise.

How Do Inflation Expectations Impact the Bond Yield?

Currently, there is no breakout in inflation expectations. We should not forget that in the decade after the global financial crisis, inflation expectations have fallen to very low levels. In the past decade we were collectively much more concerned about deflation. Inflation breakeven rates currently are between 2 and 2.2%, whereas the average range during the decade before 2009 was more like 2.5 to 3%. So, inflation expectations are returning to normal levels.

This means that 10-year Treasury yields are probably at fair value today given the state of the economy. Markets will always fluctuate, so it is possible that bond yields rise a bit further, but we don’t think that US Treasury yields will exceed the 2% level as long as the Fed continues its ultra-dovish stance.

Although global bond prices have come down circa 3% since the start of the year, we are a little bit more positive for the remainder of the year. As we do not expect bond yields to rise much further, the higher rates today will translate into higher income yield for the remainder of the year.

Inflation Outlook

We are not concerned that inflation will be structurally higher in the short term. Having said that, we could see higher headline inflation numbers in May and June, but we think that this will be temporary inflation and mostly because of the base effect compared to 12 months ago when the whole world was in lockdown. That said, we could see more structural inflation pressure in a couple of years from now if aggregate demand keeps building on the back of structural government investment.

If we look at the fiscal position of the United States, the budget deficit is almost 20% of Gross Domestic Product (GDP). The Fed balance sheet has expanded by $7 trillion USD since the beginning of the pandemic, and the money supply measure M2 has exploded upward. This must be inflationary, right?

What happened is this: For all of 2020, the U.S. government unleashed $3.5 trillion in various rescue packages, because of which the federal government debt rose by $3.6 trillion. At the same time, the household sector’s disposable income increased by $3.5 trillion, and household savings shot up by $5.5 trillion. In other words, American households not only saved up all the transfer payments they received from the government, but they even saved $2 trillion more from their own income. These rescue programs did absolutely nothing to generate additional demand or GDP growth. What we have seen was not a fiscal stimulus to boost aggregate demand, but a transfer payment. This was no different than a one-time tax cut. We know that people’s spending behavior is determined by their outlook for sustainable income. If you give them a one-time tax cut, they will save it.

Now that the U.S. and Europe are reopening, we will likely see a demand surge. Consumption spending has been repressed for over a year as a result of Covid-19 related restrictions. When the world economy reopens, this spending will be released. But this is not inflationary, as the boom will be temporary. People will not party for the next twenty years. They will party for the next six months or so. For inflation to be a structural threat, you need aggregate demand exceeding aggregate supply on a sustainable basis.

We do not see that happening any time soon. The government subsidies simply amount to a huge balance sheet swap: government debt as a share of GDP has gone up, while consumers’ net worth has gone up even more. This balance sheet swap has nothing to do with additional aggregate demand.

What could be the driver for more structural inflation is real government spending, rather than stimulus checks. Extensive investment by governments in, for example, infrastructure could have this effect, as this could also lead to a boom in corporate capital expenditure, which has been relatively low since the global financial crisis.

President Biden’s American Jobs Act is a step towards that kind of transition. But it is not as big as the headline number suggests, because it envisions spending roughly $2.2 trillion over eight years, so each year it would add only about 0.8 or 0.9% of GDP. On top of that, Biden is proposing higher taxes to fund it. So, his infrastructure plan creates some growth on one hand, while taking it away with higher taxes on the other hand. Its net impact will only be around 0.4 or 0.5% of GDP per year. This will not be a game-changer in terms of inflation.

However, if this is done on a global scale in Europe and Asia as well, it could have a more structural impact on commodity prices or wages, which could translate into structurally higher inflation in a few years from now.

Dovish Central Banks

There is a tug of war going on between the Fed and financial markets: The Fed says they will stay dovish for a long time, while markets expect a lift-off in short-term rates next year. Who is right?

If you think about the last decade, Fed policy was always tight: The projected interest rate path by the Fed, as seen by the so-called Dot Plots, was always higher than market expectations. Because of that, we had several financial tremors: The taper tantrum in 2013, the collapse in oil and commodity prices in 2015, the collapse in stock markets in late 2018. We had almost ten years of low inflation and periodic stock market chaos because of monetary policy being too tight. In the end, the Fed always caved in and moved towards the market.

Now it is the other way round: The Fed is more dovish than market expectations. The market has priced in four or five rate hikes through 2023, while the Fed suggests they will not do anything before 2024.

The question is which side is right? If you only looked at the lessons of the last decade, you would say the market is right. But the difference today is that the Fed has abandoned its old reaction function and wants to stay ultra-stimulative until inflation is above 2% for a while. The Fed is now adamantly saying they are willing to be late this time, allowing the economy and inflation to run hotter than they would have in the old days. If that is the case, then markets may be wrong because they still assume the old reaction function of the Fed. So, we do not know yet, but it’s possible that the Fed will stay dovish much longer than markets think.

The consequence of this new Fed policy could be quite positive for risk assets. The stock market has already performed well and could go even further. If you look back in history you notice that asset bubbles grow back every ten years or so, and they are usually driven by easy monetary policy and lots of liquidity. So, this new reaction function by the Fed, plus the support from fiscal policy, means that markets could go through a bubbly period. This could apply to all risk assets including equity markets, but also real estate and digital assets can profit from this.

How Big Can An Asset Bubble Get?

If you look at history, all speculative bubbles burst eventually by tightening monetary policy. You never had a bubble burst while monetary policy was still easy. Asset bubbles pop when central banks tighten policy to a point of yield curve inversion. Today, we are far away from that. That is why this bubble could get a whole lot bigger.

Currently, we could be in the early stages of a stock market bubble, especially in the United States. There are many signs of speculative behavior, be it Bitcoin, Gamestop, and so on. But it is not as pervasive yet as it was in the late 1990s. When the technology bubble burst in 2000, everybody was bullish. Today, many people, even large investors, are still bearish. When they throw in the towel, then the final phase will begin. This bubble could be bigger than the 90s and it could run a lot longer than we think.

Could Rising Bond Yields Hurt the Equity Market?

Historically, rising yields hurt the economy and stock prices only when both long and short interest rates were moving up. It is unusual to see the long end of the curve move way up while short-term rates remain pressed down, as is actually the situation today.

There is a limit to the pain long-term rates can create for the economy because borrowers can always slide down the maturity curve to avoid having to pay higher interest rates. That is why we think 10-year Treasury yields are unlikely to move much higher than their fair value, while short-term rates remain at zero.

Based on this a possible scenario is that we will continue to see rising equity market for the next two years, with multiples going higher still. Then comes the point where the Fed just cannot remain dovish anymore and they will raise rates. At that point, the end would be nigh and that is the moment we could potentially see the next bear market but timing that is near impossible.

Currencies

Late last year, everyone was bearish on the dollar. After staging a rebound in the first three months of the year, the U.S. dollar has resumed its weakening trend.

We expect the dollar to drift lower over the next 12 months, as global growth momentum rotates from the U.S. to the rest of the world, the Fed maintains its ultra-accommodative monetary stance, and the U.S. struggles to finance its burgeoning trade deficit.

China will provide adequate fiscal and monetary support for its economy, which can drive up commodity prices, the yuan, and other emerging markets currencies. The Euro/USD could rise to 1.25 by year-end. At the same time, the pound should strengthen against the Euro.

Emerging Markets

A global economic boom and a weaker dollar should be bullish for emerging markets. However, we must keep in mind that today’s emerging markets are very different from 20 years ago. Today, more than 40% of the MSCI Emerging Markets (EM) Index is made up by China. In China, the equity market is predominantly driven by big tech, with stocks like Alibaba and Tencent. So, China has a similar issue like the US tech sector: In an environment of rising bond yields, growth stocks tend to underperform.

The stock market is very sensitive to changes in liquidity conditions. We see a world of inverted roles: After the financial crisis, China embarked on a huge monetary and fiscal stimulus. Today it is the U.S., while China is tightening.

Last year Chinese growth stocks performed very well. This year their stock prices are struggling while earnings remained robust. So, we have seen valuations in some of Asian largest companies come down quite a bit. In the short term, the stock market is very sensitive to changes in liquidity conditions. If credit growth is slowing down, stocks perform poorly. From a longer-term perspective we think the Asian stock markets offer an attractive entry point now.

We offer an Asia Leaders Portfolio, which invests in leading companies across sectors that benefit from the growth of the domestic consumer in Asia. Recent underperformance offers an attractive entry point as we believe this strategy could outperform over the coming 12 months.

Portfolio Diversification

Other than equity risk exposure we have been observing commodity assets since the beginning of 2021. In our core portfolios we have included a commodity position that has exposure to diversified industrials and precious metals, energy, and agriculture positions. Thus far, commodities have risen nicely, and we expect this addition to help hedge against short-term inflationary pressures.

PLEASE READ THIS WARNING: This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

*Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.  It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.  There are risks associated with these types of investments and include but are not limited to the following:  Typically no secondary market exists for the security listed above.  Potential difficulty discerning between routine interest payments and principal repayment.  Redemption price of a REIT may be worth more or less than the original price paid.  Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.  Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.  This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein.  The offering is made only by the Prospectus.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred.  Returns do not include reinvested dividends.

Diversification does not guarantee a profit or protect against a loss in a declining market.  It is a method used to help manage investment risk

By

Spring Cleaning. Clearing Out the Financial Clutter.

Spring has arrived in Texas. I know this because my back is sore from raking leaves and clearing out gutters. For my family, this time of year is all about taking advantage of the nice weather with soccer games on Saturday mornings, bike rides, and trips to the park. While we enjoy the more fun family activities, the change in season is also a convenient reminder to catch up on necessary activities. Yardwork, testing smoke and carbon monoxide detectors, and replacing air filters. What does this have to do with finance? Regular maintenance is the key to keeping a house in good shape. In the same way, your finances need a few annual tune-ups. It might feel like a pain (like it did when I was doing yard work), but now is an excellent time to get a few essential items done to get your financial house in order.

Clear out the clutter

You should file and keep certain documents, like tax returns and statements for non-qualified brokerage accounts. However, it would be best to shred many of the financial documents you receive, like pay stubs and checks deposited online. Why shred? To protect your information. Yes, it’s an unfortunate reality that your paper documents are susceptible to identify theft, but you don’t have to invest in a commercial level shredder. Several micro-cut shredders are available through an office supply store for less than $100 – which isn’t a bad investment for the protection it provides. 

For those who have gone digital with financial documentation, check your computer files or cloud drives to clean out what you need and permanently delete files you don’t. Many institutions can also archive your statements for years, saving time in managing documents and keeping them in a more secure setting. 

Whether you’re clearing out physical or virtual clutter, it makes it much easier to find what you need in the future.

Annual credit report

Once every 12 months, everyone is entitled to a free credit report check at http://www.annualcreditreport.com. This is the only official website authorized by federal law. Be wary of any other services that pose as the official program and charge a fee. While your report is free, if you want to see your actual credit score, there is a cost at each of the credit bureaus. 

Another place to get your annual report is with your current credit card provider or banking institutions. It’s becoming more popular for financial institutions to partner with the credit bureaus and give customers free credit monitoring and offer ongoing access to your score and annual report. It’s worth checking if you can sign up or if you already have it. 

Annually reviewing your report can help you catch the signs of identity theft early or even discover and fix incorrect information.

Review subscriptions

From food subscription boxes to video streaming, this has to be the year of subscription services. Even before the pandemic, the average person in the U.S. had 12 paid media and entertainment subscriptions. If you live in a multi-generational household, that number could be as high as 17.

There’s a reason so many companies offer a monthly subscription or free trials. It’s easy to forget about it and not realize that you’re being charged month after month. Now is a good time to scroll through your expenses and see what subscription services are charging you each month. Either update the subscription level to an amount you actually use or say goodbye to the ones you don’t. 

Check on your estate plan

First, make sure you know where your essential estate documents are located. Then, review them to see if they need to be updated. Is there a need to change any of the designations you’ve made? Also, be sure to look at your financial accounts because named beneficiaries on accounts or insurance will supersede anything written in a will. If there has been a significant life change (e.g., birth, death, or divorce), there may be a need to update your documents. 

It may go without saying, but if you read this last item and said, “I don’t have an estate plan,” then your annual spring cleaning is more of a yearly to-do list. Having an estate plan is one of the essential items in your financial planning basket, as is having an emergency plan for the home. 

This list is not meant to be exhaustive, but instead a few quick items to help keep your financial house in order after a particularly challenging year. If you run across any questions as you work through the steps, please reach out to your Financial Advisor for help.

DISCLAIMER: The information provided is for educational purposes only. The views expressed here are those of the author and may not represent the views of BFT Financial Group. Neither BFT Financial Group nor the author makes any warranty or representation as to the accuracy, completeness or reliability of this information. Please be advised that this content may contain errors, is subject to revision at all times, and should not be relied upon for any purpose. Under no circumstances shall BFT Financial Group be liable to you or anyone else for damage stemming from the use or misuse of this information. Neither BFT or the author offers legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Past performance is no guarantee of future results.

By

Financial Update | April 2021

Listen to the brief audio version or read the full overview below.

A Volatile But Positive Quarter for Equity Markets

March turned out to be another volatile month for equity markets. The continued rise in U.S. bond yields continued to put pressure on equity markets, especially on higher valued growth stocks.

The sharp sell-off in U.S. Treasuries since the start of the year raised hopes that the Federal Reserve (Fed) would take a more active role in calming markets. They did not do that, disappointing financial markets. Instead, Jay Powell (Chairman of the Board of the Federal Reserve Bank) stressed that the Fed takes a broad view of financial conditions and that they remain highly accommodative, justifying the Fed’s current stance.

Moreover, he stressed that the economy is still far from meeting conditions that would warrant tighter monetary policy. He highlighted the fact that the unemployment rate is still high and that it will take time for the U.S. economy to recover properly.

The good news is that the economy is recovering as evidenced by economic data. Helped by the economic stimulus combined with the vaccination drive, the global economy should continue rebound over the course of the year, with momentum rotating from the US to the rest of the world.

The approval of the American Rescue Plan by congress also stoked fears that the additional $1.9 trillion of stimulus will lead to much higher inflation. U.S. households were sitting on around $1.7 trillion in excess savings as of the end of January. Households generated about two-thirds of those excess savings by cutting back on spending during the pandemic, with the remaining one-third stemming from stimulus payments.

It is estimated that the latest stimulus bill will boost household savings by an additional $300 billion, bringing the stock of excess savings to $2 trillion by April. As the lockdown measures ease, it is reasonable to assume that households will spend a portion of this cash cushion.

Unlike President Trump’s Tax Cuts and Jobs Act, Biden’s American Rescue Plan Act will raise the incomes of the poor much more than the rich. Since the poor tend to spend a greater share of each dollar of disposable income than the rich, aggregate demand could rise meaningfully.

Well, who’s afraid of a little inflation? Certainly not the Fed.

Consumer prices will rise “well in excess” of 2.5% before settling back, Robert Kaplan (President of Dallas branch of Federal Reserve Bank) said, adding that the Dallas branch forecasts GDP growth of around 6.5% this year. Charles Evans (President of Chicago branch of Federal Reserve Bank) also downplayed inflation of 2.5%, saying even 3% “would be welcome, actually” for some period. He reiterated that rising bond yields is a sign of economic optimism.

Chairman Powell also reiterated that the Fed views the upcoming inflationary spike as transitory and will not justify a change in Fed policy. Powell’s recent speeches highlighted that while Fed policy will remain accommodative for an extended period, the central bank will not attempt to micromanage fluctuations in long-dated bond yields.

Is the Federal Reserve’s Relaxed View Towards Inflation Risk
Justified?

The Fed knows full well that headline inflation could temporarily reach 4% over the next two months due to base effects from last year’s economic shock, supply chain disruptions, the rebound in oil prices, and the lagged effect from dollar weakness. However, as it did in late 2011, when headline inflation nearly hit 4% and producer price inflation briefly topped 10%, the Fed is inclined to regard these price shocks as transitory. The Fed believes that headline inflation will tick up to 2.4% this year but then settle back down to 2% by the end of next year as most fiscal stimulus measures end.

Our view is that the Fed will be right about inflation in the near term, but that it could be wrong in the long term. That is to say, we think that core inflation will probably remain subdued for the next two years, as the Fed expects. However, inflation could rise significantly towards the middle of the decade, an outcome that is likely to surprise both the Fed and financial markets.

Stocks usually outperform bonds when economic growth is strong, and money is cheap. The end of the pandemic and ongoing fiscal stimulus should support growth this and next year, allowing the bull market to continue. With inflation slow to rise, monetary policy will remain accommodative over this period.

The recent back-up in long-term bond yields could destabilize stocks for a month or two. However, as long as yields do not rise enough to trigger a recession, stocks will shrug off their effect. Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stock markets.

End of the Pandemic

Over the past 6 weeks, the U.S. has continued to make incredible progress in vaccinating its population against COVID-19.

The pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the U.S. will have vaccinated 90% of its population by the end of September. And these calculations assume the continuation of a two-dose regime, meaning that the rollout of Johnson & Johnson’s Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further.

The situation is clearly different in Europe. The vaccination progress in several European countries is well behind that of the U.S. and the UK, and per capita new cases in the euro area have again risen significantly above that of the U.S.

Clean Energy, Infrastructure and Commodities

Last week’s unveiling of President Biden’s $2.4 trillion “American Jobs Plan” to modernize U.S. infrastructure is the biggest construction and highway upgrade since the 1950s. Spending will take place over 8 years, financed in part by an increase in corporate taxes. This will provide a short-term boost to growth and is positive for equity markets as investors expected the tax component and the spending is front-loaded while the tax increases are spread out over 15 years.

The proposal is not pure old economy – it includes $650B for green infrastructure, clean water and high-speed broadband, along with $180B for the biggest non-defense Research and Development program on record. The proposal has a high likelihood of passage before the end of the year given that infrastructure is popular and Democrats can pass the bill via reconciliation with zero Republican votes.

The plan will create jobs but will likely also need a lot of base commodities from iron ore for railroads to copper and lithium for upgrading the broadband grid.

The past 10 years have been rough for commodity investors. After a decade-long bull market in the early 2000s, major commodity indices have continuously underperformed equities. The question now is what to expect going forward?

The conditions that propelled natural resource prices in the early half of the 2000s are very different from today. Back then, China’s economic expansion was a major tailwind. Fast forward to today, China is prioritizing stability over growth.

However, another tailwind for commodities is emerging. Alongside preventing financial risks, Chinese policymakers are also prioritized the environment. This is consistent with global efforts to adopt greener technologies. Somewhat ironically, it implies greater demand for commodities – industrial metals in particular – to buildout power grids.

The global movement toward a low-carbon renewable-energy future is a key factor underpinning metals demand over the next decade. The U.S., E.U. and China have committed to net-zero carbon targets by 2050 / 2060. This will unleash immense investment into and restructuring of everything from energy grids to city design to even bitcoin mining. Advances in renewable costs likely mean oil and coal are on their way out.

This comes after years of low capital investment in metals and mining. The confluence of supply constraints and rising demand will ultimately drive-up commodity prices.

Bond Portfolios are Suffering

Global bond markets are experiencing one of their worst starts of the year and are down circa 4%. Given the low interest rates, it is hard to see how global fixed income can generate a positive return this year.

Interest rates continue to tick higher on the back of solid economic data. There is a self-limiting aspect though to how high bond yields can rise when inflation is subdued. Higher bond yields lead to tighter financial conditions. Tighter financial conditions, in turn, lead to weaker growth, which justifies an even longer period of low rates. It is only when inflation rises to a level that central banks find uncomfortable that tighter financial conditions become desirable. We are far from that level today.

However, sharply falling bond yields are also not in the cards, so being short duration and owning corporate bonds and emerging market debt in our fixed income portfolios is helping us to create outperformance.

Investment Implications

Equities might face some more near-term volatility stemming from the recent rise in bond yields. But our core view is that the “Goldilocks” environment for risk assets, where growth is strong, inflation is contained, and monetary policy is accommodative, should last another two years. We expect corporate earnings to grow healthily this year and next, and strong earnings will continue to underpin the global equity markets.

Value stocks could lead the equity market higher over the next 12 months. The pandemic benefited growth names, especially in the tech space. The end of lockdown measures will favor value names. Not only is value still cheap in comparison to growth, but traditional value sectors such as banks and energy companies have seen stronger upward earnings revisions than tech stocks since the start of the year.

Looking further ahead, the cyclical bull market in stocks could end when inflation rises so high that central banks are forced to tighten monetary policy. While this is not a near-term risk, it is a major risk for the middle of the decade and beyond. Inflation is often slow to rise in response to an overheated economy, but when it does rise, it can rise fast.

Investors looking to hedge long-term inflation risk should favor inflation-protected securities over nominal bonds, precious metals and commodities, and they should.

PLEASE READ THIS WARNING: This newsletter contains general information that may not be suitable for everyone.
The information contained herein should not be construed as personalized investment advice. Past performance is no
guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come
to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information
presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

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*Investments in commodities may have greater volatility than investments in traditional securities, particularly if the
instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in
overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular
industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international
economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an
opportunity for increased return but, at the same time, creates the possibility for greater loss.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as
well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the
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By

March 2021 Financial Update

When Good News Becomes Bad News

Just like in January, global markets gave up most of their gains in the last few days of February this time because of rising bond yields, which made the market nervous.

What is important to note that it was not only U.S. Treasury yields that rose but also the European and Chinese bond yields, so it was a global sell off in government bonds.

Why Did the Equity Market Get Rattled by Rising Bond Yields?

Normally rising bond yields are an indication of strong economic growth, which should be positive for equity markets. However, historically, rising yields have been negative for stock valuations when yields increased in response to hawkish central bank rhetoric. This is clearly not the case today. The Fed’s accommodative stance should limit any near-term upward pressure on U.S. bond yields. Therefore, we continue to favor equities over a 12-month horizon.

This equity and bond market sell off was triggered by fears that all the fiscal and monetary stimulus will lead to much higher inflation, which would force the Fed to raise interest rates and tighten monetary policy, which in turn would put pressure on stock market valuations, especially on stocks with high valuation multiples. That is the reason why for example the NASDAQ dropped more than the Dow Jones Index.

Rising Yields and Inflation

We expect U.S. inflation to move higher over the coming months. Oil prices have risen 70% since the end of October and rising energy prices will likely push up headline inflation. In addition, the effect from a weaker dollar should translate into higher goods prices in the U.S.

A stronger labor market and a slower pace of rent forgiveness should also boost housing inflation. If we add everything together, we think there is a risk that headline inflation in the US could temporarily rise to 3 to 4% in the coming months, which would increase the long-term inflation expectations and could again lead to a short-term increase in bond yields, which could cause another scare in the equity market.

Fiscal stimulus could further supercharge demand, adding to inflationary pressures. The impending passage of the $1.9 trillion American Rescue Act, combined with the economic stimulus packages from 2020 brings the total fiscal support to almost 25% of U.S. Gross Domestic Product (GDP), which is arguably larger than the economic damage caused by the pandemic.

However, we think this increase in inflation numbers will be temporary as the economy is still in recovery mode. So, we do believe Fed chairman Powell when he says the Fed is planning not to take any action for the next two years. If the Fed sticks to that plan, then the economic stimulus will support corporate earnings.

We have to remember that inflation is not necessarily bad for equity markets. Deflation is bad for stocks, just as is high inflation. Somewhere between deflation and inflation, however, lies reflation. Reflation is good for stocks. We are currently in a reflationary zone, where inflation expectations have risen but not by enough to force the Fed to tighten monetary policy.

A period of ultra-easy monetary policy can sow the seeds for economic overheating, rising inflation, and ultimately, much higher interest rates. Since this is precisely what happened in the 1970s, it is prudent to ask whether something like that could happen again. Investors today certainly do not believe a replay of the 1970s is in the cards. Yet, we would argue that a 1970s-style inflationary episode is at least a risk we need to keep in mind.

While no two periods are exactly the same, there are a number of striking similarities between the late 1960s and today. As is the case today, fiscal policy was highly expansionary back then. The same goes for monetary policy: just like today, the Fed kept interest rates well below the growth rate of the economy. In the 1960s, the Federal Reserve was still focused on avoiding a repeat of the Great Depression and the deflationary wave that accompanied it. Today, the Fed is equally focused on reflating the economy.

As long as the economy is growing solidly and the Fed remains on the sidelines, it is too early for investors to sell out of equities. Instead, equity investors should favor sectors that could benefit from higher inflation. Looking further out, the secular bull market in stocks will end when inflation rises to a level that the Fed cannot ignore. That day will arrive, but probably not for another two years.

Pandemic Subsiding

We cannot yet declare victory over COVID-19 but it is clearly going in the right direction as new case counts have plummeted from their January peak. Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy, but even in Sweden and the U.S., which avoided EU-style restrictions, the virus has lost momentum. The roll-out of the vaccines will help to suppress another flare up of the virus and supports our view that economies will be able to open up sustainably within the next three months. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction.

Why This Time It is Different

The global economy has seen two significant crises in the space of a dozen years. The monetary policy response to both events has been substantially identical; the Fed swiftly cut the fed funds rate back to zero and started buying large amounts of Treasury and agency securities to support market liquidity.

The fiscal response has been dramatically different, however, with governments this time seemingly not concerned at all by borrowing large amounts of money to finance the economic stimulus plans.

Therefore, the outlook is quite different today compared to 2010 as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed the fiscal efforts after the Global Financial Crisis across the major economies. Once Congress passes the $1.9 trillion American Rescue Act, the U.S. will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remain to be seen, but it is clear that the post-pandemic economic recovery will not unfold in the same way as in the past decade.

The Difference

From 1966 until 1997, U.S. equity prices were negatively correlated with U.S. Treasury yields. Since 1997, U.S. share prices have been positively correlated with US government bond yields. We believe we are now in the process of a major paradigm shift in the stock-bond correlation, reverting to the pre-1997 relationship.

The positive correlation between share prices and US bond yields – that has been in place since 1997 – is likely to turn negative, which effectively means that stock prices will fall when U.S. bond yields rise and will rally when Treasury yields drop. The reason is that the market will shift its focus from seeing deflation as the major risk to seeing higher inflation as the main macro risk. Investment strategies and frameworks that have worked over the past 24 years might require modifications as balanced portfolios that only hold equities and fixed income might not provide sufficient diversification in this macro climate.

What Happened in 1997?

In case you are wondering what happened in 1997: The basis for the 1997 reversal in the stock-bond correlation was a regime shift in the global macro backdrop. Before 1997, the main risk to business cycles and share prices was inflation. From 1997 until very recently, the main risk to equity markets was deflation or very low inflation. The watershed event that triggered this global macro shift from inflation to deflation was the Asian Crisis in 1997. The Asian currency devaluations allowed local producers – operating in these large manufacturing hubs – to cut their export prices in US dollar terms. The price reductions unleashed deflationary forces that spread all over the world.

The Impact on the USD

The Fed’s accommodative stance should limit any near-term upward pressure on the U.S. dollar. Whereas stocks are most sensitive to absolute changes in long-term real bond yields, the dollar is more sensitive to changes in short-term real rate differentials with U.S. trading partners. Since the Fed is unlikely to tighten monetary policy anytime soon, U.S. short-term real rates could fall further as inflation rises.

The Fed falling behind the inflation curve is fundamentally bearish for the U.S. dollar. That is why the primary trend for the dollar remains down. However, the dollar is oversold, and a short-term rebound is possible, especially if U.S. bond yields continue to rise, triggering a period of risk-off in global financial markets.

Investment Strategy

Given these conclusions, we recommend the following investment stance over the next 12 months: Stay positive on equities, which will generate excess returns over government bonds and cash in the absence of a negative COVID surprise.

Despite the high valuations of growth stocks, we favor a balanced approach as we expect corporate earnings to remain strong this year, also for growth stocks. We could see periods of rising bond yields which will create short-term fears and corrections in the markets. But we think bond yields will not rise sustainably this year and the monetary backdrop will remain supportive for equity valuations.

Longer-Term Investment Strategy

Relatively higher equity valuations means that a lot of good news is already discounted in prices and that means the equity rally is entering a riskier period where short-term corrections become more likely. Share prices will advance when U.S. bond yields drop, and they will dip when Treasury yields rise. As and when share prices drop due to concerns about higher inflation, the Fed will attempt to calm investors arguing that inflation is transitory, and it knows how to deal with it. Stocks and bonds will likely rally on reassurances of this kind.

Commodities

We are following commodities and may favor holding a position in precious metals and base commodities as a long-term diversification in a multi-asset portfolio.

Base metals prices have rallied by over 50% in dollar terms since last year’s COVID-induced meltdown. Nevertheless, we see further upside in metals prices, with the potential to develop into a multi-year structural bull market. The key driver is the world’s decisive push to a greener future, which in turn will significantly boost demand for several key base metals used in new energy infrastructure.

Although the world’s awareness of climate change has been increasing over the past several decades, 2020 became a pivotal year as major countries affirmed their commitment with concrete and measurable targets. The EU and Japan announced last year that they are striving for net zero greenhouse gas emission by 2050, while China is aiming for the decade after.

In the U.S., President Joe Biden also intends to set the U.S. on a path to net zero emissions by 2050 and has issued an executive order to rejoin the Paris Climate Accord, alongside other actions in favor of environmental policies. To meet the ambitious goals outlined in the Paris Agreement, governments need to implement aggressive efforts focused on improving energy efficiency, decarbonizing the power sector, switching to low or zero-carbon fuels, and utilizing carbon-capture technologies. These efforts could profoundly change energy infrastructure and consumption patterns in the coming decades.

In short, the combination of regulatory, financial, and social incentives points to an acceleration in the development of green infrastructure, including the construction of solar and wind energy power plants and electrification of vehicles, many of which are heavy consumers of copper and some other base metals. This holds the promise of significantly boosting demand for these resources.

China’s demand for copper has been strong in the past several decades, and still holds the key in the near future. While the country’s transportation infrastructure has vastly improved, its campaign to build “new infrastructure” on the digitalization of its economy has just begun. The country has laid out ambitious plans to expand its 5G network and data centers, all of which are heavy consumers of copper.

Portfolios

Global Equity markets performed strongly up till the last week of February when the rising bond yields created a sell-off which wiped out most of last month’s gains. Our balanced approach in portfolios of combining value with momentum worked well.

As bond yields have been rising globally, bonds didn’t have a great start of the year. Global fixed income markets are down 2.5% since the start of the year while equity markets are up 1.5%. Which means that fixed income heavy portfolios are lagging. Non-qualified models have benefitted from municipal bond holdings as they have fared better than their treasury counterparts. Qualified models will see the return of senior floating rate bank notes to the lineup after a short absence. The potential for rising rates and the low duration associated with senior notes make them a favorable addition.