My last post was one year ago. The topics dominating headlines have changed (other than the pandemic), but what hasn’t changed is uncertainty. The longer I’m in this business, the more I realize that uncertainty is always present. That is, it’s a present-tense issue. Uncertainty is misremembered in hindsight. Things tend to look obvious and follow a cause-and-effect pattern after we know the outcomes. The future is also less uncertain than the present. The market goes up in the long run. Technology and medicine will continue to advance. The world will be a better place. The present is incredibly uncertain, though. Real and imagined threats are everywhere. As we have access to more and more data, the more uncertain the present feels.
There are four major themes I’m following that blanket most of my present-tense concerns over uncertainty: The Federal Reserve, Inflation, Politics, and the Pandemic.
There is a saying that bull markets don’t die of old age, they are murdered by monetary policy mistakes. In the past, these mistakes happened in secret as the Federal Reserve did not communicate well. The modern Fed telegraphs their moves and explains their reasoning thoroughly. They get immediate feedback not only from the talking heads on TV, but from the market itself. It’s no secret that they plan to taper their asset purchases by the end of the year (likely announcing this officially on November 3rd). Since the Financial Crisis, the market has had a habit of reading good news as bad news (good economic news would mean Fed tightening = “bad” for stocks) and bad news as good news (bad news brings continued loose monetary policy = “good” for stocks). Recently, this has stopped and even the announcement of a taper has been met with a shrug of the shoulders by the markets. I think this is a sign that the market is removing the Fed’s thumb from the scale, possibly freeing the Fed to react less to the markets and focus more on their dual mandate. Which brings us to…
Energy and real estate get most of the ink/pixels when inflation is in the headlines. Energy prices are a big component of inflation and an easy to find indicator as anyone can see the price of gas displayed at any gas station in town. The world shot itself in the foot by sacrificing fossil fuels on the altar of politics. Here in the US we killed a major pipeline partnership with our neighbor to the north while also increasing regulation on the energy space, especially fracking. Europe handed control of its energy prices to Russia while shifting to solar and wind too quickly. An unexpected shortage of wind revealed issues in energy storage and backup. I expect high energy prices to be resolved through high prices – reduced demand as consumers cut back and increased supply as producer break-evens are met.
Real Estate prices have been on a tear as anyone who has tried to buy a house recently can attest. However, inflation only takes into account rents, not the asset price of the real estate. Rents dropped during the pandemic and are only now starting to rebound. Eviction moratoriums and general vilification of landlords haven’t helped.
The big unknown with inflation, however, is the labor market and wages. Wages are rising as employers are having a hard time finding workers. I’ve heard several theories as to what’s going on:
- Women who left the workforce during the pandemic to take care of kids due to lack of daycare/schools are finding this to be a better fit than going back to work.
- Men (particularly older men) are leaving labor-intense, low-wage jobs to either retire, work in an office, or work from home.
- Retail and service workers (think waitresses, line cooks, dishwashers) are leaving low-wage, high-stress jobs for better paying, lower-stress employment
- Workers laid off during the pandemic switched careers or went back to school
- Baby Boomers (a large cohort) continue to retire and many find themselves ahead of schedule as the market soars; many are retiring early
- Wages are rising and workers are willing to leave for more money (4 million people quit their jobs in August!) or are not working (living off savings), waiting for wages to peak
Nobody seems to have a good answer. It’s probably a combination of factors, but what is clear is that the labor market is tighter than the numbers say it is.
The Fed expects inflation to be transitory. The year-over-year inflation number should moderate as we move past the pandemic lows. Every new data point on energy, or wages, or inflation is followed by howling about how wrong the transitory expectation is. We should wait until March at the earliest until burying the transitory narrative, more likely through the second quarter of 2022. We can’t be certain about the extent of inflation today, but calls for hyperinflation should be dismissed.
Do I have to write about this? I brought it up so I guess so. Politics is a wildcard and always subject to change. I’m not freaking out about the proposed spending packages, especially since they are spending spread over 10 years as opposed to the trillions we spent over the last 18 months of pandemic. Further, everything is subject to negotiation, especially when the margins on the votes for these proposed bills will be so slim. Never make portfolio changes based on proposed legislation. It’s often very different from what actually becomes law. Even since I started writing this, the proposed taxes have changed wildly from increasing the top tax rates on corporations to a new tax on unrealized gains for the “extremely wealthy”. No details on where exactly that line is drawn, but if people call you a weirdo, you probably won’t have to worry. If people call you eccentric, contact your accountant.
Side note: Does anyone else think it’s weird that legislators argue the amount of spending first, rather than what the spending actually goes to? Isn’t that completely backwards?
The data around the pandemic is constantly improving. I mean that yes, the news is better, but also the data itself is more robust meaning we can make better decisions based on it. However, it’s hard for policy to change since that involves human nature. Humans hate to admit they were wrong. Admitting you were wrong publicly opens you up to criticism and blame, regardless of whether the new information was knowable or not. This is the paradox of leadership today. It’s even difficult for our leaders to admit that policies put in place a year ago worked and that things continue to improve. It is obvious that we are in a better place today than a year ago. We have a better idea of what works and what doesn’t. JP Morgan estimates 80-90% of American adults are either vaccinated or carry natural immunity through previous infection.
Of all the factors I’m watching, the pandemic has the widest array of outcomes. Maybe we continue making steady progress with occasional setbacks like the Delta variant. Maybe there’s a mutation that proves difficult to deal with, setting off a new round of lockdowns and fear. Maybe a scientist posts a chart upside down on accident and the misinformation goes viral. Or maybe we have a breakthrough to the positive side and things get markedly better due to a new medicine, technique, or just pure luck.
A couple other items that are on my radar, but maybe not quite on the front burner: China and Interest Rates.
There is some rumbling about Chinese regulators cracking down on companies there. I’ve spoken with China-focused analysts and it looks like this is part of the ongoing Chinese regulation cycle. In the US, we have regulations in place before start-ups start breaking things (or early on in the breaking things process). The US addressed automated driver systems early on – what roads they could drive on, whether there was a human driver present, etc. In China, it’s somewhat the reverse. Start-ups build and run as far and fast as they can until they become a problem for the Party. When the new start-up or market segment is being too clever in tax payments or begins to act as though it is equal to the Party, the regulation begins. This can be harsh if you’re the founder. In China, anyone can be disappeared. Once the Party’s issues are resolved (often installing Party officials in some controlling capacity or “advisory board”), the cycle continues until someone else gets out over their skis.
China may also have some problems in their real estate sector. Some real estate companies are having trouble making payments on their bonds. Will this insolvency spread? It’s too early to tell, but China has a greater ability to step in with regulation or liquidity than the US did during the Financial Crisis. With the lack of transparency in China, we may never even know what ends up happening.
Central Banks are still holding rates at rock bottom. My worry right now isn’t rates themselves, but risk. Rates this low are encouraging risk-taking as investors abandon bonds that used to provide decent income for other instruments. We’re seeing a breakout of risky investments hitting the mainstream: IPOs, SPACs, Cryptocurrentcies, and now NFTs. Investors are experiencing fear of missing out (FOMO) after seeing huge gains in some of these assets (you never seem to hear about the ones that fail, though). That FOMO is in spite of huge gains in the S&P 500 over the last few years. Can these conditions continue? If the market reverts to its historical average, people taking on too much risk will get walloped.
A large shift in any of these factors may warrant a shift in asset allocations, but if history is any guide, underlying investments will keep up with the pace of change. Whether it’s a new stock sector leading the index or a rising rate environment, a diversified portfolio will often adapt at a better pace than actively trying to time the changes.