The last year created great challenges and opportunities, sadness and awakening. The little corner of the world that we share, investments, was in some way a reflection of the larger environment: panic, fear, hope, reflection and then opportunity.
The Federal Reserve and Congress, having learned from the mistakes of the Great Financial Crisis, acted quickly and forcefully to create liquidity and stabilize markets. The safety net that the federal government provided afforded markets the time to digest and integrate this totally unpredictable event. In a relatively short period of time, investors saw the pandemic as a tsunami, and in time, the crisis was relegated to the rear view mirror. As asset values stabilized, stocks began to look past the pandemic, slowly at first, but as the hope of a vaccine became real, with increasing strength. From the bottom, equity markets had their strongest run since 1936:
As we enter the post-pandemic period, the challenge is how best to navigate the capital markets. In order to noodle through the myriad variables, I believe we need to divide our thoughts between the next year-and-a-half and thereafter. The Fed is now predicting 6% GDP growth for 2021, driven by the trillions in emergency relief aid provided by Congress, and the Fed’s stated intention to keep short-term rates pinned at zero over the next year or two. There are many economists who believe that this combination of fiscal and monetary stimulus will accelerate growth in excess of the 6%, which in turn will create inflationary pressures well beyond the Fed’s target of 2%. Historically the global economy has allowed companies to produce offshore, taking advantage of huge cost savings, resulting in minimal inflationary pressure. In many ways, this approach has become a problem during the pandemic, as huge supply chain disruptions have resulted in higher prices. The global economy has become less reliable, and concerns have surfaced that companies bringing manufacturing back to the U.S. will create higher costs that might be passed to the consumer.
But it seems to me that inflationary pressures will prove short lived, arising only as a consequence of too much government intervention at a time the economy was already facing pent-up demand, outsized savings and the momentum of a vaccinated population. This next year-and-a-half may be as unique as the year prior, and not particularly indicative of the economy’s long-term trajectory. The inflationary experiences during the next year or two will be a direct result of liquidity being thrown into an already turbo-charged system, creating a short-term pop that will eventually settle back to pre-pandemic levels, with inflation staying at or below the target rate of 2%.
Standing at what seems to be an inflection point, there is a need to protect assets from a near-term explosion of liquidity and speculation. U.S. debt is running at 125% of GDP, and will probably push closer to 150% in the foreseeable future (Japan’s debt is 250% of GDP). This is the highest ratio of debt-to-GDP since World War II, so even if interest rates stay near zero and inflation of 1%-2%, there is little protection from currency devaluation. As long as the U.S. dollar is the trading currency of the world, the U.S. government will get away with unbridled spending and diminish the value of the dollar. Under these circumstances, we need to convert our currency into assets.
One of the saving graces is that there is a growing global economy. Middle class values are spreading around the world, as is the desire to have a quality of life similar to the West. Global growth will allow even mature economies to grow, aided by science and technology. Even as the U.S. economy reverts to pre-pandemic levels of slow growth, there are many opportunities in the global markets. The expanding global middle class is accelerating the demand for goods and services, and well-managed companies here and abroad are prepared to meet those growing needs. The ability of businesses to leverage resources around the world in order to drive efficiency and to stay productive will hold down inflationary pressures.
If interest rates respond to inflationary fears by rising over the next year or two, I believe this will provide a wonderful opportunity to lock in higher yields. Because before too long, and I do believe the risk is that it will come sooner than most think, the bond market will realize that the forces driving current inflationary concerns are not here for the long haul. At that point, rates will stabilize and/or fall back. In the meantime, stock values will continue to expand with an accelerating economy.
Important keys to investment success will be diversification and the willingness to endure volatility. Although those factors have always been true, they seem to be even more important as we enter these next two phases; post-pandemic and post-post-pandemic.
Harold G. Kotler, CFA
CEO, Chief Investment Officer