Where Could All This Market Optimism Lead Us?
Money supply growth is helping fuel a lot of the market optimism. What could be around the corner?
- A lot of optimism and fuel (money supply growth) embedded in stock prices and in actual business activity.
- Are we on the cusp of a new regime in interest rates and inflation?
- Are we embarking on a monetary revolution?
Good day. This is Brian Barish, President, and Chief Investment Officer of Cambiar Investors. Thank you for tuning into our latest Market outlook podcast, where I will discuss the current financial environment and provide our outlook for the remainder of 2021.
The environment in the first quarter was a continuation of strong market conditions from late 2020. This includes massive money supply creation from the Fed, very high corporate and household liquidity, and extremely high readings for forward-looking industrial indicators, such as the ISM Manufacturing Index, the ISM Services Index, and the Philly Fed Survey. All of these hit the highest levels seen this century and in some cases the highest since the 1950s. Basically, there’s a lot of optimism and a lot of fuel in the form of money supply growth to permit that optimism to express itself in stock prices and in actual business activity. This has led to massive capital raising in capital markets, to the point where junior investment banking staff are pleading for mercy and at least a day off here and there from senior staff who don’t seem particularly amused by any of this.
Markets are generally forward-looking and thus companies that are more geared to the physical economy have performed better while some of the pandemic beneficiary companies in more defensive type of stocks that dominated performance in 2020 have lagged. Our big picture views in the near term are not a lot different from the general consensus. We see an economic reopening happening in the U.S. starting now and outside the U.S. over the balance of the year. The government seldom get much praise for making good decisions, but the U.S. government should get some credit for a smart vaccine procurement strategy. The United States went with a multiple ‘shots on goal’ approach to vaccines and made sure it reserved a lot of early production even if this cost more money. Outside the United States, governments tended to go with the ‘cheapest is best’ approach, making them very dependent on the AstraZeneca COVID vaccine, which is not having a very good rollout, leading to longer lockdowns and avoidable health issues. This situation overseas seems to be improving now as vaccine capacity by Pfizer and Moderna keeps growing rapidly, helping supply.
As 2021 progresses, reopening will occur and that should translate into a bulge of economic activity, as more than a year’s worth of pent-up consumer and industrial demand are quenched. Given practical realities, this bulge of activity is likely to keep going well into 2022. There are already a number of industrial production bottlenecks showing up, such as semiconductors for cars, building materials for homes, copper and rubber among base commodities, and somehow disposable packages of ketchup in burger shops are in short supply. Since the first successful vaccine trials were announced, stocks more geared to the physical economy have outperformed as these stand to benefit greatly from the reopening and all the very visible pent-up demand issues. Large physical footprint businesses tend to be more heavily clustered in value stock indexes. So value as a category has performed quite strongly in the last six months. It is also true that physical economy and value stocks were priced very punitively during the peak pandemic, giving them ample room to rise. Alongside these developments, bond yields have risen anticipating higher economic activity and some inflation.
Given the tone of the markets, which has indiscriminately favored physical economy stocks after indiscriminately disfavoring them, we are pleased to have kept pace, especially after a really good 2020.
Given the tone of the markets, which has somewhat indiscriminately favored physical economy stocks after indiscriminately disfavoring them, we are pleased to have kept pace, especially after a really good 2020. As we move into 2021 and beyond, there are a couple of important financial topics worth thinking about. The first is whether the confluence of reopening the economy and the massive monetary actions by central banks mean that we are on the cusp of a new regime in interest rates and inflation, where both of these move up considerably from the low levels of the last ten years, or is the COVID recession and reopening just a very big one-off event, such that by 2023, when all the supply and demand disruptions wash through the world economy, the world will wind up back in the same low growth, low inflation and low money velocity reality that has persisted since 2009? Let’s call this the Slow-Flation Thesis. Does it persist after the COVID recovery or can central banks engineer a new and more inflationary regime?
The second, and perhaps the more interesting topic is whether we are on the cusp of a monetary revolution where digitized currencies become widely accepted as a means of storing wealth and paying for things. The Bitcoin phenomenon is just a very loud first cannon shot in this battle. During the first quarter, China and its plans to issue a digital Renminbi, creating an immediate question as to whether this amounts to some kind of one upsmanship game versus the U.S. dollar. Fed Chairman Jay Powell appeared on 60 Minutes in early April and said the Fed is studying this issue closely as are several other European countries. Earlier in January, when asked about the overall threat posed by financial technology businesses to traditional banking, JP Morgan’s very visible CEO, Jamie Dimon answered colorfully that the risk and gravity of FinTech startups should scare all traditional banks. The era of digital currencies seems likely in the next few years with the world’s economic superpowers understandably not wanting or planning to be laggards as this develops.
If the New Inflationary Regime Thesis proves correct, inflation and interest rates are heading much higher than today. If you were a bond manager and you believe the New Regime Thesis, you would want a very short duration portfolio. And conversely, if you believe the New Regime Thesis is some form of wishful thinking, you would probably want to sustain some duration of your portfolio until this all shakes out. Equity investors are facing a similar dilemma right now. The New Regime Thesis favors rate-sensitive stocks like banks, commodities, manufacturers, and even physical retailers. These are the stock market equivalent of short-duration bonds. Secular growth, technology, and internet stocks that have dominated the markets for the last 15 years should compress in value or at least perform less well as they embed very high duration assumptions and don’t benefit as directly from economic reopening. Bond proxy stocks like REITs and stable, but slow growing consumer stocks would also seem very vulnerable. On the flip side, if you believe the new era of inflation and rates thesis sounds dangerously similar to a ‘this time it’s different’ thesis, which almost never proves to be true, you would want to be very careful about overestimating the fundamentals in these short duration stock categories.
It’s hard to imagine that short duration stocks not experiencing a period of outsize profits as pent up demand is unleashed, but beyond the next 12 months, the forces that most people believe cause slow-flation, which are digitalization, globalization, poor demographics, and persistent industrial efficiencies, none of these are going into reverse. In the digital era, money velocity has tended to fall because banks are not able to channel all of the money supply growth into the physical economy. A large portion of the Fed’s extravagance stays trapped in the financial system, leading to financial excesses, such as we have been seeing in the stock market lately. In the accompanying chart, you can see that money velocity has consistently decreased since the mid-1990s and fell acutely in the pandemic. It will probably recover a bit as the economy reopens, but to achieve durable inflation, the slope of this line needs to turn in a positive direction.
So where do we stand? We’re electing, for now, to straddle the new inflation regime issue and not attempt to make a big call about it. We want to let the stocks come to us where we can clearly parse their fundamentals. In other words, we don’t wish to depend on a narrative where central banks need to succeed in objectives that they have previously failed to achieve many times over because of secular deflationary forces that have shown clear persistence.
We do not see a path back to the industrial economy of the 20th century, where bank lending to grow the physical asset base of the economy suddenly accelerates relative to intellectual property formation and digitization. On the other hand, central banks are very powerful and seem ideologically motivated to push inflation expectations higher than they currently are. If they are successful, and we really won’t know this for a couple of years, labor price inflation could become persistent creating a form of durable inflation through wage growth expectations. For now, there’s little question that we will see some elevated inflation readings in coming months as the initial phases of the pandemic, which were outright deflationary are anniversaried.
On the digital money front, it is similarly difficult to say what digital dollars will really mean to the average American, but this sure looks like it’s inevitably coming to your wallet. At some level, if you are using Apple Pay to buy groceries at the store or pay with a QR code at a restaurant or use a tap-to-pay Visa card to buy coffee, your payment is already taking a digital form. Digitizing the dollar just takes the next logical step with a parallel payment and clearing system to what already exists. Creative minds with big imaginations see a fully digitized payment system as offering far more expansionary possibilities than these examples. We’d say, we don’t really know.
We don’t know where this is all going. It could be a Roaring ’20s boom that is just starting or an asset bubble that will one day hit the wall as these things tend to do, with very costly consequences. However it goes, we intend to be disciplined as to price, business quality, and the capital discipline of the companies that we invest in for clients.
Thank you for tuning into our first quarter 2021 market outlook podcast. We appreciate your interest and support in Cambiar Investors.
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