10 Aug Quarterly Letter to Clients – July 2021
We hope you are enjoying summer and rediscovering some of life’s missing pleasures as we all try to emerge from the very difficult pandemic.
Market performance has been robust during the first half of 2021, with the S&P 500® delivering 15.2% and the Russell 2000®, 17.5%. The market is clearly anticipating a stabilizing and strengthening economy, with some in the most optimistic camp suggesting a post-WWII-like environment. However, key obstacles remain: labor participation rates (particularly in the retail, restaurant, and manufacturing sectors – “Help Wanted” signs abound!), inventory imbalances and demand shifts stemming from the economic shutdown, unprecedented stay-at-home policies and government intervention.
These effects are creating inflationary impacts in most areas of the economy. Whether inflationary effects are temporary or longer-lasting seems to be up for debate, not unexpectedly. The Federal Reserve has forecasted a spike in prices as the U.S. economy reopens, and even legendary investor Warren Buffet said during Berkshire Hathaway’s annual meeting in May that he is seeing “very substantial inflation” and his companies are raising prices.
Federal Reserve Chairman Jerome Powell and other officials contend that the recent spike reflects the effects of demand/supply imbalances resulting from the pandemic. The Fed has made clear it doesn’t expect inflation to prove stubborn and is willing to tolerate an economy that runs hot and pushes inflation above its usual target of 2% for an unspecified period before pulling back on its extraordinary monetary stimulus efforts.
Is inflation good for stocks?
The answer may depend on whom you ask and what historical data you think is germane. Inflation is not all bad. Some inflation can be beneficial. For example, under some circumstances modest inflation could stimulate job growth. Mild inflation is generally good because it is a sign the economy is growing and businesses can typically raise prices. There may even be a sweet spot for inflation. Stocks may provide some protection as a hedge against inflation as a company’s revenues and profits should grow at the same rate as inflation, after a period of adjustment.
As economists grapple with whether the U.S. is in store for a prolonged bout of inflation or a mere blip on the chart, equity analysts have turned their attention to exploring just what it would mean for the stock market if inflation were to take hold.
What does history show?
When inflation appears imminent, investor instincts are to overweight cash and bonds and shy away from higher risk/reward instruments such as stocks. What does history tell us about investing during higher than normal periods of inflation?
We analyzed the highest inflation years since World War II using raw stock, bond, Treasury bill and inflation data provided by Ibbotson Associates. Focusing on the 20 highest years of inflation in this 74-year period, eight were the highly inflationary and difficult market performance years of the 1970s. Inflation rates within the 20 years were lowest in 1987, at 4.4%, and highest in 1946, at 18.2%, immediately following WWII.
During the 20 highest inflation years, positive investment results were achieved across all investment asset classes. Modest but positive inflation-adjusted gains were made by both small and large company stock holdings. Classically viewed “safe haven” instruments, such as long-term government bonds or cash, actually saw modest declines in spending power and reduced wealth. Doing nothing but holding non-interest-bearing cash, and fighting the average annual headwind of 7.9% inflation, showed the worst outcome – leaving the non-investor, on average, with $921 of spending power vs. his $1,000, in a typical year.
A time traveler from 1946, arriving today and accustomed to stashing his cash under the mattress, would find the hard-earned money in his pocket would buy him less than 1/16 of what it could in 1946. If invested before his journey in large company stocks, for example, and avoiding emotional responses to the world’s good and bad news of the last 74 years, but still achieving their returns, he would likely be very surprised to find his $1,000 investment valued at over $2.7 million, or at 225 times his spending power, even after accounting for the effects of inflation!
As always, and with cautious optimism, we continue to carefully monitor market conditions as we manage your portfolio to meet your objectives.
Peter J. Connors, CFA