by Franklin J. Parker, CFA
The Summary
- Investors appear to have renewed confidence in the economic recovery. Vaccination figures continue to rise, and Friday’s jobs report showing 911,000 jobs created in March blew past the expected 647,000. In total, the US economy has added 1.6 million jobs in the first quarter of 2021. At the current pace, all jobs lost through 2020 could be recouped by the end of the year.
- Today, the Institute for Supply Management released their non-manufacturing activity index and it came in at a whopping 63.7, which is the highest reading in the history of the index. Given that the service sector is two-thirds of the US economy, this bodes well for the continued recovery. On Friday, we get data on producer prices. This is considered an important data point as it is typically the first read on inflation. Reuters polls suggest a 3.8% increase in producer prices over last year. A figure significantly higher than this could give markets pause.
- Though I say it every week, it is worth repeating: the key variable in this market run is monetary and fiscal policy. The Fed’s current low interest rate and quantitative easing policy creates an upward bias in asset prices. Asset prices get a further boost from the deficit spending of the federal government which is financed by the Federal Reserve, of which Biden’s current ~$3 trillion infrastructure spending proposal is a good example. All of this cash finds its way into financial markets eventually, and it is currently fueling this bull run. The key variable to watch, then, is a shift in this policy.
The Details
Goals-based investing (GBI) has become a bit of a buzzword in finance. Unfortunately, like most buzzwords, most of the conversation around the topic is merely marketing.
But GBI is legitimately different from more traditional financial theory. Where traditional theory idealizes markets and investors, goals-based investing is concerned with how we can use financial markets to accomplish financial goals given real-world constraints.
Probably the most important difference between goals-based investing and traditional financial theory turns on the definition of “risk.” Traditionally, risk is defined as the amount of volatility (the up-and-downs) your portfolio is expected to suffer. Less portfolio risk, then, is less volatility. However, as you become less willing to accept volatility you also receive less return.
Goals-based investors, however, define risk as the probability of failing to achieve their goals. Portfolio volatility plays a role in that definition, of course, but so does return. The key, then, is to find the optimal balance between return and volatility that yields the highest probability of achieving your goals.
This redefinition of risk changes the conversation quite a bit. Cash, for example, has traditionally been considered the safest investment because it doesn’t change in value—it has no volatility. Goals-based investors, however, may well view cash as the riskiest asset class since, at times, it virtually guarantees the investor will not achieve her goals!
Investments, then, are simply tools to get various jobs done. To understand how to manage your investment portfolio, and to understand what risks you can afford to take, you must first understand the job you need doing. We cannot manage money in the abstract, as traditional theory may suggest.
Your investment portfolio must be fully defined by your objectives. If that is not the case, it wouldn’t hurt to open a conversation!
Chart of the Week
The prices producers pay (purple line in the chart below) usually moves with consumer prices (blue line in the chart below). This makes sense, of course, since manufacturers will tend to pass along their price increases to consumers. Consumer prices are the most widely followed measure of inflation, but the Fed generally prefers to look at “core” CPI, which factors out food and energy costs (black line).
For most people, however, food and energy costs are a substantial budget item. This is especially true for the poor who tend to spend a higher percentage of their incomes on food and a lower percentage on consumer goods. Recent food price inflation, then, should be a growing concern for policymakers as it is a cost borne disproportionately by the poor. Whereas consumer goods have benefited from disinflationary trends (like automation and off-shoring labor), commodities for which production cannot be so easily shifted (like food) have begun to see concerning levels of price increases—even after the Covid-induced supply constraints are factored out.
The recent surge in producer prices is also a concern, though the Fed has suggested that they expect it to be a transient effect. Polls of economists do seem to indicate a leveling off of producer price increases, but Friday’s figures will be very telling! Since inflation is the real constraint on current easy-money policy and ongoing deficit spending from Washington, these figures are getting considerably more attention than they used to.
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