Category: Uncategorized

by Franklin J. Parker, CFA

The Summary

• On Tuesday, we get the latest read on inflation. Producer prices posted much higher than expected last week, though higher input costs have yet to be passed on to consumers. Food and energy have begun to run pretty hot, but the Fed likes to factor those out and look more closely at consumer goods. Even so, a headline inflation rate much higher than the expected 2.5% year-over-year would almost certainly push stock and bond prices down.
  
  
• Retail sales also post this week (Thursday), with the consensus hovering around a 5.9% expansion (though some estimates are as high as 7%!). Consumer spending is a key variable to the ongoing economic recovery—fully 2/3rds of the US economy is just people buying stuff. The stimulus program in March and the effects of the extreme weather in February are expected to combine to produce solid growth figures in retail sales!
  
  
• Biden has proposed a $2.3 trillion infrastructure package. Republicans have balked at the size of the deal, and even some moderate Democrats are expressing concern, both appear willing to consider a more targeted approach. That said, top Democrats seem more willing to move forward without bipartisan support. In either case, it is expected that a spending bill of this size would be mostly funded by newly-created money from the Federal Reserve. As with all monetary supply expansions, this has the side effect of driving up asset prices, and I expect this to be little different. Again, it is my view that so long as monetary policy is easy and the money supply is expanded, the bias in prices is up.
  

The Details & Chart of the Week

The ascension of China as the world’s economic superpower is so often talked about that the standard assumption is not if but when. It is easy to see why this is the standard assumption. Most economic growth models carry population and productivity as inputs, and with a population of 1.4 billion people, China need only slightly increase productivity to massively increase economic output.

Yet the not-so-often-talked-about addendum to this discussion is that, in the modern economy, not all economic output is created equal. The leaders of today’s economy do not compete just in manufacturing, but rather in information and technology. Today’s economic leadership is not defined by productivity on a factory floor.

In this week’s chart, Fathom Consulting illustrates the economic areas that China has both gained and lost ground over the past 15 years. These are not necessarily drawn from official figures, so they have sorted out some of the politically-biased reporting that we’ve come to expect from China’s official figures. What I find interesting is how China has held her own in several important fields—IT, New Energy, New Materials, and Medicine. She has lost substantial ground, however, in other key industries like Robotics, Aerospace, and Agriculture. Advanced Railway and Maritime Engineering are the only two places China has significantly increased her competitive advantage.

Said differently: it may well be that, through sheer numbers and ongoing productivity gains, China overtakes the US in economic output, but it is not raw output that matters. The type of output matters more than the absolute value of that output. South Korea is a perfect illustration of this fact. Though they are the 10th largest economy by output, they remain among the most important technological economies, ranking 1st on the International Innovation Index (China ranks 15th, and the US ranks 2nd). And remember, innovation is just a fancy word for an improving quality of life.

In the end, China has substantial ground to cover to gain a competitive advantage in the advanced modern economy. It isn’t enough to simply modernize or hold pace, since other countries continue to advance—she must advance more rapidly than other countries to gain true leadership of the global technological economy.

And even when China is the largest economy in the world, I find myself skeptical that this somehow dooms other countries to serfdom. Quality of life will continue to improve so long as innovation is central to our economic thinking.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Markets were rattled on Friday (and Monday) by what appears to be the largest margin call ever. Bloomberg reports that the family office of Bill Hwang—a controversial Wall Street figure who previously pled guilty to insider trading—was behind the selling. Many stocks were effected, including the banks who lent Hwang the money, and traders are not sure if the sudden selling is over or if this could create systemic issues, yielding some nervousness in prices this morning.
  
  
• The Fed again reiterated its commitment to current policy. In a flurry of speeches last week, Fed officials basically said the same things they have been saying—they are going to wait until the actual economic data improves before normalizing policy. In a similar vein, the Biden administration is expected to reveal a $3 trillion infrastructure spending package, though quick passage seems unlikely.
  
  
• We get March jobs data on Friday, and consumer confidence tomorrow. The jobs data will be important because it is an indicator for Fed policy, and since consumer spending has waned recently a boost in consumer confidence could help bolster prices. Again: so long long as the Fed continues their current policy, our view is that the bias in prices is up.

The Details

Almost every economic growth model carries population growth as an input. All else equal, growth in population tends to fuel growth in the economy. Economists, then, spend quite a bit of time attempting to forecast how much the population will grow in the coming years.

As The Economist recently reported, Covid appears to have slowed the birth rates in developed countries, contrary to some predictions. The US and China, for example, saw a 15% decline in births in 2020. Of course, most developed countries have long had native birth rates well below the 2.1 children per woman required to maintain their population, so Covid has simply compounded a problem that has been in the works for some time: peak population. With the recent global deaths from Covid and the reduced birth rate, it appears the human population is now likely to peak and then begin declining sometime around 2050—about a decade sooner than previously expected.

And it isn’t the absence of labor force growth that is of most concern, that effect is likely to be offset by automation. It is the decline of innovation that carries the largest economic consequence. With fewer minds to solve problems, fewer problems will be solved. Standards of living could then begin to slow and reverse. If global fertility rates stabilize below the required 2.1 children per woman, mankind will have to learn to deal with a new problem: getting economic growth from an ever-smaller population.

There have been, of course, no shortage of doomsayers through the years proclaiming the coming decline of humanity. What those doomsayers repeatedly fail to remember is the power of unbridled innovation. Just when economists were predicting great famines across Europe due to lack of food, Fritz Haber invented a way to capture nitrogen from the air and make fertilizer. Crop yields massively increased and the famines were averted. Just when England had felled all her forests in support of the “great wooden wall” that was her navy, shipbuilders turned to steel and built inconceivably powerful ships.

In the end, I tend to believe in the plucky and inventive nature of mankind. We tend to solve problems, and I think this will be no different. Even so, population growth has slowed in recent years. One lesson that Japan has given us in recent decades is the drag on economic growth that ageing and shrinking populations can create in modern economies. While this is, in many ways, “tomorrow’s problem,” it is a large-scale force that we must consider as investors.

Chart of the Week

Despite all the market drama of the past month or so, the main stock market index, the S&P 500, was only down 5.8% peak-to-trough. After rallying back off of its low, it pulled back a mere 3.4% in the most recent two weeks. It is important to put these recent market moves in perspective, because once we do, it becomes clear that this is all pretty normal and shouldn’t be concerning to long-term investors.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• The FOMC meeting last week reaffirmed the commitment of the Federal Reserve to keep short-term interest rates low and asset purchases going, which is exactly what was expected. In addition, Powell advised markets that any inflation spikes are expected to be short-lived (largely due to the “bullwhip effect“).
  
  
• Yields continue their march higher, and investors betting on the Fed to intervene and curtail the increase in 10-year US Treasury yields were sorely disappointed last week. Higher borrowing costs are generally seen to hurt businesses reliant on cheap capital (like tech), and the rotation out of growth toward value is in full swing.
  
  
• Powell testifies before congress on Tuesday and Wednesday of this week, and critics of current Fed policy on both sides of the aisle are becoming more vocal. He is likely to face tough questions about inflation, asset bubbles, and prudence. On Friday we get a read on the health of US consumers with personal spending, income, and consumer sentiment posting.

The Details

A new consensus is emerging in economics.

In short, the consensus centers around the real constraints facing government borrowing. Traditionally it was inferred that governments must be responsible with their borrowing lest they go bankrupt. Under this new paradigm, however, bankruptcy is not considered a danger because governments can simply print more of their own currency to repay debts. In contrast to the traditional view, spending constraints come from economic dislocations like excessive inflation, asset bubbles, unemployment, and productive capacity, rather than from the difference between tax revenue and spending.

This shift in paradigm can be fairly readily seen in a breakdown of US debt ownership. As of July 2020, the largest holder of US Treasury bonds were US government related entities. The Federal Reserve owned about 36% of US debt, whereas social security, Medicare, and various government-related pensions owned around 28%. That puts the US government as the largest single holder of US government debt: 64% of debt outstanding is owed to entities tied to the US government. To place this in perspective, China—the largest foreign holder of US Treasuries—owns only about 4% of US debt.

This new economic consensus tends to give governments a much longer spending leash. Deficits are not viewed as a net negative always; rather, deficit spending is context-dependent. That is to say there are times when deficit spending is bad and times when it is good. More traditional guidelines are also abandoned: the Phillips curve (the link between inflation and unemployment) has been largely discarded, and the Taylor Rule (which has traditionally guided interest rate policy) have both left the policy conversation, to name just two.

Without the more traditional hard-and-fast rules, we must rely on the insight and wisdom of policymakers to manage the various economic variables properly. This creates risk, of course. An economy that is heavily reliant on policymakers is fragile with respect to bad policy. There is a legitimate risk that policymakers get it wrong eventually, and the subsequent economic dislocations do real harm to people.

As citizens, we all have opinions on whether such a shift in the economic paradigm is, long-term, good or bad. However, as investors, we cannot play the game we want, we must play the game that is actually on the field. Whether good or bad, this is the current economic consensus, and it has several outcomes, such as:

• central banks are a key variable in market returns;
• plentiful liquidity can override economic fundamentals (i.e. poorly-run companies can continue to succeed for quite some time);
• inflation is likely divergent—consumer goods (where automation can lower prices) tend toward deflation while commodities (where production is constrained by location) tend toward inflation;
• asset prices will tend to increase while wages will tend to stagnate.

To be fair, our current economic regime has no precedent, so it can be difficult to make confident predictions. In this environment, mental flexibility is likely to be an investor’s most valuable trait. As is usually the case, wisdom, prudence, and tradecraft stand to add considerable value to investors with goals to achieve.

Chart of the Week

Markets get a read on the most important component of US economic growth: consumer spending. The past year has seen a considerable contraction in spending from individuals. However, with the recent round of stimulus, a high savings rate, and the ongoing economic recovery, the US consumer is expected to come roaring back in the first half of 2021. This Friday, we get a sense of how much traction consumers really have.

Reuters polls expect consumer confidence to increase slightly to 96 (it was around 130 in February 2020), and personal consumption to have increased by 0.1% month-over-month.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• It is Fed week! The Federal Open Market Committee (FOMC) meets to debate ongoing policy as well as set the target Fed Funds rate. We expect no change in policy at this month’s meeting. However, investors will parse the Fed’s language to gauge when the they might begin to slow their current pace of asset purchases (known as tapering).
  
  
• Stimulus checks are expected to post to accounts this week. A survey by Deutsche Bank indicated that about a third of these checks would flow into stocks (an inflow of about $170 billion). Those inflows will probably be concentrated in “meme stocks” (like AMC and GME). MSFT is another benefactor of the stimulus package: nearly 1/3 of the funds directed toward cyber security are expected to flow to the software giant (some $150 million).
  
  
• Biden is expected to unveil a tax bill in the coming week or two. Among others, we expect to see an increase in corporate tax rates from 21% to 28%, increasing income taxes for people earning more than $400,000/year, and treating capital gains as income for people who earn more than $1,000,000/year. Once the bill is presented, I would expect investors to re-price shares in direct proportion to the new taxes. This would be a short-term repricing, though a protracted political battle would add to market volatility.
  

The Details

Tax policy is obviously a highly political issue. Because of its politically-charged nature, it can be difficult to garner clear analysis of its effects on markets. As investors, our first job must be to develop expectations which are as dispassionate and as accurate as possible, and since such analysis is difficult to find, I spent some time looking at markets in 1992—the last time tax rates were meaningfully increased. Some disclaimer here is warranted: there are always many factors influencing market prices. It is, therefore, very difficult to tease apart the effects of tax proposals from other macroeconomic factors that were in play at the time.

The story in 1992 is pretty simple, and coincides with our expectations. In February of 1993, Bill Clinton proposed increasing the top income tax bracket from 31% to 39.6% and higher brackets for corporate taxes (from 34% to 38%). Markets trended down about 6% over the following months, then traded sideways as the bill was debated in congress. It was a contentious proposal, and there were shifts in sentiment as the debate progressed. It seems reasonable to attribute some of the market selloff to investors adjusting their portfolios in anticipation of the coming tax changes.

When the bill became law in August of 1993, markets again adjusted. However, these adjustments were relatively short-lived, and markets found their footing in October of 1992, rallying to end the year 6% higher. And, of course, the 1990s would go on to be one of the best decades in stock market history.

In the end, tax policy does matter. Like any other factor, investors will adapt and adjust to accommodate it. However, it is not the only factor that matters to markets. Indeed, there are more powerful effects which can overshadow any tax policy effects (like economic growth and monetary policy). While investors should be cognizant of tax policy, it should not loom too large in portfolio decisions. As with anything, we must keep it in perspective.

The lessons of 1992 seem to indicate that policy debates can add to market volatility as investors jostle portfolios in anticipation of tax adjustments. However, that volatility tends to be short lived as tax policy fades into the background and other macroeconomic factors become top-of-mind.

Chart of the Week

We get data on industrial production this week. A look at the quarterly change in total productivity tells the story of who is working where. Much of the recent recovery in jobs has been in the services sector, which tends to be more labor-intensive than manufacturing—that is, the leverage of technology is more pronounced in manufacturing than in services, so a manufacturing worker is considerably more productive per hour of work than a services worker. From a metrics perspective, then, as services become a greater component of an economy, the economy appears to grow less productive.

In the most recent quarter, economic productivity contracted at the fastest pace since 1981, but this was after expanding at the fastest pace on record. The productivity expansion two quarters ago was driven by the re-opening of manufacturing capacity, while the recent decline is the story of re-opening the services sectors.

This is, in fact, good news, though it may appear to be bad. It is always important to dig into why a data point is what it is, rather than simply accept it at face value.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

The Summary

• The roller-coaster ride continued last week as investors digested higher rates, a commitment from the Fed to keep easy money flowing, and no commitment from the Fed to arrest the rise in rates. It is widely believed that there is some level of rates and/or market selloff where the Fed would step in to “stabilize” markets. This means that there is likely some floor to market selloffs so long as the Fed is committed to maintaining their current policy.
  
  
• Wednesday morning we get a read on inflation. The consensus is that inflation sits right around 1.4% (annualized). A print much higher than this expectation would likely send markets reeling. Thursday is initial and continuing jobless claims, which are also important. The expectation is for 4.22 million continuing claims and 725,000 new claims. Again, if the jobs market is improving faster than expected that would likely be bad for markets. Both inflation and employment are central to Federal Reserve policy and since that policy is generally driving markets, major changes in the data could lead to major changes in policy, which is a net negative for financial markets hooked on easy money.
  
  
• I still see the Fed as being very supportive, despite the recent worries to the contrary. Recent market volatility, in my view, is likely to be short-lived and provides a good entry point for investors with cash to deploy. That said, there are some adjustments to portfolios investors should consider given the rise in interest rates. Current clients have already seen those adjustments, and I am, of course, always happy to discuss what those are!

The Details

Market news and commentary has been dominated by the Federal Reserve the past few weeks (I lump inflation in with the Federal Reserve). Since the story of the Fed is largely a story of changes in liquidity, I spent some time over recent months trying to better understand the role of liquidity in market pricing. The high-level results of that analysis were recently published at the CFA Institute’s blog.

In a nutshell, when you add cash to the marketplace, investors will pay a higher price for the exact same investment. Conversely, when you remove that cash from the marketplace, investors pay lower prices. Neither of these pricing effects have anything at all to do with a change in the fundamentals of an investment, they are entirely driven by the relative liquidity of investors operating in the market.

While this may seem obvious, it is not the traditional view of markets.

I have been mildly surprised by the reaction of various money managers to the actions of the Federal Reserve. Traditional value investors have been frustrated at the absurd expansion in stock valuations. Growth-oriented investors—the main beneficiaries of Fed policy—have taken a few victory laps, while macro-oriented investors, like Ray Dalio’s Bridgewater Associates, realized quickly that their fortunes are intimately tied to Fed policy. Last year, in fact, Dalio quickly called on the Fed to “go big” in their efforts to salvage the Covid-striken economy. Coincidentally, his fund was down 20% at the time (and has recovered in the wake of the Fed’s actions).

The point is, liquidity matters differently to different investment styles. For growth-oriented investors, the massive expansion in liquidity has been a tailwind driving increased valuations. Value-oriented investors, however, have experienced a marketplace that does not reward well-run companies nor punish poorly-run companies. Recent liquidity flows have created winners and losers.

But things change often in markets. As Bob Dylan said, “for the loser now will be later to win… for the times they are a changin’.” In times like today, mental flexibility and an ability to adjust quickly can be the difference between achieving your goals or not.

Chart of the Week

We have some historical examples of how markets react during rising rates. In 2013, we had the “taper tantrum” wherein the 10-year US Treasury moved upward 1.35 percentage points in the space of about four months. In this week’s chart, we look at how this move affected markets, and how the current year compares.

In May 2013, the 10-year US Treasury began to move slowly upward (bottom panel in the top chart below). Note that it took almost a month before markets began to readjust. From its peak in mid-May, the S&P 500 (top panel in chart below) fell about 6% over the course of a month. It rebounded strongly, rallying 8% in July, only to fall another 4.5% into September. As the 10-year US Treasury stabilized, markets recovered strongly, rallying 6% through September 2013. After another quick downswing, the S&P moved steadily higher afterward.

This is all eerily similar to recent market moves (bottom chart). Since January 2021, the 10-year US Treasury yield has moved from about 1.0% to 1.6%, and is expected to continue its climb. As in 2013, it took a solid month for markets to realize this move was here to stay. Similar to 2013, there have been moves down and back up.

Of course, the moves in 2013 took 4-6 months, and we are only about 3 months into the current move. As in 2013, I would expect to see continued volatility in stocks, but with a general trend upward. And while history doesn’t repeat itself exactly, it does tend to rhyme—It looks like 2021 is going to rhyme with 2013.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Worries about inflation spread through risk markets last week despite assurances from the Federal Reserve that they plan to continue current policy for the foreseeable future. Bond investors were particularly unconvinced and the benchmark yield on the 10-year US Treasury spiked to 1.50% (meaning bond prices fell, generally).
  
  
• This week sees speeches from several Fed governors, as well as important data drops. We get a read on the health of manufacturing as well as non-manufacturing sectors from the Institute for Supply Management’s various indices.
  • Manufacturing PMI posted this morning at a whopping 60.8—beating the expected 58.8! Anything over 50 is expansion, and 60 is about as good as that index ever gets.
  • Headline unemployment data also posts on Friday and the expectation is a headline unemployment rate of 6.3%. Ironically, a post much less than that may be bad for risk assets (like stocks) as it could perceived as a trigger to slow easy-money policy.
    
    
• Last week’s market movements showed just how dependent all investments are on Federal Reserve policy. The traditional idea that bonds offset losses in stocks (and vice versa) has been broken as all asset classes have traded in tandem with the same cause: the Federal Reserve. In short, diversification is not working when we need it to. Finding alternative ways to mitigate risk in our portfolios, therefore, has become a chief concern.

The Details

I remember in 2008 how I began to question whether the traditional advice still worked. Diversification, specifically, was on my mind because it didn’t work very well. I remember in October of 2008, stocks, bonds, and gold were all down. Even worse, after the failure of Lehman Brothers, money market accounts were in danger of not returning dollar-for-dollar. The FDIC stepped in and temporarily guaranteed money market funds against loss just to calm the panic. In short, not even cash was safe in October of 2008.

Our current environment is not as dramatic as all that, but it poses similar challenges. Markets have shown us over the past year that diversification is not working like it should. In moments of stress, stocks, bonds, and even gold, tend to sell off in tandem! Yet, when markets rally again, they tend to not move up together. This gives us the worst of diversification with none of the benefits.

I am not advocating for the abandonment of diversification. However, I am beginning to use some other risk mitigation techniques within our portfolios. There are pockets of the bond market, for example, which do not trade so directly with the Federal Reserve, and cash is a nice hedge against stressful moments. Of course, I cannot be too specific because different individuals will require different techniques, but suffice it to say that we may be entering a period where tradecraft can play a greater role in portfolio management.

Chart of the Week

The big news last week was, of course, the move in 10-year US Treasury yields. They reached their highest rate in about a year. This week’s chart places recent yield changes in a broader context. Clearly, the past 12-months have been the aberration in yields, not the norm—a more “normal” yield for the 10-year US Treasury is in the 2% range (though even that is low by historical standards).

Recent moves can really be seen as a return to more normal times.

That said, there is a rather wonky technical effect also at play. Stocks are priced as the sum of discounted future earnings. Most analysts use the 10-year US Treasury as a discount rate. So, as this rate rises, stock prices should fall all else being equal. The second plot illustrates this. For the P/E ratio on the S&P 500 to remain the same when yields rise, economic growth expectations must rise, as well. Conversely, if rates rise and growth expectations do not, then the P/E ratio will fall (and so will price).

There are many forces at work, of course, so we cannot make too much of this. Even so, it is a legitimate effect that must be considered in our investment portfolios.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Suddenly everyone cares about inflation. Bond and stock investors are adjusting portfolios in an attempt to get ahead of a possible inflation spike. This is pushing bond yields higher (and prices down) and generally pushing stocks down, though some sectors are holding up fairly well.
  
  
• The $1.9 trillion stimulus package is entering its final stretch. The House is expected to vote on the provision at the end of this week, and negotiations in the Senate are in full swing–all 50 Democrat senators are needed to pass the measure. Markets have priced-in the direct stimulus provisions, such as the $422 billion in direct payments to individuals and $250 billion in extended unemployment benefits. Signs of wavering would likely send stock prices lower.
  
  
• This is a busy week on the economic data front: we get talks from two Fed governors (who will no doubt address the inflation concern), Fed chairman Powell testifies on Wednesday, durable goods orders post on Thursday along with initial jobless claims, and Friday sees data on personal incomes/spending and consumer sentiment. I would expect some volatility, especially on Wednesday, as investors digest this information.
  

The Details

Inflation is dominating the news (seriously, inflation is pretty much the only story across my news feed). It is interesting to me how a known problem can come to dominate market consciousness all at once. There is nothing all that different about today’s economic environment versus six months ago, but all of a sudden investors across stocks, bonds, and commodities, are moving portfolios around in an attempt to get ahead of a possible spike in inflation. To be fair, US Congress is about to authorize $1.9 trillion in spending that is to be financed largely by the Federal Reserve (read as: newly created money).

That said–and I admit this is difficult for me to say–I’m not sure inflation is as big a concern as everyone is making it out to be right now. Of course, I am taking steps to inoculate portfolios from inflation risk, but there are three basic reasons why I see the sudden excessive worry as misplaced.

First, the Federal Reserve has a unique way of measuring inflation: they tend to factor out energy and food prices (because they are volatile) and they look more closely at prices on consumer goods. While we have begun to see some price inflation in consumer goods, much of that is simply due to Covid-related supply shortages (which can be fixed relatively quickly), not necessarily from a structural shift. The Fed has repeatedly made this point, so I would not expect a policy shift from them even if inflation spiked for a few months.

Second, the Fed changed their policy on inflation management. Previously, the Fed would take action if inflation posted higher than 2%. Now, however, the Fed intends to “average” inflation over “a cycle.” The vague language is almost certainly intentional. The current inflation management policy gives the Fed plenty of room to let inflation run hotter than normal before taking action. On the downside, the lack of a clear line also makes reading their next move that much harder.

The third reason brings us to the Chart of the Week…

Chart of the Week

It is my view that inflation won’t be a problem until interest rates rise meaningfully, which hasn’t happened yet. There is some nuance to this view, but in the end it has to do with opportunity cost. All of this newly-created money is getting “stuck” in financial markets, banks, and corporations because there is no difference between holding cash and investing it. Because people are hoarding that cash it isn’t causing inflation.

When interest rates rise, however, suddenly there is a cost to holding cash. People begin to invest their cash as do corporations. At that point, cash begins to move around the economy and that is when inflation shows up. As you can see in this week’s chart, even though the money supply has expanded at the fastest pace on record, the velocity of money (a measure of how often a dollar changes hands) has simultaneously plummeted in 2020.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

by Franklin J. Parker, CFA

The Summary

• Investors will be closely watching the progress of the latest stimulus package. The current proposal is worth around $1.9 trillion. Though Congress is out this week, the package has cleared initial negotiations and appears to be on track to pass via the reconciliation method, which only requires a simple majority. The bill is expected to be assembled by the House Budget Committee this week, with passage in the House expected next week. Markets are likely to trade on news, pricing the likelihood and timing of passage.
  
  
• Wednesday has a couple of important data drops: the Fed minutes, and the producer price index. The Fed minutes will be parsed by market participants looking for clues to when/if policy normalization is to begin. Producer price indexes are usually viewed as an early indicator of inflation, though some of that link has been weaker lately. Either of these could move markets.
  
  
• Earnings have been generally good (with about 75% of companies having reported): more companies are beating their estimates than average, and they are beating these estimates by a larger margin than average. No big surprise, tech and financials have posted the largest percentage of “beats” across sectors, while energy and real estate have posted the fewest percentage of “beats”. Still, 67% of energy companies have beaten earnings expectations, which is still quite good. Interested folks can read more at FactSet.

The Details

As we’ve discussed before, extreme market valuations are being supported by the central banks. Low interest rates and continued expansion of the money supply (printing money) serve to keep financial markets up. The latest round of stimulus proposals, then, are an important component of this continued market rally, and investors are likely to push prices around in response to any news surrounding it.

To fund stimulus, Congress authorizes the US Treasury to borrow money. In the past, it was investors (both domestic and international) who lent that money to the United States. In recent years, however, a significant percentage of that money is lent by the Federal Reserve. The Fed creates the money and then lends it to the US Treasury. In this scenario inflation becomes the major constraint on spending–higher inflation limits the Fed’s ability to print money, which limits the Treasury’s ability to borrow, and ultimately hinders Congress’ ability to spend. In the end, this pushes investors to watch inflation data very closely.

This is why markets are heavily influenced by central bank commentary (hence the importance of Fed minutes scheduled to post on Wednesday) and inflation data. Hints of the Fed pulling back spending would lead investors to push down stock valuations.

On the upside, earnings are posting generally better than expected. Most companies in the S&P 500 have posted results, and most of those are better than anticipated. Even energy, the laggard over the past year, has seen 2/3rds of companies post earnings which are better than expected.

It is my view that markets will continue to be bolstered in the coming months by the Fed and Congressional stimulus. There are certainly risks facing investors, and ultimately your goals and objectives will determine your course, but I see more upside than downside risk in the coming months. In my view (which can change in a moment, by the way), investors can use market dips as entry points.

Chart of the Week

As frigid temperatures grip the Southern US this week (parts of Texas are colder than Alaska!), energy markets have been sent on a wild ride! This week’s chart comes from Bloomberg, and it shows the spot cost per megawatt-hour of Texas electricity–a 3400% jump within a few hours. Oil and natural gas prices are also getting a boost from the sudden cold snap.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.