Perspective : Second Quarter 2021: The Download

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Is it time to be fearful when others are greedy?

Net dollar flows into equities in 2021 are astonishing.  If they continue at the current pace, more money will flow into equities this year than in the last 20 years combined.[1]

 

  1. Equity investing is red hot

With dollar flows into equities this year breaking historic records1, investors appear unbelievably bullish.  Where does all this money come from? Some claim stimulus checks, others the Fed. Maybe it’s financial engineering, some suggest. However, a more likely explanation is that the flows are coming from changes in current investors’ stock/bond/cash ratios and leverage. It seems that everyone is bullish and ramping up their equity exposure—and that everything is happening at the same time.

 

Consequently, stock prices around the world just experienced another solid quarter. But what about valuations? Are investors paying reasonable prices for the future prospect of the businesses they are ultimately investing in? The answer is, unequivocally, no!

 

There are many common metrics available to determine whether stock prices are high, reasonable, or low, relative to history. Whether it be price-to-equity (P/E) ratios, dividend yields, earnings yields, price-to-book-values (P/B), or market cap comparisons to the economy, stock prices in the U.S. are undoubtedly high.

 

Many have pointed to these high valuations and claimed that value stocks offer a more reasonable value than the growth stocks. This claim is problematic, though, since value stocks, too, are currently priced at historical valuation highs[2]. Based on our research, international and emerging markets stocks offer more reasonable value, but the valuation difference, when compared to U.S. stocks, has been apparent for some time.

 

Key investor takeaway

Increasing equity exposure is easy. Today, investors can push a button and change their risk exposure or buy more equity. For some investors, this seems to be the staple move that helps keep them on track with their financial goals. But let us not presume that the ability to increase one’s exposure to equities with the snap of a finger is always a good thing. Satisfying investors’ demands to keep up with rising asset prices while simultaneously being mindful of future risks can be a tightrope.

 

One thing to consider when assessing the future prospect of equities is the historic relationship of valuations and future returns. Across most capital markets and through most time periods, buying assets at high valuations has led to lower long-term future returns and vice versa[3]. The old adage of buy low/sell high holds true over time, but in the short run, it can be hard to abide by.

 

“OK, Geremy. Stop dropping hints and just say it out loud.” Fine. What I’m telling you is that I believe it is highly likely the returns for U.S. equities over the next five years will be different than they have been for the past five.

 

  1. Inflation, inflation, inflation

The big surprise this quarter was inflation. The latest CPI-U year-over-year inflation print for the 12 months ending May 2021 is 5%[4]. Regardless of whether the rise in general prices—influenced by the sectors of energy, lumber, or used cars—has been lumpy or not, it does appear that most of us are witnessing pockets of inflation in our lives. And inflation is often contagious. Inflation in one area, often spills over into others.

 

This current inflation appears to be an about-face from the decade of deflationary forces that languished through the decade prior to COVID. The 2010s were characterized by slow growth, low inflation, and low interest rates. To combat the persistent slow and low economy, central banks around the world were unrelentless in their efforts to stimulate the world’s economy, which largely just led to rising asset prices. Fast forward through one pandemic and one year later, and BOOM! An explosion in consumer demand. Have we entered a new paradigm of demand and exceeding supply, or will we return to the old, oversupplied economy that we are all so used to? In other words, is the inflation that we are witnessing transitory or persistent?

 

It is not enough to just witness and explain why inflation happens. The key is to comprehend whether inflation will increase or decrease in the coming years from its current level. To answer this question, let’s pontificate on why there is inflation today. We at Frontier believe that the current inflation we are witnessing is attributable to the following variables:

 

  1. Rising asset prices spurring demand – when asset prices rise, we all feel wealthier.
  2. Continued expansion of money supply from central banks and federal governments around the world.
  3. Supply shortages around the world attributable to flat-footed businesses and to fits and starts of manufacturing due to COVID.

 

To answer whether inflation is here to stay, all you have to do is determine whether the factors presented above are transient or persistent—in other words: play a guessing game. Today’s inflation, however, leaves no room for speculation. It is higher than any time in the last ten years.

 

Key investor takeaway

One of the most effective ways to hedge against inflation is to invest in commodities. Historically—and logically—when inflation occurs, the general rise in prices coincides with a rise in input prices (commodity prices). Conversely, inflation negatively impacts the returns for fixed income instruments. Despite all the speculation that stocks can be a good hedge against inflation, this specific relationship is murky. In general, stocks can perform well if inflation is measured and predictable, but unpredictable inflation or inflation that hinders the economy may be bad for the prospects of stock ownership.

 

So, should you sell your bonds or buy commodities? Not so fast. Commodity prices have already risen considerably and will require inflation to accelerate from here to offer significant gains. Further, commodities are highly volatile, and have historically been extremely hard to time. On the other hand, to sell bonds would ignore their hedge value against economic slowdowns, or worse, a decline of heated stock prices. To do both—buy commodities and sell fixed income—would greatly increase the downside risk exposure of a portfolio. Doing so now could be considered questionable timing.

 

  1. Believe it or not, bonds are also performing far beyond expectations.

Interest rates fell and bond prices rose during the second quarter[5]. If you understand the relationship of interest rates to the economy, to the stock market, and to inflation and commodity prices, this was a shocking quarter for bonds.

 

Academically, bond prices have an inverse relationship to the economy, to stock prices, and to inflation.  Stocks like a good economy, bonds like a bad economy, and bond prices should move inversely to inflation. The economy is great, stock prices are booming, and inflation is rearing its ugly head—yet bond prices rallied during the quarter. Further to that point, interest rates for the 10-year treasury bond have only risen about 1% from their all-time low set during the COVID-quarter[6]. And just look at what has happened to the economy and asset prices since then! So, what gives?

 

The only logical explanation for why bond prices have been so strong in the face of all this negative pressure is that fixed income investors must still either require or expect a reason to hold safe assets. This only makes sense if fixed-income investors do not believe the current growth explosion will continue, and if they believe that the current inflation we are witnessing is transient. As it stands today, most of the entire global fixed income complex—treasuries to junk bonds—offers yields below the current rate of inflation.

 

Key investor takeaway

No matter how many pie slices or asset classes an investor holds, in effect there are only four true exposures in most investor portfolios. Equities represent exposure to growth in the economy and earnings, commodities represent exposure to inflation, high-quality fixed income can represent exposure to deflation, and near cash represents asset storage. That being said, with interest rates below inflation, exposure to fixed income and to near cash do not offer much investment value.

 

“Why should I even hold bonds at all?” I wish to remind us of the value of bonds in a risk-managed portfolio.

 

  1. Not every investor needs to be exposed to the full force of equity risk, some investors require risk management, and many would prefer more consistent return patterns than that of a 100% equity portfolio.
  2. Some types of bonds can be used to hedge equity risk or deflation.
  3. The right combination of bonds can provide both added value and an equity hedge over just holding cash.
  4. When equity markets have boomed, and investors are at their most bullish, it maybe an important time to temper risk.
  5. Risk management, or at least temperament, might be more important today than ever before.

 

Carry on.

 

Download the Commentary

 

[1] BofA Global Investments
[2] Bloomberg
[3] “Guide to the Markets”, J.P. Morgan, June 30, 2021
[4] U.S. Bureau of Labor Statistics
[5] Bloomberg Barclays U.S. Aggregate Bond Index
[6] FRED (Federal Reserve Economic Data)

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