Second Quarter 2021 Client Letter

Second Quarter 2021 Client Letter

Second Quarter 2021 Client Letter


In the spy comedy, Austin Powers: International Man of Mystery , the villainous Dr. Evil cryogenically freezes himself in 1967. He awakens 30 years later in the “modern” age of 1997. Intent on making mischief, he threatens to blow up the world unless the United Nations pays him the grand sum of one million dollars! After he is met by rude laughter, he quickly adjusts his request to $100 billion. Having missed out on the past 30 years, it takes Dr. Evil a bit to catch up to the reality of modern-day finances and the steep depreciation of the dollar due to inflation.

In economic terms, inflation is defined as an increase in prices and a fall in the purchasing power of money.  Inflation has been in the headlines lately, but it is hard to tell from the news whether today’s inflation is here to stay or merely “transitory.”  Perhaps more importantly, what are the long-term drivers of inflation and is this something that investors need to prepare for?

The $1 Million Question: Is Today’s Inflation Transitory?

Despite all the talk of inflation, stocks continued their ascent virtually undisturbed in the second quarter, with all major indices posting gains. Traditional bonds, which are especially vulnerable to inflationary pressures, were up small in the second quarter but still have a loss of 1.6% for the first six months of the year. The most dramatic move came from the broad commodity index, up around 21% with rising prices (essentially the definition of inflation) in everything from lumber and oil to copper and certain agricultural goods.

It is not just the financial markets that are pointing to inflation; the data unmistakably shows that inflation is on the rise. After hovering in the 1–2% annual range for years, inflation dipped down close to zero in 2020 in response to the pandemic. However, in recent months, it has gotten as high as 5.4% on an annualized basis. The government is very eager to assure everyone that this pickup in inflation is just a short-term response to the drop that we saw in 2020. The word“transitory” has become a buzzword that government officials, especially those at the Federal Reserve, use to reassure us that this jump in inflation will be short-lived.

Before we explore the nature of the current inflation, it is helpful to harken back to our days in Economics 101. If inflation in its most basic form is simply prices going up, what are the drivers that cause these price increases to occur? The two drivers are either increased demand or reduced supply, and we are seeing pressure on both sides of the equation today.

Higher Demand Is DrivingUp Prices

Starting with the demand side, let’s explore what’s happening in the real economy today to push up demand and, consequently, prices. First and foremost, nothing is better for increasing demand than economic growth. If you have a growing economy, there is typically more demand for goods and services as more consumers are making money, feeling optimistic and spending more. The below chart shows GDP, or economic growth, over the last five years.

We were growing at a steady pace but then COVID-19 hit and we had one of the worst economic downturns in our country’s history. Given how large the downturn was, the snapback in growth in recent quarters has been tremendous to the upside. This growth has resulted in high levels of demand and pricing pressures. Is this increased demand transitory or more permanent in nature? With regards to economic growth, we feel that these pressures will be transitory. The pent-up demand has been huge as people want to get back to their consuming ways. But growth is already slowing down meaningfully and the consensus is that growth will return back to a slow and steady pace by the end of 2021. If that occurs, we think demand should go back to more normal levels as well.

Another factor that is driving demand higher is the huge amount of government stimulus since the onset of the pandemic. Various government stimulus measures have totaled over $5 trillion, an unprecedented level of stimulus. Where has all of this money gone? A tremendous amount of it has gone into the hands of the American consumer. In fact, post-COVID-19, almost 35% of average household incomes in the United States come from the government. Pre-pandemic, that amount was closer to 17%. The end result is that consumers have more money and are spending more. Retail sales, for example, took a big hit in 2020 but have since rebounded dramatically and surpassed previous sales records.

The question of whether the increase in demand due to government stimulus is transitory or permanent is a little tricky. If we hit another economic downturn, will the government continue to provide stimulus and unemployment benefits like it has been doing? While this is possible, future stimulus is unlikely to be as large in size as it has been in the last year. It does not seem like these levels of stimulus and benefits are sustainable. So we would label this inflationary pressure as more transitory than permanent.

Lower Supply Is Driving Up Prices

Switching to the supply side of the equation, COVID-19 gave everyone a real-life Econ 101 lesson in how decreased supply increases prices. Remember not being able to find toilet paper?  Some may be embarrassed to recall how much they paid when they found a stash of it hidden away on Amazon and clicked “Buy” before they could reconsider. Quite simply, the lower supply of goods made the price of those goods go up.

Now that the economy is in the recovery process, supply is still struggling to catch up. Manufacturing fell off a cliff when COVID-19 first happened, due to both health concerns in keeping factories open as well as the paralysis that many companies felt regarding how bad the pandemic would be and when they should start producing again. The data now shows that manufacturing is recovering from the COVID-19 shock and catching back up to pre-COVID-19 levels, making this particular pressure seem more transitory in nature.

Delays in shipping have also resulted in supply shocks. Many consumers have found themselves experiencing delivery delays while awaiting their purchases. Cargo ships are waiting at anchor to unload their goods in unprecedented numbers and for unprecedented amounts of time. In recent months, an average of 30 container ships a day have been stuck outside the port of Long Beach waiting to deliver their goods. The normal amount is zero or one ship per day that has to anchor in waiting. Are these shipping delays and supply shocks more transitory or permanent in nature? We think and are hopeful that these pressures are more transitory in nature. Some of these supply chain bottlenecks should open up over time and the pent-up demand should die down too, which we think will reduce these inflationary pressures over time.

Finally, labor shortages have also been pushing up prices. It seems strange for wage pressures to be an issue in this tough economic environment, where unemployment levels are still relatively high. Typically, when you have high levels of unemployment, employees cannot pressure companies for higher wages. But something else is happening. Even though unemployment is still elevated, people do not appear to want to go back to work. Job openings are at the highest levels they have ever been. Whether due to COVID concerns, challenges with childcare or high unemployment benefits, it appears as if a large amount of people would rather stay unemployed. The result is that companies are needing to incentivize people to come back to work with signing bonuses or wage increases. Is this transitory or permanent? There is not a clear answer as this tug-of-war plays out. While unemployment remains high, as long as benefits and other factors discourage people from returning to work, wage pressure may be in our future.

The $100 Billion Question: Are We Poised for Long-Term Inflation?

While many of the shorter-term dynamics support the idea that current inflation may be transitory, we believe that the longer-term trends are clearly pointing to inflationary pressures. Longer-term inflationary trends that are more sustainable can create major challenges for the economy. As Ronald Reagan struggled with inflation in the early 1980s, he described it being “as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Or, in terms Dr. Evil would understand, it can be as scary as “frickin’ sharks with frickin’ laser beams attached to their heads.” Neither comparison sounds particularly enjoyable.

Our Morton Capital commentaries have devoted plenty of space to our debt issues as a country and the growing mountain of debt that accelerated even further in 2020 as a result of the pandemic. These debt levels are very concerning because it can be a real challenge to get out from under their burden. The least painful way to solve a debt problem is to grow out of it. But our growth as a country has slowed meaningfully in the past decades. Whereas we used to grow at roughly 3–4% per year from the 1950s through the 1990s, in the last two decades we have grown at a little less than 2% per year. This is not doom and gloom as we are still growing. But 2% growth is not close to fast enough to counteract the massive growth in our debt. Despite the short-term pickup in our GDP growth as a result of the pandemic rebound, it is highly unlikely that we can return to a sustainable 3–4% growth rate per year. This is due to a few factors but the main one is demographics. Our population is older, people are not having as many children and immigration is not as robust as it was in the 1900s. This headwind makes growth unlikely to be the solution for the debt problems we face.

So how else can we solve our debt riddle? We could practice austerity as a country and spend less on social benefit programs, infrastructure or the military. While it’s possible that some of these will have occasional cuts, the trend now for several decades is very clear. We tend to spend more on government services with each passing year instead of less. Do we as voters have the will to demand less spending from our politicians? We would say that’s unlikely. Similarly, do politicians have the courage to recommend austerity and the challenges that would ensue from that? We would say that’s unlikely too.

Another potential solution to the debt problem is that our country could default on our obligations. But given the dollar’s status as the world’s reserve currency and the wide-reaching implications of a default, we think this option is not on the table, especially not when politicians have money printing as another one of the choices. We have the tremendous luxury of the printing press, where, out of thin air, we can print more dollars to pay back our debts. But when this occurs and more dollars exist in circulation, the value of each dollar is worth less over time. Going back to Econ 101, if you have a fixed amount of dollars chasing a fixed amount of goods, the price of those goods should stay fairly stable. But if overnight you double the amount of dollars that can be used to buy the same goods, the price of the goods will double. This is inflation: the erosion in the purchasing power of the dollar.

To illustrate this point further, below is a chart of the value of the dollar over the last century.

One dollar 100 years ago was over 20 times more valuable than a dollar today. Another way to describe this is that $1 dollar a century ago now has 4 cents of purchasing power today. This erosion in the purchasing power of your dollar can be a very effective strategy if you are paying back debt. If the government borrows on a 30-year note, for example, the dollars they use to pay back that debt in 30 years will be worth a lot less than those dollars today. Inflation makes debt repayment much more manageable.

Our current money printing is not the first time this strategy has been pursued in the United States. Most people only think of the 1970s as a time of high inflation but the 1940s and ’50s had very high inflation as well. During the 1940s and early 1950s, inflation was mostly in the mid-to-high single digits, but sometimes north of 10% and even approaching 20%. This inflation eroded the value of the dollar and made our debts from World War II smaller in size. This is the playbook that worked in the past so we have our eyes wide open that this is likely to be the playbook that our government will pursue to pay back our current debt levels.

How Do We Protect Our Portfolios Against Inflation?

Most investors only have the traditional tools of stocks and bonds in their tool kits. But these asset classes can be very challenging in inflationary environments. Traditional bonds with fixed rates and limited upside potential can be one of the hardest hit asset classes in inflationary environments.

Stocks are more of a mixed bag but can also face challenges from inflation for two main reasons. The first is that inflation often comes with higher interest rates, putting natural selling pressure on stocks as investors rotate out of risky stock assets and into higher-yielding savings accounts. Second, corporations will be challenged in an inflationary environment as they face rising costs without necessarily having the ability to increase their own prices. It all depends on how much pricing power a company has: can the company raise the prices it charges the end consumer in an inflationary environment? Pharmaceutical companies are an example of an industry that can typically raise its prices in an inflationary environment. If people have medicines they need to take, they will likely be more than willing to pay a higher price for that medicine. But most other industries do not have that luxury. Think about a simple business like a restaurant. Restaurants have large costs to running their business, from their food costs to the rent they have to pay for their space to the cost of their staff. If the costs of these things rise, the restaurant owner will try to raise the prices on their menu items, but there are limits to how much of these price increases they can pass on to the consumer. So if your costs go up and you cannot raise your prices accordingly, the end result is that your profits go down. For this reason, most corporations and stocks in general have a tough time in an inflationary environment.

Instead of hoping that traditional assets will hold their own, incorporating real, tangible assets that you can touch and feel into a portfolio can be good protection against inflation. Real estate is one such asset with which most investors are familiar. If you track housing prices vs. inflation for the past 100 years or so, you will find that home prices have tracked pretty closely with inflation. Gold is another real asset that can be attractive to hold during inflationary periods. While gold can be volatile over shorter time periods, over longer time periods it has been a resilient store of value that has maintained its purchasing power.

Lastly, if inflation picks up, it becomes even more important to find assets that can distribute cash flow at a rate that matches or beats inflation. For quite a while, Morton Capital’s research team has dedicated substantial time to finding alternative assets that can generate an attractive yield, even after inflation, without taking on undue risk. We have been pleased with the types of investments that can be found in the private credit or loan space as these tend to throw off cash flow in the high single digits. With these types of investments, we believe that investors are trading certain market risks and exposures for more illiquidity risk as many of these strategies are not daily liquid. Depending upon a client’s unique circumstances and financial plan, we typically feel that some level of illiquidity is an attractive trade-off for the higher cash flow and reduced exposure to traditional market risks.

It is important to note that while we are concerned about inflation and are positioned accordingly, if inflation does not pick up, we still believe our portfolios will do well. While strategies like nontraditional bond funds, real assets and private credit should do well in an inflationary environment, all of these strategies are not dependent on inflation going up to do well. We believe that they should be resilient in a low inflationary environment too, just as they have been in recent years. Our goal is to select investments that will be resilient in most any environment, whether inflation picks up or stays tame.

Please reach out to your Morton Capital wealth advisory team if you have any questions or would like to discuss some of these topics further. As always, we appreciate your continued confidence and trust.


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