Will the Markets Ever Stop Going Up?
There were plenty of days when volatility reigned, but the financial markets had another strong quarter in April, May, and June. Unusually, investors made money in both stocks and long-term bonds during the quarter. The second quarter of the year saw the rally in equities continue even as interest rates in the US moved steadily higher. The S&P 500 gained 8.5% while the MSCI All Country World Index (ACWI) - representing all significant stock markets in the world - rose 5.5%. At the same time bonds also gained ground, in spite of concern over inflation. The benchmark yield on ten-year US Treasury bonds had fallen to only 1.45% on June 30th.
The stock market continued to react positively to strong earnings growth and the re-opening of the economy as the Biden administration’s vaccine campaign reached nearly 70% of the US population and the pandemic receded in much of the country. While the recovery from months of lockdowns has been very uneven and employment remains well below the pre-pandemic level, optimism about economic growth appears well-founded.
The momentum from the re-opening of the economy. and the various massive relief programs will eventually slow over the next couple of years. Growth forecasts for 2023 and beyond are not very inspiring (1-2%). Nonetheless, should Congress succeed in passing a significant portion of the President’s extremely ambitious infrastructure proposal, the economy would likely benefit substantially over the medium to long term from the increased investment, providing further support to the stock market. The proposal also includes substantial funding for climate change mitigation.
Do We Still Care About Inflation?
The strong performance of bonds is more difficult to explain than that of the stock market. At first glance it makes no sense that bond prices should rise, driving down interest rates, at a time when the economy is accelerating and inflation is rising.
In June, consumer price inflation reached an annual rate of 5.4%, the highest rate posted in 13 years. Double digit price hikes for gasoline and used cars were key factors behind this. Lumber prices have also hit the headlines, at one point soaring over 250% year on year before falling back to where they were at the beginning of 2021. While these price jumps are a reflection of depressed prices a year earlier when the US economy was locked down and of the inevitable distortions as the economy re-opens, the risk that they lead to sustained higher inflation across the economy is real. Many service businesses have been reporting labor shortages and the resulting pressure for higher wages. Higher lumber and other costs have increased new housing prices, adding to the pressure from strong demand, particularly in less densely populated parts of the country. Consumers’ inflation expectations have risen, potentially a prelude to a temporary effect becoming more permanent.
Economists from across the spectrum have been warning of the risk of higher inflation for months. They have been calling for the Federal Reserve to cut back on its bond buying and other measures it took to keep the economy from seizing up in the pandemic. Prominent liberal economist Larry Summers even called for the massive COVID relief package that Congress passed in March to be cut back. Many have cited perceived parallels with the inflation of the 1970s.
Yet the Federal Reserve has repeatedly made clear repeatedly its belief that the inflation we are seeing is “transitory.” The Fed’s most recent meeting minutes showed that its members began to discuss the eventual removal of the pandemic stimulus measures but did not think that economic conditions justified it yet.
Bond investors have become comfortable with the Fed’s analysis. Their expectation is that inflation will return to a more acceptable level in the short term, allowing the Fed to postpone tightening monetary policy. Investors have, therefore, resumed buying bonds, driving interest rates part of the way back down to where they were earlier in the year. As the saying goes “Don’t bet against the Fed.”
There are two key risks to this rosy scenario. The first is simply that the Fed is wrong. If inflation does not go back down as expected the market could be in for a nasty surprise. This would hurt not just bonds but stocks as well. The second is that when the Fed does begin to tighten, investors are not prepared and as a result the 2013 “taper tantrum” – when markets worldwide sold off on the mere promise of less Fed support for bonds – could be repeated. With interest rates at such low levels, the market seems to be ignoring these risks.
Sustainable Investing is on the March
At White Pine Advisory we are especially encouraged that sustainable investing had some key victories during the quarter. Shareholder activism on climate change has gone mainstream.
Activist investors scored three high profile wins over big oil companies in the last week of May. The biggest trophy was Engine No. 1’s success in getting two of its nominees elected to the Board of Exxon Mobil, against strong opposition from the company. Engine No. 1 – a brand-new activist fund - successfully argued that Exxon’s failure to address climate change was hurting its earnings and would continue to do so. Engine No 1 owned only a minuscule 0.02% of Exxon Mobil’s shares but it was backed by big mainstream investors including California’s giant state pension funds, CalPERS and CalSTRS, the New York state retirement fund, British fund manager Legal & General and even giant index fund manager BlackRock. Independent proxy advisors ISS and Glass Lewis - whose advice on how shareholders should vote is widely followed - also endorsed some of Engine No 1’s nominees. Exxon Mobil has long been the most outspoken proponent of the argument that climate change is not a problem and its strategy has been to continue to pump as much oil as it can, ignoring both environmental and financial arguments to the contrary, as well as its own internal climate change research. If the new members of its Board are able to force the company to change this could have a major effect on the entire oil industry.
The very same day shareholders of US oil major Chevron passed a resolution requiring the company to reduce not just its own carbon emissions but those of its customers. Simultaneously, a Dutch court ordered Royal Dutch Shell to cut its emissions in the Netherlands faster and farther than the company had planned.
Maine may have started a trend when its legislature voted in June to require the state to divest from fossil fuels in its pension and other funds. California, Massachusetts, Minnesota and New York are also working toward divestment while New York City has already done so. Underlining how political this issue has become, Texas passed a law in May requiring the state to cease to do business with any financial institution that refuses to extend financing to the oil industry.
Sadly, the politicization of sustainability – once a bipartisan issue – seems likely to continue complicating the fight against climate change. It’s not just Texas: the climate change elements of the Biden administration’s infrastructure plan are having difficulty getting through Congress. This is why sustainable investing is so important. Economic and financial realities have a way of pushing past political logjams.
What’s Next?
Inflation is perhaps the key factor to watch. For now, the market is counting on inflation following the trajectory of lumber, which soared dramatically before falling back to a more normal level. But consumer price inflation has now been accelerating for four months straight and is well above the Federal Reserve’s 2% target. The longer this continues the more likely that the price jumps seen as the transitory effects of post-lockdown bottlenecks will feed into broader inflation across the economy as a whole. This would force the Fed to take action, a risk that does not appear to be reflected in the current low interest rates.
Bonds are more immediately vulnerable to this risk than stocks. The momentum of the economy remains very strong and may continue to support the stock market even as interest rates start to rise. Stocks generally offer a hedge against inflation in a growing economy.
The infrastructure proposals currently being discussed in Congress could, if passed, lead to a further boost in inflation in the shorter term as the additional spending finds its way into the economy. In the medium to long term, however, these investments should substantially increase the productivity of the US economy, pushing inflation down.
Biden’s recent executive orders aimed at increasing competition in the US economy have received less attention but are potentially very important. For decades the economy has become increasingly concentrated. The technology sector is an obvious example but concentration has increased across virtually every industry, from farming to retail to oil. Small businesses in many sectors have either been bought up or forced out and fewer are being created. The increased concentration has reduced consumer choice, made it harder to start a business and runs the risk of stifling innovation and leading to higher prices. Some economists consider it a reason for the lower growth the US has seen in recent years. Reversing this may lead to a more dynamic economy with lower inflation, although the effects will take some time to appear and the initial effect on the stock market could very well be negative.
The US financial markets are in a very interesting moment in this abnormal recovery from an unprecedented global health and economic crisis. After a dramatic fall as the pandemic hit, stocks have barely stopped rising for over a year even as the long-term growth outlook (post pandemic recovery) is subdued. Bonds have shrugged off concerns over rapidly rising inflation, leaving interest rates at historically low levels. There are reasons for the continued strength of both stocks and bonds but there are also growing reasons to be cautious. And the risk from new COVID variants has not only not gone away but appears to be increasing.
Yet policy proposals being discussed in Washington could potentially be transformative for the US and for the fight against climate change, as well as being strong long-term performance for the markets. Investors hoping for action on climate change and other issues can join White Pine Advisory in taking encouragement from the proposed government actions and the growing clout of sustainable investment.
Urban Larson
Principal
Disclosure
White Pine Advisory LLC (“White Pine”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where White Pine and its representatives are properly licensed or exempt from licensure.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Past performance shown is not indicative of future results, which could differ substantially.