Client Investment Letter July 2021

“He can thread a needle with a well-turned phrase.” – Don Hewitt, creator of 60 Minutes

The Federal Reserve is in a tight spot. Having “saved the world” with extremely aggressive policy action during the coronavirus pandemic, the U.S. economy is now recovering rapidly. It is improving so quickly, in fact, that shortages of key materials, goods and even labor are becoming common after years with no such pressure. Wages and material prices are going up. Asset prices have roared higher for everything from stocks and bonds to real estate and even art and baseball cards. So, the Fed faces a dilemma. Does it risk withdrawing the stimulus a little early to head off inflation at the pass though possibly slowing the economy before the recovery is complete? Or, should policymakers rather maintain the stimulus until we return to full employment and only then withdraw it, even if waiting risks further inflating asset prices and increasing inflation expectations? So far, the Fed seems keen on maintaining the stimulus while talking about how it will act aggressively if inflation overshoots. Chairman Powell is indeed choosing his words carefully, and he hopes to thread the needle and deliver a just right recovery where economic growth improves but inflation doesn’t take root permanently.

In our opinion, it is unwise to think that the Federal Reserve has a crystal ball that allows it to implement the perfect policy response. Time and time again, the Fed, like all economic prognosticators, has been wrong. Greenspan famously said that “irrational exuberance” had driven asset values higher in 1996, but the stock market didn’t top for another four years. The 2008 subprime housing crisis was deemed to be “contained.” It was not. The Fed then implemented an “emergency” policy response which it was never able to unwind due to anemic growth. Meanwhile, the U.S. economy has become very dependent on debt during this time. U.S. government debt has ballooned from $11 trillion at the end of the 2008 crisis to over $28 trillion today. A similar story has played out for American businesses where debt for nonfinancial companies has gone from $6.5 trillion to over $11 trillion since 2008. Not to be left out, consumer debt has grown from $14 trillion to $17 trillion over the same period. Every dollar of new debt is providing incrementally less growth. The economy today is significantly less able to withstand a large rise in interest rates than it was at the end of the 2008 crisis.

Meanwhile, the other question that remains is whether the economy can sustainably break out of its 2% or less growth funk once the sugar high from the largest monetary and fiscal stimulus ever delivered fades? Did mostly staying home for 18 months teach us new and useful ways to work that will drive improvements in productivity going forward? Certainly, one area where businesses are not going to emerge from Covid-19 leaner is in the supply chain. Many businesses realized that “just in time” inventory management means “not at all” when stress enters the system. We suspect a fair number of businesses will invest some additional working capital to be sure that they never again miss sales due to supply shortages. This will reduce capital efficiency somewhat for the sake of resiliency.

While we want to be optimistic that the pandemic did drive some meaningful innovation in the way we do business, we don’t think it will be enough to drive a sustained positive change in the trajectory of our economy. Many of the pre-existing headwinds for the U.S. economy will still exist post-pandemic, including an aging population and declining birth rates, an inefficient healthcare system, and a class of recent graduates that is over-indebted. So, on balance, we think once the excitement of “free money” policies wears off, we are probably back to a slow and steady 2% growth economy in the United States. To overcome these headwinds, we will need to see meaningful reforms passed in Congress to drive lasting change, including reducing bureaucracy and red tape, getting the government out of market-distorting subsidy businesses like student loans, mortgages, and healthcare, making it easier for people including foreigners that we educate here to start businesses in the U.S., and other pro-growth policies that reward innovation and hard work. Given how divided Congress is, we aren’t holding our breath. Slower growth, rather than an overheating economy, may end up being the right thing for the Federal Reserve to worry about.

However, let’s assume the Fed stays accommodative for too long, and inflation ends up becoming endemic instead of temporary. A client recently asked us how we would reposition his portfolio if this came to pass? The answer is we wouldn’t change much. In an inflationary environment, you certainly don’t want to hold cash or bonds. Companies can raise the prices on their goods and services, but bond coupons offer no such protection. While we wouldn’t expect stocks to perform well if inflation becomes pervasive (mostly because multiples for all assets would fall), we do expect them to perform better than bonds in such an environment. The companies that we bought during the pandemic are primarily those that either sell commodities (an inflation hedge) or have significant pricing power in their markets. So, in a sense, we already are prepared for an inflationary environment. We have avoided companies that are highly leveraged and dependent on the debt markets, as those are the ones that will truly suffer if inflation becomes a big enough problem that the Fed is forced to raise rates to much higher levels. If the inflationary storm comes, high-quality companies purchased at reasonable prices will do as well as anything else at protecting your purchasing power.

As we write this letter, some of the more speculative excesses in the market are abating. Bitcoin has dropped 50% from its highs. Blank check companies aren’t able to raise billions of new capital like they could a quarter ago. And even lumber futures have fallen 50% since May. So far, the world isn’t ending as these speculative excesses fade. With any luck these isolated mini bubbles will burst without spreading to the real economy or the broader market.

Another question we have fielded a lot recently: aren’t we due for a correction?  Statistically speaking, the market tends to have corrections of 10-20% every 18 months or so. However, predicting when these will occur is nearly impossible. For instance, from 1991-1996 there were no corrections of 10% or more. In 2008-2009, such corrections seemed like a weekly occurrence. A little like earthquakes, while you can have a good sense of how often they happen on average and what might set them off, it is very difficult to predict when they will occur with any precision. And for our taxable clients, all of whom have significant unrealized gains at this point, trying to outsmart a correction would likely do more harm in the form of realizing taxable gains than good if the downturn isn’t persistent. Only a year into the economic recovery, we think it is too early to say that another recession will happen soon. So, we expect any correction to be of a milder form from risk aversion and multiple compression as opposed to the more severe type that is typically driven by a full-scale turn in the economic cycle and falling earnings.

We continue to look for high-quality companies that might have a place in your portfolio. If the Federal Reserve isn’t able to thread the needle and volatility in the markets ensues, we are prepared to take advantage of opportunities that arise. In the meantime, Jerome Powell will keep talking, and we’ll hope that the market continues to give him credit for both easy conditions now and an ability to tame future inflation. Thanks for the trust you place in us and enjoy your summer.

Penn Davis McFarland, Inc.
July 2021