INVESTMENT ENVIRONMENT1
Source: Orion Advisor Services, AlphaGlider
Global equity markets continued their strong upward momentum at the start of 2021. Our global equity market benchmark, the MSCI ACWI IMI,^d was up 5.1% during the past quarter. The US equity market outperformed this benchmark (+6.1%), buoyed by continued aggressive fiscal spending, loose central bank monetary policies, and by a successful rollout of its COVID-19 vaccination program. Although down on pre-pandemic levels, most global economic readings improved from their late 2020 readings. Optimism over the economy triggered a rotation in the types of equities that outperformed, with value, small capitalization, commodity-based, and financial companies taking the lead.
The improving expectations for the economy also drove a substantial expansion in bond yields. As yields move inversely with prices, this was the worst quarter for US Treasuries and corporate debt since the 2007/08 financial crisis.
The last 12 months were spectacular for global equity markets. MSCI ACWI IMI was up 57.6%. Emerging markets equities led the way (MSCI Emerging Markets +58.4%), narrowly beating out US equities (S&P 500 +55.6%). Smaller companies, tech companies, and companies exposed to commodities were especially strong.
Bond markets, on the other hand, were mixed over the last year. Although our fixed income benchmark, the Bloomberg Barclays US Aggregate Bond Index, was up less than 1 percent, long term Treasuries were down double digits while short term inflation-protected Treasuries (TIPS) where up in the high single digits.
PERFORMANCE DISCUSSION
AlphaGlider strategies had a solid first quarter of 2021. Our more conservative strategies outperformed their respective benchmarks, while our more aggressive strategies performed inline with theirs. With strong fossil fuel prices during the quarter, our ESG strategies trailed the performance of their equivalent core strategies.
Rising interest rates and inflation expectations hit fixed income investments especially hard during the quarter, causing our fixed income benchmark, the Bloomberg Barclays US Aggregate Bond Index, down 3.4%. However, our strategies benefitted from their fixed income positioning, specifically their short duration (Vanguard Short-Term Treasuries, VGSH,2 -0.1%; Vanguard Short-Term Corporate Bond, VCSH, -0.8%; iShares ESG 1-5 Yr Corporate Bond, SUSB, -0.7%) and large exposure to inflation-protected Treasuries (Vanguard Short-Term TIPS, VTIP, +1.0%; Schwab US TIPS, SCHP, -1.5%). Our mortgage-backed securities fund also held up relatively well (Vanguard Mortgage-Backed Securities, VMBS, -1.2%). Within our equities allocations, our strategies were helped by US value (Vanguard Value, VTV, +11.1%; Nuveen ESG Large-Cap Value, NULV, +9.9%) and financials-heavy Singapore (iShares MSCI Singapore, EWS, +9.0%).
The largest detractor to our strategies during the first quarter was our new physical gold fund (SPDR Gold Minishares, GLDM, -10.2%). Another relative underperformer in our strategies was our overweight position in emerging market equities (SPDR Portfolio Emerging Markets, SPEM, +3.8%; iShares ESG Aware MSCI Emerging Markets, ESGE, +3.2%). Our more aggressive strategies were held back by the larger US equity underweighting and developed international equity overweighting, as well as their US technology equities (Fidelity Information Technology, FTEC, +1.5%).
Twelve months ago we were near the bottom of the COVID-19 bear market. Since that time, our strategies matched approximately 85-90% of their respective benchmarks’ performance. Our strategies were harmed by my September purchase of gold (GLDM, -8.5% since our September purchase) and their overweighting to developed international equities which were strong in absolute terms but fell short of our equity benchmark’s 57.6% return (SPDR Portfolio Developed World ex-US, SPDW, +47.9%; iShares ESG Aware MSCI EAFE, ESGD, +45.4%; EWS, +38.8%). US value (VTV, 51.6%; NULV, +50.4%) and US high quality (Vanguard Dividend Appreciation, VIG, +45.5%) were also relative underperformers for us.
Just as in the first quarter of 2021, our strategies benefitted strongly over the last twelve months from their fixed income positions’ short duration (VCSH, +6.4%; SUSB, +6.0%) and inflation protected Treasuries (VTIP, +7.3%; SCHP, +6.4%) — mightily outpacing our fixed income benchmark’s +0.7% showing. Our strategies also were helped by their overweight positioning to emerging market equities (SPEM, +54.1%; ESGE, +60.6%).
OUTLOOK & STRATEGY POSITIONING
The potential for changes in inflation was the dominant force across the investment world during the first quarter, roiling many asset classes at home and abroad. The Treasury and US corporate debt markets had their worst quarters since the 2007/08 financial crisis. In equities, small caps crushed large caps, value outpaced growth, energy and financials rebounded strongly while technology took a breather. Bitcoin soared while gold fell. Inflation was the common thread in the narrative of these significant market movements. One could write a book on inflation and its impacts on investments markets, but I’ll try to succinctly summarize what I consider the key issues of the day when it comes to inflation and how it impacts our investment strategies.
First, inflation in the US is currently low, laid out by poor demand and high unemployment caused by the COVID-19 pandemic. As shown on the chart to the upper right, core inflation (excluding volatile food and energy prices) was only 1.65% in March — at the low end of the 1.6-2.3% band we experienced in the 10 years prior to the pandemic. But as with most things related to the market, it’s the view through the windshield, not the rear view mirror, that’s important. And that’s where the next chart comes in: investors are expecting significantly higher inflation going forward. Using prices for Treasuries and inflation-protected Treasuries (TIPS), one is able to back out the market’s assumption on future inflation (the breakeven inflation rate). The market is pricing in 2.6% annual inflation over the next five years on average (red line) — well above March’s 1.65% and the 1.6-2.3% band leading into the pandemic. Within this 2.6% 5-year annual average inflation rate expectation is probably an expected peak of 3-3.5% next year or the year after. The 2.4% 10-Year breakeven rate (blue line) implies the market expects inflation to cool back down to an average of 2.1% for the 2026-2031 period.
Second, let’s discuss what’s causing this expected reflation to occur. Inflation, or lack there of, all comes down to supply and demand. The pandemic delivered a sudden collapse in demand and a smaller hit to supply, thus prices fell. But now with light visible at the end of the so-called pandemic tunnel, thanks to the rollout of effective vaccines, demand is rebounding and could easily overshoot levels seen before the pandemic given all of the pent-up demand, and increased savings with which to fund it. The US government’s massive $6 trillion in fiscal stimulus in 2020 and 2021 adds significant fuel to this demand. And Biden’s $4 trillion “Build Back Better” spending plan ($2.3 trillion announced with detailed breakdown, $1.7 trillion expected to be announced in May), if passed by Congress later this year, would maintain high levels of government-led demand for years to come. The Fed is also trying its hardest to spur demand with low interest rates by pledging to keep its overnight benchmark rate near zero through 2023 and by buying $3 trillion in government, corporate, and mortgage-backed bonds with newly printed money (i.e. quantitative easing) over the last year.
Meanwhile, aggregate supply is down as many companies have either gone bankrupt or reduced capacity through personnel layoffs and facility closures, and the global supply chain is in a state disarray. Energy markets, a key component of the global supply chain, have acted as a turbocharged microcosm of this process — the benchmark price for oil hit negative $37.63 per barrel last April (yes, negative; no one was using oil and most storage tanks were full) and it climbed to nearly $60 exiting the first quarter of 2021.
Third, the real question(s) the market is grappling with is not so much if we will get rising inflation, but rather how much of it we will get and how long it will linger. Currently the range of estimates for these two questions is quite large as we’ve never seen a situation like this. As I mentioned earlier, market consensus is for an average of 2.6% annual inflation over the next five years and 2.1% for the following five years, but this is just the weighted average of all market participants’ expectations. Some are expecting a short period of modestly higher rates, some are expecting a short period of strongly higher rates, and some believe we’re entering a new era of elevated rates.
Source: longtermtrends.net
Historically, the growth in the amount of money circulating in the economy has offered relatively good insight into future inflation rates. As the chart on the left shows, inflation rates followed money growth fairly well, especially in the period between the end of World War II and the mid-1990s (M2 is measure of readily assessable cash and near cash instruments). One of the more striking aspects of this chart is that it shows that the level of money growth we have seen over the last year dwarfs anything that we have experienced in modern US history — 25% now versus ~10% peaks during the 2001 and 2008/09 recessions, the low teens during the stagflation period of the 1970s, and the high teens during World War II.
The link between money growth and inflation is not a direct one, and its connection can be thrown off by the rate at which money circulates within the economy, otherwise known as the velocity of money. The chart on the right shows that the velocity of M2 halved since the late 1990s, which helps explain why inflation has been less responsive to money growth over the last two decades. This has been especially true during the pandemic. There is 25% more M2 (cash) out there than one year ago, but it’s not moving around and thus not triggering inflation. The Fed, the controller of money growth, is pushing on a string. The velocity of money will likely rebound sharply as we emerge from the pandemic with such aggressive fiscal stimulus from the US government, but when and how much will be the largest determinants of inflation over the next few years.
Fourth, I’ll try to briefly explain how changes in inflation can impact the values of investments. Generally speaking, consumers, investors, and central bankers want a little inflation, but not too much of it. Too little inflation/deflation is indicative of weak demand in a weak economy, and disincentivizes investment and purchases — leading to even less demand going forward. Why buy that TV today for $500 when it will cost $475 in a few months? Why would a company invest in R&D, build new manufacturing capacity, and hire more employees when consumers aren’t in a mood to buy. Fear of low and falling inflation can become a self-fulfilling prophesy. On the other hand, inflation that is too high erodes the purchasing power of one’s savings and raises the cost of borrowing as interest rates typically move with inflation rates. Somewhere in between is the Goldilocks level of inflation that keeps everyone happy.
We had Goldilocks inflation for much of the last decade, but the pandemic threatened to push us into a destructive deflationary spiral — crushing stocks, bonds and commodities for about four weeks in February/March 2020. Then the US government and Fed swiftly reacted with massive levels of monetary and fiscal stimulus to remove those concerns, triggering a sharp market rebound. And as I discussed in the second point, the market is now beginning to worry that the economy will overheat and trigger higher inflation that may be difficult to control.
Rising inflation expectations hit longer duration bonds harder than shorter ones, and here’s why: Let’s take the case of a longer duration bond first. Say you bought a 10-year bond with a 2% yield for $100 while inflation was running at 1%. You would get $2 after the first year, $2 after the second, and so on until year 10 when you would get $2 plus your $100 principal back. I’ll save you the math, but you would end up with $121.90 with reinvested dividends at year 10. If inflation continued to hold at 1% for that 10-year period, you would have received a 1% real return (after inflation) on your investment — i.e. you would have increased your purchasing power by 1% annually. However if inflation spiked up to 3% right after you bought that bond and stayed that way for the 10 years, then you would have received a -1% annual real return. Ouch.
But let’s say you were concerned about rising rates but still wanted to invest in bonds for their relative safety over the next 10 years, it would be smart to invest in short term bonds and roll them them over into new short term bonds when they mature. So let’s say you bought a 1-year bond with a 1.5% yield for $100 when inflation was at 1%. After a year, your bond would mature and you would be left with $101.50. Your concerns about rising inflation did materialize (the 3% inflation scenario from the previous example), so you lost 1.5% in purchasing power that year. However, the next nine 1-year bonds that you buy yield 3.5%, giving you 0.5% annual real return over those nine years. Again, I’ll save you the math—you would end up with $138.33, way better than that the initially higher yielding 10-year bond investment.
Growth stocks are usually hit harder by rising inflation expectations than value stocks because of the timing of their respective cash flows. The worth of a company today is merely the sum of the company’s future free cash flows, discounted back to today (to account for inflation). As the distribution of free cash flows is usually weighted more to distant years for growth stocks than for value stocks, rising rates are more damaging to the present value of the cash flow from growth stocks, and thus their current value.
Financials tend to perform well during periods of rising rates, especially if it results in a higher yield curve (i.e. longer rates rise faster than shorter rates). Lending, the core feature of most financial companies’ business models, is predicated on borrowing short (such as interest on a checking account; you are the lender and the bank is the borrower) and lending long term (such as interest on a car loan; the bank is the lender and you are the borrower). Right now the Fed is pegging overnight rates at near 0% and has pledged to keep them there through 2023, while we’re seeing longer term rates rise.
Commodities typically do well with expectations of rising inflation as their prices are, by definition, one of the key components of inflation. The classic commodity to hold when fearing rising inflation, gold, fell 10% during the quarter, much to my and many others’ surprise. One possible explanation is the rush into Bitcoin and other cryptocurrencies funded in part by inflation-fearing investors selling down some of their gold positions.
Fifth, let’s talk about where inflation is likely to settle in the medium to long term as that’s what really drives prices, not temporary moves in inflation caused by the pandemic. As I pointed out earlier, the market is pricing in a 2.1% average inflation rate for the 2026-2031 period — a level which is in line with what we experienced between the financial crisis of 2007/08 and the pandemic.
Inflation has been subdued for decades (see M2 growth vs inflation chart) which many attribute to the rise in automation (pressuring wages) and globalization (pressuring the price of goods and services; lower cost regions finding new ways to reach consumers around the world), aging demographics in the developed world and China, and more interventionist central banks. At present the conventional wisdom is that once COVID-related stimulus packages work their way through the system over the next couple of years, inflation will return to its previous low and stable levels, or even lower as artificial intelligence and aging demographics will be causing even more downward pressure on prices and wages than in our recent past. It’s these investors who are buying 10-year bonds yielding only 1.75% (as of March 31) even though the overall market is pricing in 2.4% inflation over the next decade.
On the opposite end of the spectrum is a growing cadre of economists and investors who are concerned that inflation will surge north of the tight band of modest inflation rates experienced over the last 30 years. This camp is concerned that the Fed has overextended itself with its balance sheet expansion, money growth, and its pledge to keep rates low for another three years. They are concerned that the US government has overextended itself with significant deficit spending during the 2007/08 financial crisis and the pandemic (see following chart). At $28 trillion, the federal debt is now greater than 125% of GDP, higher than its previous peak achieved during World War II.
Source: longtermtrends.net
As the chart shows, the government was able to grow its way out of most of its post World War II debt over the following two decades. It did this by growing GDP faster than its absolute debt. The potential for a repeat of this over the coming 20 years seems low given that GDP growth potential is lower (the US economy is more mature now and the population is growing more slowly), and government spending is likely to increase going forward (higher Medicare and social security expenditures due to aging demographics).
The remaining ways a government can reduce its debt relative to the size of its economy are: 1) cut spending, 2) raise taxes, 3) default on the debt, and 4) inflate out of debt, and/or some combination of these. Cutting spending seems unlikely as mentioned early, and as demonstrated by both Trump and Biden administrations. The prospect of raising taxes is equally unlikely — Republicans complain that taxes are already too high and Biden’s proposed tax increases on corporates and the wealthy are likely to offset only some of his proposed spending increases. The long lasting damage from defaulting on debt makes it the absolutely last resort measure. That leaves debasing the US dollar to inflate (i.e. create sufficient inflation) the country out of its debt position. It’s this latter option that seems to be growing in likelihood with the spectacular rise (doubling) of US debt to GDP since 2007 — and that’s what has some investors worried that the Fed and government are deliberately trying to create runaway inflation. Right now the US government owes a whole host of players, including my clients and me, $28 trillion. If inflation were to spike, the government’s revenue (i.e. taxes) would spike along with it because the wages, company profits, and capital gains it taxes would go up with inflation. However, most of the government’s liabilities (the $28 trillion) wouldn’t change much because of the fixed (low) interest rates attached to them. Think of inflation as another government tax, one targeted at the holders of cash, fixed rate debt, and other assets that don’t reprice with inflation. With growing its way out of debt an unlikely option for US politicians and the Fed, engineered higher inflation appears to be the most politically palatable route to reduce the mountain of debt in a manner that is somewhat unnoticeable to voters.
This leads me to my sixth and last point — what we think about future inflation here at AlphaGlider, and how this thinking translates into our investment positioning. Since we don’t have a crystal ball that gives us 20/20 clarity on the future, we like to think of possible outcomes in statistical terms and to compare them to what the market is pricing in.
Even before the pandemic, we were cautious about the low yields provided by most of the bond market. I have spent most of my 25-year investment career in an environment where stocks had modest dividend yields but good long-term potential for capital appreciation, while bonds had much higher yields but their expected capital appreciation was low. But after the Fed adopted its zero interest rate policy, the world turned upside down — it wasn’t unusual for stocks to yield more than bonds. It didn’t seem worth it to stretch for a modest increase in yield with longer duration bonds because you had to take on significant capital risk should interest rates rise off their historical lows. When forced to choose, we chose equities over longer-duration bonds.
We have been holding bonds at levels close to their benchmark weightings in our strategies, but this is more out of concern over high US equity valuations than for the upside potential in those bonds. We have skewed our bond holdings to the shorter side on duration. Even though we haven’t received much in interest from them, they do protect our strategies from a rise in interest rates and from a hit to the equity markets. They serve as ballast that we can use to sell down to buy more equities in a bear market, which happened a year ago.
Source: Koyfin
Although the Fed has pledged to hold down shorter term bond yields through 2023, the successful vaccine rollouts and massive fiscal stimulus have caused the economic outlook to improve markedly and longer term bond yields to rebound over the last six months (see chart to right). This hit bond prices, particularly those of longer duration bonds. These higher yields pushed us to add about one year in duration to our bond holdings. At 5.2-5.5 years, we are running our bond durations a tad south of our benchmarks’ 5.9 year duration.
We have held sizable positions in inflation-protected Treasuries (TIPS) and they have performed well for us over the last year as near-term inflation expectations have risen above pre-pandemic levels (see second chart in this section). We still think that the market is underestimating the potential for inflation to overshoot current expectations, however we will likely begin to trim our TIPS positions should inflation expectations continue to expand much further. We think this could happen if Biden is able to get his Build Back Better spending plan through Congress relatively intact.
Soon after the Fed announced its new “average inflation targeting” policy last fall (which effectively tipped that it wants to drive inflation over its 2 percent target in the short term), we started positions in a physical gold fund (GLDM) as a hedge against inflation. Although most other commodities have increased in value since this time, gold has declined. We are a bit confused and definitely disappointed by its recent price action, but we remain confident that gold has not fallen out of favor as an inflation indexed store of value as it has been over thousands of years. We have rebalanced into larger gold positions as a result of its weak price action.
Another hard asset we think will perform well in an inflationary environment is international real estate. Our strategies hold positions in an international real estate investment trust fund, Vanguard Global Ex-US Real Estate (VNQI). It returned 31% over the last 12 months despite heavy exposure to office buildings that were largely emptied by the pandemic. About one quarter of this return came from the depreciation of the US dollar, a side effect of the US government’s more aggressive fiscal and monetary stimulus relative to other governments’ reactions to the pandemic slowdown.
In summary, the market is waking up to the prospects of rising inflation. Although we don’t rule out the possibility of the return to a low inflation environment in the medium term, we assign a larger probability of higher inflation for longer than the overall market. We have constructed the fixed income portion of our strategies to be resilient should inflation surprise to the upside. This positioning helped our strategies during the last quarter of 2020 and the first quarter of 2021 when inflation expectations rose significantly.
1% FOR THE PLANET
With 2020 in the books, AlphaGlider is pleased to announce that it made its 2020 donation to the Ojai Valley Green Coalition (OVGC). OVGC is a small non-profit that is active on many environmental fronts, including the implementation of projects that help Ojai adapt to climate change and mitigate its future impact.
A little over one-half of AlphaGlider’s client base has lived, or is currently living, in Ojai, and will know the extreme toll that climate change has inflicted on the Ojai Valley. Drought conditions have been the norm in the valley over the last 15 years and has left Ojai’s primary source of water, Lake Casitas, at only 38% of its capacity. The drought contributed to the severity of the Thomas Fire which encircled Ojai in December 2017.
As a reminder of the rising damage being caused by climate change in the US, please refer to the Brookings chart above which tracks the monetary cost (in present dollar terms) and death toll of large climate disaster disasters since the 1980s. It’s charts like these that have us extremely concerned about our global investments over the long term and why we donate one percent of our revenue to causes that are working to address climate change. Please be on the lookout for great environment nonprofits working in Texas, another area many AlphaGlider clients call home that has been negatively affected climate change as of late.
