Everybody, Look What's Going Down

Strategic Insights 1Q/2021 (link to full commentary)

Key Topics: Global Economic and Capital Market Outlook, Transitory Coronavirus impact, Political risks of narrowly divided Congress, Economic Implications of Divisive Policies, Earnings Growth and Profit Margins, Manipulated Rates and Moral Hazard of Extended Easy Money of Federal Reserve, Monetary Normalization, Election 2020, Soaring Fiscal Debt, Equity Valuations, Global TAA forecasts, Sources of Uncertainty and Risk.

Roaring 2020s was a catchy US investing theme a year ago, but 2020 proved to be a challenging year for investors. Volatility proved costly to those that let fear and emotion overwhelm portfolio decision making, if not heartbreaking for others that missed out on recovery, much like in 2009/GFC. Wild swings in equities and interest rates again provided tactical opportunities, while reinforcing the importance of strategy discipline and rebalancing in the face of global economic uncertainty and geopolitical turmoil. While there are many opinions available, consistent practical perspectives are hard to find these days.

Last year was not the kind of year we anticipated. After the global pandemic took hold, everything changed. Lockdowns caused a rapid decline in economic activity, and was implemented without much evaluation of the consequences of social distanced isolation. We expected the precipitous economic decline to reverse quickly once lockdowns were relaxed given the nature of this health crisis. A Transitional economic recession resulted from artificial and self-imposed lockdowns, rather than financial or economic imbalances, thus the GFC playbook (new normal, fiscal and monetary stimulus) was ill-conceived. Government decisions to shut-down non-essential businesses and other activities, including education, travel, entertainment, services, and socializing caused a steep short-lived recession.

Unlike disorderly natural causes of typical recessions and financial crises, the recessionary forces caused by pandemic lockdowns were transitional. Once relaxed, a rapid “V-shaped” equity market rebound anticipated economic recovery that took many by surprise. US large-cap growth companies led the way, but still low Treasury yields have not responded to economic recovery or rising inflation. Company earnings plunged with decreased sales and increased operating costs, but recovery that began with larger growth companies is now driving small-cap.

Source: Strategic Frontier Management

Economic growth accelerated in 2H/2020, but 2020 growth was still just modestly negative (-2.4%). Pent-up consumption demand and earnings growth should to continue to rebound as the output gap has closed quickly. Economic and financial market rebound followed rapid development of multiple vaccines and therapies coinciding with learned smarter approaches to slow infection.

Source: Refinitiv Datastream & Strategic Frontier Management

Given a continuing economic and financial market recovery, neither additional monetary nor fiscal stimulus is needed. Change in retail sales over the last year increased 8.2%. A strong 2H/2020 closed the yawning output gap with real GDP of -2.5% in 2020. Economic acceleration and plunging unemployment diminish any notion that the economy could have been managed better, particularly relative to conditions in Europe, Japan, and elsewhere. Over $5 trillion appropriated in the three US stimulus relief bills was more than double what was likely needed, we believe.

The unemployment rate jumped from 3.5% in February 2020 to 14.8% by the end of last April, near the trough of the recession. As states re-opened to varying degrees, business activities rebounded and unemployment has plunged to just 6.2% by February 2021—quite a round-trip in just a year. The current US unemployment rate is just above the 70-year average unemployment rate of 6.0%. This is a more appropriate basis for judging full employment, rather than the tight labor market of 2019 to justify further monetary stimulus.

Source: US Department of Labor

The extended cycle overlapping with disinflationary forces of the Fourth Industrial Revolution raised little concern about inflation, but maturing forces will give way to higher labor, food, energy, and housing costs that drove inflation before 2020. We expect CPI inflation will pick up where it left off trending toward 2.5-3.0%. Stronger growth also drives higher inflation and interest rates. Emergency monetary stimulus is no longer needed and reinforces inflation expectations.

Consumer inflation is always a function of changing wages, basic resource prices, housing cost, and taxes, as well as money growth, fostering available credit. Today at least three of these key forces driving inflation are in play. However, this was the first recession that household income increased during recession (compare 2008-09) given government stimulus checks plus unemployment insurance benefits, which replaced up to or more than 100% of wages for many. Logically, there is always a high correlation between CPI inflation and changes in wages. 

?Source: Refinitiv Datastream & Strategic Frontier Management

US Monetary Normalization of hiking interest rates and reducing central bank holdings was a theme we identified in 2015, and observed steady progress from mid-2016 until economic wreckage in the wake of the global pandemic during 2020. Central banks believed they must support financial markets, but emergency stimulus ceased to be needed last Fall. Central Banks should end explicit moral hazard of bond market manipulation by maintaining negative real interest rates, quantitative easing, and forward guidance. Excessive fiscal and monetary stimulus can drive inflation expectations that are more difficult to contain.

We are not embarking on a new business or market cycle, rather observe an interrupted and still extended cycle given a transitional artificial recession due to economic wreckage of lockdowns. Talk of shifting toward an investment playbook consistent with early cycle recovery is misguided. Instead, later cycle behavior of higher inflation, lower growth, and declining profit margins might be aggravated by adverse fiscal, regulatory, energy, and trade policies.

Most infrastructure needs discussed are typically privately held in the US. Bridges, highways, pipelines, railways, airports, power plants (inc.: nuclear, coal, gas, wind, solar, etc.), fiber networks, transmission lines, electricity grids, tollways, dams, water treatment, or desalinization can recover construction costs from user utility fees. Consider why does the US have such a uniquely vibrant and competitive industry of defense contractors, while our greatest military advisories rely on socialist government development and manufacturing? Most highway, road, and bridge construction is financed by federal and state fuel and tire taxes--why not boost the current tax rate per gallon, which hasn't increased in 27 years?

Many projects may not require government outlay of funds, although this idea is not obvious to the public yet. We've observed first-hand that private investor accountability of asset owners, such as pension and sovereign wealth funds, improve project cost and development management with better aligning private operators to efficiently develop and productively manage assets. Swapping real property ownership to finance new projects balance social good with fiscal prudence. Regulatory relief of relaxing permitting and administrative hurdles, as well as providing government lending or research and development incentives, plus financing concessions (government guarantees lower financing cost) can bolster project returns to incentivize investors. Public-private partnerships tend to be better managed during development and operational life at lower taxpayer cost.

If an infrastructure program does go forward, we believe alternative funding paths are still likely that few seem to appreciate yet. The US government has amassed non-strategic land, property, buildings and other assets that can be privatized or sold -- essentially swapped -- to fund government capital project development. Furthermore, asset owners’ hunger to invest in infrastructure, and Public-Private Partnerships provide better outcomes with alignment seeking commercially competitive returns. There are much better ways to achieve infrastructure development goals at 1/10th the cost (about $250B) with much better outcome and less government spending that we can’t afford after more than $5 trillion of debt-financed pandemic stimulus. We believe the affect of tax increases plus undefined infrastructure spending to be a net drag on real economic activity as recently proposed in President Biden's infrastructure proposal, now rebranded as the American Jobs Plan.

Source: US Government - OMB

Global equity valuations are less compelling as equity indices recovered ahead of earnings, causing an inflection point in our equity forecasts. Earnings yields will deteriorate further if bond yields increase, as we expect. We observe the first inflection point of weakness of our global tactical equity and US dollar forecasts in nearly two decades. Pension funds and retirement savings will suffer if equities and bonds lag inflation due to deteriorating economic conditions.

Our updated strategic allocation forecasts reflect similar valuation, inflation, and interest rate concerns of our tactical forecasts. Global bond markets remain stretched with marginal or negative real yields. Its time to Look What’s Going Down regarding whether new policies can support potential growth and profit margins to deliver sufficient earnings growth beyond recovery. Manipulated interest rates for an extended period increase explicit moral hazard of extended market manipulation. Based on low interest rates, US equities are not too stretched despite still depressed earnings, but manipulating interest rates maintains negative real bond yields that must eventually normalize.

Source: Strategic Frontier Management

Our long-term strategic forecasts suggest negative real bond returns over the next five years, while periodic nominally negative bond returns could trigger an critical asset allocation rotation. Under these conditions, cash or short-term and floating rate bonds are wonderful low-fee alternative investments with low correlation, while being a stable store of value as US yields eventually creep higher to exceed inflation.

We cover a lot of other ground in our commentary this quarter, including our outlook for infrastructure, updated strategic asset allocation return forecasts, and our take on Title 47: Section 230 - Protection for private blocking and screening of offensive material in Electronic Communications Privacy Act. Has our dependency on social media become too consuming, and what are the consequences to society if limited free expression and compromised journalistic integrity? These and many other questions we tackle in our quarterly Strategic Insights from Strategic Frontier Management.

(See our full Strategic Insights commentary: www.StrategicCAPM.com/Commentary or Strategic Outlook Briefing maintained at: www.StrategicCAPM.com/topical)

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Strategic Insights This publication is for general information only and is not intended to provide specific advice to any individual. Some information provided herein was obtained from third party sources deemed to be reliable. We make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication, and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of this author, and future market movements may differ from expectations. Index performance or any index related data is provided for illustrative purposes only and is not indicative of the performance of any portfolio. Any performance shown herein is no guarantee of future results. Investment returns will fluctuate, and the value of holdings may be worth more or less than original cost. ? Strategic Frontier Management (www.StrategicCAPM.com). 2021. All rights reserved.