Quarterly Letter

July 2021 – Quarterly Letter

By September 13, 2021 No Comments

July 28th, 2021

The market continues to recover from the pandemic-induced slowdown. Earnings for U.S. companies are coming in much stronger than expected. Earnings estimates for 2021 are about 10 percent higher today than they were at the beginning of the year. Stocks are up almost about 17 percent for the year so far.

The most significant deviation from consensus expectations regards the forecast for inflation. A few months ago, investors were convinced that inflation was going to come on strong. They moved away from the large growth stocks that worked the best during the past few years and they moved into the sectors of the economy that would most benefit from an increase in inflation. These sectors include industrials, energy, financials, and commodities. Interest rates finally turned higher after a multi-year period of decline.

Investors don’t appear to have a lot of conviction in the reflation trade, which would benefit the long underperforming economically sensitive stocks. At the first sign of economic weakness, they tend to move back into the well-known growth stocks. Interest rates fell substantially during the previous quarter, and investors predictably moved back into the sectors that worked the best during the past few years. Technology, communication services and consumer stocks led the market during the second quarter.

Beginning in September of last year, value stocks had rallied as much as they had at any point over the last twenty years. Many of the most prominent growth stocks fell as much as thirty percent during the shift to economically sensitive stocks. Over the last few months, they’ve given almost all of it back. Growth stocks are now just a few percent away from making new highs relative to value stocks. Many of the top growth stocks are now trading at all-time highs.

Looking at portfolio returns over the last year, both value and growth investors are more than satisfied. The only lagging sectors are defensive. High dividend paying stocks, utilities and consumer staples are stuck in neutral. Fixed income is also struggling to meet return expectations.

In the first quarter of 2021, value stocks were up 30% while growth stocks were flat. In the second quarter of this year, growth stocks were up 15% while value stocks were flat. I don’t know of any investment strategy that’s capable of anticipating such extreme, short-term rotations. My objective is to maintain a balance between value and growth and to own the best value and the best growth stocks. When value is in favor, our value stocks should do at least as well as the average value stock. When growth is dominant, our growth stocks should outperform the average growth stock.

The increasing number of COVID cases is undermining confidence in the recovery. Most countries are lagging the U.S. vaccination rate. The rate of new vaccinations is also slowing in the U.S. Currently, approximately fifty percent of the U.S. population is fully vaccinated. Epidemiologists believe that we need to get to at least seventy percent to achieve herd immunity. The market does not currently expect that we will have to lockdown the economy again, so if a new wave of infections requires shutting down the economy, the market will likely deteriorate.

The probability of shutting down a substantial portion of the economy seems remote. In the absence of a national policy, local policies are dictating the response to the pandemic. These policies fall on a spectrum ranging from aggressive mask mandates and social distancing to completely voluntary.

The experts have had to continually revise their assumptions about how the virus spreads, so it seems there are few clear-cut answers on how to balance public health with the need to support the economy. If the next wave of the virus hits harder than we currently expect, we are not likely to see the dramatic economic shutdowns that we endured last spring. We will likely see some restrictions on the unvaccinated population, but governments seem reluctant to completely shut down economic activity.

The politicians continue to work towards a major increase in government spending. The only question is how large of a spending package is sustainable given the fragile bipartisan consensus. The low-end is around one trillion. The high end is as much as five trillion. To put that in perspective, the Obama administration was only able to get $700 billion of stimulus following the credit crisis of 2009. A trillion dollars of new spending will super charge economic growth. The risk is that too much stimulus will cause inflation to spike higher. The rate of inflation is the most important factor in determining which sectors lead the market over the next few years.

If we look at the U.S. economy in isolation, it seems that inflation should be a significant threat, but the U.S. doesn’t operate in a vacuum. There is no shortage of unskilled labor in the world today. This should keep the rate of wage inflation low. Without wage inflation, it’s hard to see how inflation could approach the severity of what we experienced in the 1970s. Population growth is slowing, both in the U.S. and the rest of the developed world. When population growth slows, so does the demand for borrowing. Without a substantial increase in the demand for credit, interest rates will stay low.

Major long-term drivers of world-wide disinflation are coming up against short-term factors like increasing government spending. I doubt that an increase in U.S. government spending is enough to offset the global forces of disinflation. As we’ve seen in the last year, investor opinion can change rapidly. Just the perception of an increased risk of inflation is enough to create a bear market for growth stocks and a bull market for value stocks.

Eric Barden, CFA