| 2nd Qtr.
| 12 Mo.
|10-yr Treas. yield||1.443%||1.746%||-0.303%||0.653%||+0.79%||+0.526%|
|Fed funds rate||0 – 0.25%||0 – 0.25%||n/a||0 – 0.25%||n/a||n/a|
(stock indices are before dividends; yield and rate changes are absolute changes)
The US stock market kept chugging along, with the S&P 500 hitting new highs all five of the last trading days of the quarter (and extended that streak for the first two days of July). The NASDAQ also hit a new high and both the Dow and international stocks posted a respectable quarter. Once again, the 12-month gains are eye-popping across the board. (The Dow industrials, expanding from its original 12 companies to today’s 30, hit its 125th anniversary and has grown at 7.69% annually over that time.) The benchmark 10-year Treasury slid from its 2021 high on March 31 as inflation fears eased (see Looking Forward).
After a couple of slightly disappointing months, the June jobs report beat expectations with 850k jobs added and the unemployment rate at 5.9%. There are still 6.8 million fewer jobs than in pre-pandemic February 2020 but more workers than any period since 2016 are voluntarily leaving their employers, presumably to find a better job. Average wages grew by a healthy 3.6% for the last year amid 9.3 million job openings, the most since tracking began in 2000. Not surprisingly, the “labor market differential” which measures whether jobs are considered plentiful or hard to find has jumped considerably in favor of plentiful jobs.
Only eight months into the government fiscal year, the budget deficit hit a record $2.1 trillion. A bipartisan $1 trillion infrastructure agreement was reached but was then made conditional on a second broader relief package including many of President Biden’s social programs. The initial budget proposal for 2022 included increases in corporate taxes and capital gains taxes on estates and the wealthy but still showed a deficit of $1.8 trillion and grew government spending to 25% of GDP. In what may turn out to be purely symbolic, the G-7 countries proposed a minimum 15% corporate tax rate to slow corporate relocations for tax purposes.
The housing tune remained the same, with prices increasing (median prices up 23.6% for the year as of May) and supply shrinking (up in May but still down over 20% from last year, only a 2.5-month supply). Overall incomes declined with the reduction in stimulus payments and consumer spending on services grew as people grew more comfortable going out. Manufacturing growth was strong, and new orders were even stronger, although there is still strain from the shortage of semiconductors. It doesn’t look like there will be a “COVID baby boom” as the 2020 birth rate was the lowest on record and half of the early 1960’s. For the first quarter GDP growth came in at 6.4%, the best since 2003.
With consumer inflation at 3.9% year-over-year, and its own measure at 3.4% (the highest in 14 years), the Fed had been clear that it believes the recovery still has a long way to go, and it needs support for as long as it takes. The Fed is “not even thinking about thinking about” tapering its monthly bond-buying program even as other countries have begun to taper their bond purchases, and the Fed’s balance sheet has doubled to $8 trillion in the last year. The Fed sees some room for optimism if COVID vaccinations continue to increase and expectations for rate increases accelerated just a bit for two rate increases by the end of 2023.
In addition to the recent inflation numbers, we can feel it all around – lumber prices have skyrocketed, it’s nearly impossible to find a new car, iron ore an copper hit records, used cars are going for more than a comparable new model, rental cars and airfares are climbing, the housing market is nuts, grains are at 8-year highs, housing rentals are going up, and jobs are going unfilled, prompting wage increases and employment incentives. Surely inflation is here to stay. Or not.
Commodities play less of a direct role in final production than in the past as businesses have become more efficient; the World Bank estimates the US tripled its economic output per kilogram of oil in the last 25 years. Some prices are returning to pre-pandemic levels, so the “increase” since mid-2020 is not really indicative of the longer term. If the US consumer begins to shift more their spending to services, which are less sensitive to commodities, the pressure on commodity prices will ease.
Supply chain disruptions are another big contributor to higher prices. New orders and backlogs for manufacturers are accelerating and inventories are depleted. Some supply problems are relatively straightforward but others, such as semiconductors, will take longer to resolve. And as long as governments continue to pump up their economies, increased demand will mean that supply could fall further behind.
The Fed, for one (a really big one), thinks inflation will be “transitory”. The high May inflation number is due to the pandemic economic slowdown, and the annual inflation rate since May 2019 is a manageable 2.2%. The long-term disinflationary factors that were in place before the pandemic, such as demographics, globalization and automation, are still around. Stimulus will eventually wind down. Labor shortage may be limited to mismatches between skill requirements and local workers, and some workforce mobility can address the problem. The bond market has priced in an inflation rate of around 2.47% over the next five years, which is certainly high compared to 2008 to now but normal for the four years prior to 2008. Consumers surveys show inflation expectations for the next year going down.
The case for inflation sticking around rests largely on pent-up demand. Consumers have taken up spending with gusto, but the savings rate has been high enough to create a cushion for a long period of spending. Consumers have very short memories and they may want to spend most of their cash, especially if the economy recovers; still, consumer inflation expectations for the next year declined. Even without legislation, there is broad support to raise wages at the bottom rung. Those inflation expectations, even if they are slightly declining, can become self-fulfilling.
Maybe spoiled US consumers will have to get used to not having everything they want at their fingertips, at least for a while.
Apropos of nothing, one of the money market funds at Charles Schwab had a 200% increase in income yield – from 0.01% to 0.03%!!
Since we have commented on digital assets from a number of angles (see Everything Is Coming Up Digital below), we might as well take an analytical look at the effect of adding bitcoin to a portfolio. The CFA Institute Research Foundation earlier in 2021 published a guide to digital assets for investment professionals, which included just such an analysis.
Chartered financial analysts (CFA’s) are serious investment professionals who have completed a rigorous three-part graduate-level education and examination program. Unlike CFP’s (certified financial planners) who incorporate a wide range of financial planning issues, CFA’s focus on technical and quantitative aspects of asset valuation and portfolio construction.
One takeaway from the CFA analysis, especially since it bolsters the current fascination with bitcoin, is that over the period from 2014 through 2020, a 2.5% allocation of bitcoin to a traditional 60% stock/40% bond portfolio (rebalancing quarterly to retain that 2.5% target) increased the cumulative return by over 23% and increased portfolio volatility only slightly. A 1% bitcoin allocation eliminated the volatility increase but still added 9% to the return, while a 5% allocation added 50% to the cumulative return but at the cost of higher volatility.
So, let’s all run out and add bitcoin to our portfolios, the CFA’s say it helps a portfolio. A look at the concepts underlying the conclusion, however, might make you think twice.
The contribution of the increase in value of bitcoin is obvious, around 8000% over the seven years compared to a measly 90% for the S&P 500. The other component is “correlation” or the extent to which two assets move in tandem with each other. Low correlation is generally a good thing, helping part of a portfolio hold up if another part falls, and contributing to lower volatility for the overall portfolio. Bitcoin had a -0.11 correlation to the S&P 500, indicating that bitcoin tended to zig slightly when the S&P 500 zagged.
Logic would question whether these two factors can continue. The analysis acknowledges that bitcoin has fallen in value over 70% six times since 2010, while the S&P 500 had only three declines of 19% or more during that time. And as bitcoin has gotten more attention and almost become “mainstream”, it is much more likely that broad economic factors and investor confidence will play a more central role in bitcoin value, just as they do for stocks.
In other words, if a loaf of white bread had the same price history as bitcoin, adding it to a portfolio would yield a similar conclusion, but that would not necessarily make the loaf of white bread a good investment going forward.
The CFA guide concludes that the value of bitcoin will remain in flux for a while , citing the overall market value of bitcoin, its value as a currency, the number of participants in the bitcoin network, the cost of production (miners use a lot of power), and the scarcity not only of bitcoin but of crypto alternatives. We would add the practical challenges noted below, and would also refer to 2021, when bitcoin increased another 115% and then fell back to near its starting value for the year.
Digital assets are not going away but are still in their infancy. Watch with interest but proceed at great peril. But if you choose to wade in and hit a home run, we will be very happy for you.
Everything Is Coming Up Digital
We thought we would provide a summary of our inaugural investment discussion of Cryptocurrencies and Digital Assets held earlier this month for those of you that could not make the presentation (or frankly, wanted nothing to do with Zoom after the last year!).
To understand digital assets, it is important to know some of the history. In 2008, an anonymously published white paper described the technology and processes to create the blockchain and cryptocurrency known as Bitcoin. The white paper proposed a system that would allow for the rapid, low-cost transfer of value over the internet, eliminating the need to use third-party intermediaries or the reliance on government-issued currencies. The technological process called the “blockchain” is a distributed ledger (or database) that records and stores transactions. “Miners” are independent parties that verify transactions (and are compensated) by solving complex mathematical equations. Since the ledger is decentralized it is not easily manipulated by one person or entity (e.g., bank, government, etc.) and it cannot be altered by one party without consensus of the entire network, which greatly reduces fraud and other manipulation. Essentially the blockchain allows for 24/7 peer-to-peer transactions, such as the purchase of Bitcoin, to take place quickly without the need for an intermediary bank or financial institution. While Bitcoin was the first cryptocurrency (a term that is no longer widely used), there are now thousands of crypto assets built on versions of blockchain technology that serve a multitude of purposes.
Bitcoin and the blockchain has evolved from the concept of a decentralized monetary system (i.e., a cryptocurrency) to an embrace of the technology and its potential uses. Further, some see certain cryptos as a store of value, thus the term “digital assets” is now more widely accepted to describe Bitcoin and other cryptos. In fact, Bitcoin is often referred to as “digital gold” because it is seen as a store and it has a limited supply by design (unlike some other digital assets). The pure scale of growth has led many to ask whether and how they should invest in this burgeoning and speculative asset class. The incredible growth in market value of some digital assets has been accompanied by extreme volatility. In fact, Bitcoin has dropped in market value more than 70% at least 6 times since 2010.
We feel it is important to note how advisors have handled the emergence of crypto when deciding whether to invest in this space. Given the nascent stage of the development of digital assets and high price volatility, it is no surprise that only 9% of advisors had crypto allocation in client accounts in December 2020. Digital assets pose numerous challenges for financial advisors, including finding a safe way to store the assets, regulatory issues, valuation, and a lack of ETFs and institutional support. It should be no surprise that Gordian considers digital assets to be speculative at best and only appropriate for risk capital. In other words, only invest money in digital assets that you are willing to lose.
If you do want to invest in digital assets there are several considerations. You should decide if you want to invest directly in a digital asset, such as purchasing Bitcoin, or if you want to invest in the companies involved in the crypto space (or some combination). Furthermore, there are several different methods to invest in digital assets. Unfortunately, until there is an ETF, there are limited ways to use most of the large brokerage firms, such as Schwab, to purchase digital assets directly. Nonetheless, there are numerous options to open accounts with companies that do trade in digital assets, such as Robinhood, eToro, and Blockfi to name a few. While we do not advocate for the investment into digital assets, we are always available to discuss the types of investment choices you have and help you navigate the logistics of making your investments. Finally, if you choose to invest digital assets, start small, research your products and investment vehicles, and fully embrace volatility.