“A nickel isn’t worth a dime anymore.” Yogi Berra
Reflation, inflation, or deflation. How about a libation and we call it good?
The range of opinions about the future direction of prices we pay for goods and services leaves us with one concern: Are recent price rises a transitory blip or will they create a self-reinforcing continual upswing?
It matters because each outcome has different implications for the economy, our investments, and our purchasing power.
Most commodity prices peaked in May before falling. Many economists attribute the spike to temporary factors. For example, supply chains reduced output and inventory levels when COVID hit. The robust V-shape recovery in demand left supplies short. When demand is greater than supply, prices go up. Businesses raise prices to offset higher costs; consumers chase higher prices until they are forced to curtail saving and spending. Return on investment declines. The economy slows. The market tanks. And we need that libation more than ever!
Summary of Recent Price Action
• Used car prices up 21% from last year.
• Housing prices rose over 20% from last year (or more depending on location); inventories were at their lowest level since 1991. Bidding wars are common throughout the country.
• Stocks are priced to perfection; if rates rise, they will likely decline.
• Labor shortages bedevil many industries.
• Lumber prices increased five times from April 2020; declines over the past 2 months wiped out 80% gains for 2021.
• Gas prices are at a seven-year high
• Semiconductor shortages rippled through the auto, computer/electronics, and appliance markets
The Interest Rate View and the Transitory Case
In theory, increasing supply should tame prices. Business investment is strong which will help the supply side. And price declines have occurred in numerous segments. Housing has proved an exception because low mortgage rates increase affordability and low inventories are harder to ramp up than other markets.
Bond market interest rates typically signal inflation or lack thereof. The benchmark ten-year treasury rate tripled from 0.55% to 1.72% in late March, as commodity prices levels increased between 10% and 90%. Rates have since declined to 1.35% while numerous market prices have declined. The bond market looks like it is indicating price levels are transitory. Still, many prices levels remain at elevated levels and the forward path is unclear.
With high stock valuations and low interest rates its prudent to keep your investment allocations in line with your risk level without getting too aggressive. With the extraordinary market performance over the past several years, its good to remember that we aren’t competing with or chasing market returns. We are looking to achieve your goals with minimum risk. Maintaining a patient rebalancing discipline helps keep us on track.
Asset Class Review
The US economy grew 6.4% annualized in Q2. Manufacturing and services were both strong. Stock markets continued their rise: the S&P 500 reached a new all-time high in June. Inflation rose to 3.8% – the largest increase since 1992 as the economy began to re-open, mask mandates eased, and people starting shopping someplace besides Amazon. Biden’s infrastructure package came in closer to $1 trillion from $2.3 trillion, but was still viewed as political and economic progress.
Overseas, Europe likewise eased COVID-19 restrictions, vaccine rollouts increased, and corporate earnings were strong. April and May were strong, but the Delta variant led to concerns in June about reopening. For the quarter, small caps did better than large caps. Eurozone inflation was closer to 2.0%. Japan lagged other developed economies.
Asia (ex-Japan) was also higher but saw weakening in June due to COVID’s resurgence. Overall it lagged the US and Europe. A stronger dollar and inflation concerns also weighed on sentiment. Emerging markets were generally strong. China was weaker than the index due to regulatory concerns. Oil price increases aided Russian and Saudi Arabian markets.
REITs posted very strong results on expectations that normalcy is on the horizon. The decline in rates also made their yields more attractive. Some believe that the commercial market still is in for a correction once the various relief measures expire.
While many commodities weakened in May and June, higher oil prices bolstered the energy heavy GSCI commodity index. Industrial metals also gained as manufacturing activities increased. Gold and silver both showed modest gains. Crypto continued to gyrate like anything but a store of value.
Government bond yields diverged. US 10-year yields fell from 1.72% to about 1.45%, while yields rose in Europe. Corporate bonds did better than government bonds. The US bond market may be signaling that many of the rising prices are temporary. Still, inflation concerns persist. Many prominent economists like Larry Summers argue they will be with us for awhile unless some action is taken.
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PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.