Q2 2021

July 7, 2021

The central theme of the past 6-months has been the emergence of the world economy into a post-pandemic world. As I discussed last quarter, the market has been surprised by the number of shortages that emerged as economies have reopened. These shortages have resulted in prices spiking for many goods and with that, inflation measures have surged.

The stock markets were digesting this in the first quarter, which gave rise to a debate as to whether we were entering a period of long-term structural inflation or whether this inflation was cyclical and therefore transitory. That debate created a fair amount of volatility in stock prices during the first quarter.

The Federal Reserve has come out firmly on the side of “cyclical” inflation. In other words, they believe that once the economy passes through this reopening stage, prices will stabilize. We have already seen some of that stabilization. Lumber prices spiked to over $1,700 per thousand board feet in early May but subsequently collapsed to near $800 by quarter’s end. Similar May price peaks were seen in other key commodities. Copper prices have retreated 10% after hitting an all-time high; steel prices have also pulled back from peaks in May.

However, a significant basket of commodities remains at all-time high prices and has not yet “corrected”. Iron ore, aluminum, coal, and other key commodities remain at all-time high prices. Others, although not at all-time high prices, have increased significantly in price over the past six months. Crude oil is up over 53%, natural gas is up 43%, and corn prices are up 35%.

During the 2nd quarter, the stock market decided to adopt the Fed’s view of inflation. Investors no longer appear concerned about structural inflation, which allowed the stock markets to advance with less volatility in the 2nd quarter.

Confirming this view is the failure of traditional inflation hedge investments to signal a long-term problem. Silver and gold prices are flat to down so far this year. Maybe that has something to do with cryptocurrency becoming the new inflationary hedge, but one would expect strength in silver and gold prices if long-term inflation were a risk.

Why does this matter? I have stated in the past that current low-interest rates are providing a floor for stock prices. So long as interest rates remain low, I do not see the stock market at any serious risk of a correction.

Were inflation to start spiraling out of control, the Federal Reserve would lose its power to keep rates low. The stock market would be at risk as bond investors began demanding a higher rate to hedge against inflation.

For now, investor consensus has aligned with the Fed’s view of recent inflation, so the market for stocks remains good and rates remain low.

One concern I had as we emerged from the pandemic, was permanent job losses resulting from businesses that did not survive the shut-down. I thought business closures presented a risk to unemployment rates.

I appear to have had this all wrong. Instead of people scrambling to find jobs, it has been businesses that are scrambling to find workers. Some suspect this is merely a result of generous unemployment packages that make staying at home more profitable than working. I don’t know. But this is clearly not what I thought we would be facing on the labor front at this point.

It is important to remember that little occurs in the economy that is not correlated with other factors. In many industries, the lack of supply and rising prices is partially the result of businesses having trouble finding workers. Let’s hope that bottleneck works itself out in the coming months.

With all this said, the next couple of quarters should be good for companies and their earnings. Demand for goods and services is very strong, and the buying power of consumers, as measured by wages and recent savings rates, is in very good shape. We should see strong earnings help support stock prices.

What will be interesting is to see the permanent changes that have occurred because of the past year. Have businesses learned to operate with less travel, less space, and fewer workers? Will employees demand work at home flexibility? Will businesses rethink supply chains and take steps to diversify their options?

It has always been true that major economic disruptions create new opportunities. As we exit the initial phase of reopening, new investment themes supported by increased spending are bound to emerge. It is in that light, we are looking for new opportunities.

We all wish you a wonderful summer going out, traveling, and re-engaging with the world!

Sincerely,

Mark Hoonsbeen, CFA
Principal