Commentary

We’d like to thank our summer analyst interns, Max Persico, John Schreiber and John Hufnagel for all their help this summer and putting this important research piece together for us and our clients.   Inflation concerns continue be at the forefront of investors’ minds, and rightfully so. The CPI and PCE data over the past few months suggest inflation is a legitimate threat to the strong economic recovery. While Fed Chair Powell has stated that recent inflation strength is reflective of temporary pressure from supply chain constraints, he has also stated, “As the reopening continues, bottlenecks, hiring difficulties, and other constraints could continue to limit how quickly supply can adjust, raising the possibility that inflation could turn out to be higher and more persistent than we expect.” At TPCM, we continue to believe the inflation scare will be transitory, and the bond market rally over the past few months appears to agree with us. We have examined the July CPI and PCE reports to identify key drivers of recent inflation prints and then delved into recent company commentary for further clues as to when we can expect supply shortages to sort themselves out.

As often is the case, the equity market overcame a litany of worries this past quarter as many of the more macroeconomic and policy-oriented concerns quickly dissipated and investors focused on the re-opening of the global economy. Continued improvement in economic growth and increases in corporate profitability have buoyed investors and justified the lofty valuations of equity investments. For the quarter, the S&P 500 rose by 8.5% pushing the year to date total return to greater than 15%, surpassing many investor’s initial expectations.

In response to the COVID-19 Pandemic, the Fed dusted off its Financial Crisis playbook. Looking at the inflation rate, the real economy, and the financial markets performance since the Fed announcements in early March 2020, there is only one conclusion to reach; the Fed stepped in and was quite successful in preventing a further meltdown in financial markets. This result lends credence to the view that the Fed has the tools to keep the economy out of deflation. Given that the Fed appears to be utilizing the same playbook it used during the Financial Crisis, we believe that in this case, past performance is indicative of future performance. Thus, there is no reason to expect a different outcome this time around and therefore we expect inflation to remain subdued.

A casual observer of economics and markets could look at the first quarter of 2021 and remark that it was a very solid period with the S&P 500 rising 6% as the vaccines for COVID-19 are effectively being rolled out and the US economy has continued to re-open and show further signs of improvement.

It goes without saying that 2020 was a historic year. The COVID-19 crisis which increasingly swept the world, had a dramatic impact across all aspects of society and life including economic life; resulting in the most bewildering and astonishing year reflected in the most amazing and extraordinary chart I’ve seen in my 30 odd years of following economies and markets. How about that for hyperbole?!?

It ‘tis the season to be jolly goes the old holiday carol and that has certainly been the case for small cap investors of late. After plunging deeper and then lagging their large cap brethren from the onset of Covid-19, small caps have coming roaring back. Relative outperformance has been especially strong since early November and YTD small cap returns of 18% now eclipse the S&P 500 return of 15%.  Those are very solid returns for any year, and outstanding returns for a pandemic year! At Timber Point we had highlighted the rotation we saw occurring in the market in our quarterly update in early October suggesting a stronger weighting to small caps and we have been rewarded. The question now becomes, do we believe that small caps will continue to outperform as we move through 2021?

Although the presidential election results are not entirely conclusive, the American people have spoken and more so than anything else the election has proven that United States remains a centrist nation and investment markets have cheered that outcome. As of this writing, Joe Biden appears as if he will become the 46th US President of the United States and the Republicans will retain control of the Senate and will have picked up seats in the House of Representatives.

A very successful competitor asset manager in Boston famously produces a periodic report where they forecast expected real returns of various asset classes for the subsequent seven years. This report is often cited in the financial press and is held by many to be the standard of prudent long term thinking about opportunities across various investments and where wise, forward looking investors should allocate their monies. Unique asset classes are very often favored while run of the mill asset classes, such as US large cap stocks and bonds, are typically viewed as unattractive.

Okay, we all need to take a very deep breath. No doubt you have heard the news that Covid-19 cases have increased over the past week, both domestically and internationally. Given what we have been through over the past 6 months this instinctively brings unpleasant memories of economic “lockdowns” and stay at home orders. Let’s look beneath the surface of these numbers to help you understand why we do not think that will be the case this time around.

We reiterate our belief from our last blog that the Covid-19 pandemic is on the wane in the U.S. based on the decline in national and state Covid-19 hospitalization figures that we continue to monitor. As a reminder, we focus on hospitalizations as a leading indicator of future deaths associated with Covid-19. Hospitalization rates across the U.S. continue to decline and totals in the three “hot” states of California, Florida and Texas are no exception. Given that these three states account for ~ 50% of the daily U.S. deaths over the past few weeks this is important. With fewer deaths at the state and national level, we believe that elected officials will gain more latitude to further open local and state economies. In turn, this could lead to a rotation in the U.S. equity market to “reopening” stocks from the “work from home” stocks.