Market Commentary Q2 2021

Starting On A Dime

Investors haven’t had to pay much attention to inflation since the George W. Bush administration. For more than a decade, aspiring economists have had to be content studying its absence rather than its effects. If the ‘Dismal Science’ has anything like a universal theory, it’s that inflation is triggered when an economy exceeds full employment or monetary supply expands faster than productive capacity. Yet despite unemployment hitting a 66-year low in 2020 and more rounds of Quantitative Easing than Star Wars sequels, inflation has fallen short of the Fed’s 2% target pretty much since 2008. Until recently, inflation was beginning to seem like a quaint thing that happened in the 1970s (kind of like disco).

The suspected causes are many. Some of the more frequently mentioned are demographics (an older nation saves more than it consumes), the productivity benefits of technology and cheap imports (read China). But before we begin to opine on current events, it’s worth noting that in recent years, deflation seemed like a far more pressing concern, especially when viewed through a global lens. Because recent US GDP growth has exceeded much of the developed world, foreign investors have gravitated towards US assets, driving up demand for dollars and increasing their value. A currency that appreciates is, you guessed it, deflationary.

The primary debate in the second quarter was whether this current spate of inflation is transitory or sustainable. Count us among the former. Here are a few reasons why.

Demand Was Unknowable

Just as economies aren’t supposed to stop on a dime, they’re not built to start on one either. Imagine you are a production manager. It’s October 31st and you’re trying to forecast demand for 2021. COVID cases are setting new highs (and won’t peak for another 10 weeks). The past year has been one of the hardest of your career. In the spring, your sales had their steepest decline ever, so you intentionally destocked, attempting to align inventory with very uncertain demand. It seemed wise to slow new orders, allow lengthening lead times and
consume safety stock lest the pandemic accelerate (which it did) leaving you with a warehouse of unsaleable goods.

Nine days later, Pfizer announces an effective vaccine followed by Moderna a week later. Within six months, 152 million Americans have received at least one dose and GDP is forecast to grow 9%. In hindsight, your inventory position is woefully inadequate, and consequently, you’re left facing the mother of all supply crunches.

Now multiply that headache by every business in America. Because recent economic growth has been extremely range-bound, manufacturers leaned out their supply chains, relied heavily on just-in-time delivery and became a little complacent given extremely predictable demand. For ten years, it had been a goldilocks economy, ‘neither too hot, nor too cold.’

The same is true on the labor front. In a little over a year starting February 2020, unemployment went from 5.7 million to 23.1 million back down to 9.3 million. The gig economy has trained us to open an app and expect workers to show up. As much as we’d like to ‘turn it back on’ there are frictional considerations to bringing 14 million people back into the workforce. Never mind the paperwork.

Spenders Gonna Spend

Savings usually go up in a recession, but this is the first time the US has made $807 billion of direct payments to consumers. The Personal Savings Rate peaked last year at 34% and has since fallen to 12.4% (5% is considered ‘normal’). Thanks to government stimulus and a reopened economy, consumers spent 29% more in April 2021 than they did in April 2020. We view these rates as the definition of unsustainable. Every flavor of economic stimulus has its own half-life. Some are slow burn (like tax cuts, which can take years to take effect), while others are sugar rushes with extremely limited duration (like direct payments). Once it’s spent, it’s spent, and right now, it’s being spent.

Capacity Is Ample

For inflation to persist, there must be a persistent mismatch between supply and demand. When it comes to commodities, it’s hard to find many that are structurally under-supplied once demand ‘normalizes.’ Take oil for example. Historically, it’s been one of the best predictors of inflation as it’s an input cost in many of the goods and services we consume. The cost of Crude oil is currently up 52% YTD. But how long will that last? The US is currently producing 12% less oil than it was at the beginning of 2020. Saudi Arabia cut oil production 53% in 2Q20 and is currently increasing it 28%. One of the most timeworn adages in commodity investing is ‘high prices cure high prices. ’ The supply response is coming.

What About Stocks?

Whether inflation is transitory or persistent very much matters for stock prices. Because inflation has been modest for quite some time, and we’re currently experiencing the sharpest inflation since 1982, securities that are the most inflation-sensitive tend to be the best performers (think energy and banks). This strikes us as odd as oil prices and 10 year government interest rates (the two biggest determinants of those industries’ profitability)
aren’t that much different than 2018-19 when most considered them blasé.

What does matter to us is inflation’s impact on growth stocks. Because we’ve shown a preference for companies demonstrating exceptional growth in an unexceptional economy, many of our holdings have higher-than-market multiples. These stocks are sensitive to inflation because you’re discounting earnings far into the future and inflation erodes purchasing power. Growth stocks may continue to underperform if inflation remains
stubbornly high.

But it seems odd to us to jettison great businesses demonstrating exceptional earnings growth because inflation expectations go from 2% to 2.3%. It seems even stranger to want to replace them with businesses facing structural headwinds like banks (interest rate policy, leverage limits, FinTechs) and energy (excess supply, a strong dollar, carbon regulation). That’s not to say we don’t find attractive businesses in either of those sectors, but we don’t see the merit in chasing a ‘reflation trade’ should the inflation reset prove transitory in nature.

As usual, we thank you for your confidence and should you have any questions, please don’t hesitate to reach out to your relationship manager.

Bridges Investment Management Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Market Commentary Q1 2021

How Much is Too Much?

After spending much of the past year opining about COVID and its impact on the economy, we’d like to try a slightly different tack. Nothing elicits yawns like the subject of fiscal policy, (which our significant others frequently remind us) but to understand today’s markets, needs must. We promise to make it quick.

There are two primary ways to influence an economy, the first is monetary (think interest rates and money supply) the second is fiscal (tax policy and government spending). The Federal Reserve sets the first, Congress sets the latter. Because Fed Governors are appointed not elected, they can be fairly nimble. We saw this last March when the Fed cut interest rates twice in two weeks and announced a bond-buying program that immediately placated a jittery credit market.

But thanks to political maneuvering, election cycles and the inestimable difficulty of getting 535 politicians to agree on anything, fiscal policy can be slightly more cumbersome. There’s a reason the U.S. tax code is 2,600 pages.

Not only can Fed Governors change policy quickly, but the results are immediately apparent. If they adjust the overnight lending rate, several hundred billion in loans reprice that night. In contrast, taxation and spending proposals can take a year to debate, another year to pass and may not be felt for several more (if at all). By necessity, last year’s policy always confronts next year’s economy. We’ve never had the opportunity to pilot an aircraft carrier, but we suspect it’s not dissimilar.

While Congress deserves credit for immediately passing the CARES Act in March of 2020, there have been a total of six relief packages approaching $6 trillion and the prospect of an additional $3 trillion infrastructure bill. The amount of relief would account for 27% of US GDP, which dwarfs the response to both the Financial Crisis and the Great Depression combined.

It’s almost impossible to say what was the right amount of fiscal stimulus required to resurrect an economy hobbled by COVID. GDP has never declined 34% in a quarter before. Direct payments, enhanced unemployment benefits, and small business backstops were appropriate to alleviate economic suffering, support workers who lost their livelihood and shore up industries that voluntarily closed to save lives. But spend even a few moments unpacking the contents of the relief package(s) and you’ll discover that much of it is government largess wrapped in a relief wrapper. While it may be impossible to say just how much spending was necessary to healing an ailing economy, Congress decided the risk of doing too little outweighed the risk of doing too much.

GDP declined 3.5% in 2020. Congress spent 27% of GDP to ensure it wasn’t worse. Most agree that herd immunity, through a combination of vaccination and prior infections will be achieved sometime in 2021. Meanwhile, the stimulative effects of recent policy will accelerate an economy already on the mend. It’s as if a patient was released from the hospital, but a doctor decided to give him 5mg of adrenaline just to be sure.

This has led to an expectation that economic growth could be ‘bonkers’ in 2021. GDP is now forecast to exceed 6%, which would mark the fastest growth since 1984. Consumers eager for a sense of normalcy are armed with both higher personal incomes and net worth. Homeowners have gotten the twin benefits of lower mortgage payments and higher resale values in an extremely tight real estate market. Due to disruptive weather, shipping bottlenecks and the normal friction of restarting an economy, inflation expectations have reset meaningfully
higher.

The probability of robust growth in 2021 hasn’t nudged investors into risk-assets so much as shoved them. Equity inflows are on pace to set new records. Many stocks with the most sensitivity to economic growth (read riskiest) are the best performers. Numerous companies with the worst balance sheets have doubled or tripled. The IPO market is frothy, retail speculation is rampant and risk appetite seems insatiable.

This is a hard environment for investors like us. We try to be measured in all economies, to weigh the potential for value creation against capital loss. We prefer businesses with secular growth that aren’t reliant upon a rapidly (or rabidly) expanding economy to succeed. Our predilection is for businesses with pricing power, not prone to the whims of inflation. Many of these businesses haven’t had their outlooks rapidly change, which is part of why we liked them in the first place.

Those of you who check your performance regularly, may see some holdings have temporarily lagged an extremely ‘risk-on’ market. This is as it should be. The world is full of investors who believe they can market time inflection points in economic cycles and get in (and out) before the tides change. Not only does this approach require being right twice, it typically generates significant tax consequences.

The market currently fears inflation will get out of hand, that Congress went a step too far with the checkbook and that after a decade of underperformance, value stocks are finally due for their day in the sun. Our process is intentionally agnostic between value and growth, and we don’t jettison half of a portfolio when one style experiences a period of under-performance. We strive to generate consistent returns across market cycles, which requires discipline, process adherence and a willingness to ‘look wrong’ for periods of time.

In our experience, principles always come with a cost; a time where they seem inconvenient or can cause temporary discomfort. A phenomenon like GameStop, where a company’s stock price appears to outpace its fundamentals, will occasionally make investing in quality companies with sound capital allocation seem old-fashioned or out-of-step with the times. But in our experience, unlevel heads seldom prevail for long.

A current GDP estimate is for a more ‘normal’ 3.2% in 2022. This year, inflation is expected to be elevated but we suspect could eventually moderate. Trillions of debt will require repayment which can act as a governor on future growth. Most expect taxes to increase. In other words, this economic surge may be temporary. We thank you for your business and if you have questions or comments, please don’t hesitate to contact your relationship manager.

Bridges Investment Management Investment Committee

Bridges Trust Company Thought Leadership Disclosure

Market Commentary Q4 2020

“Trying to determine what is going on in the world by reading newspapers is like trying to tell the time by watching the second hand of a clock.”

– Ben Hecht

Most advisors write their commentaries on a quarterly basis (us included). We snap the chalk line at regular intervals to carve time into digestible chunks, then summarize them as if it were a cohesive narrative with a beginning, middle and end. However, reality can be much more nuanced. Just as a headline fails to tell the entire story, the trends that define a quarter neither begin on September 30th nor end on December 31st.

The fourth quarter was another unusual act in the very unusual play that is 2020. We wrote last quarter that “New cases of COVID-19 peaked on July 17th and seem largely in a downward trajectory.” As the ink was drying on our commentary, cases began rising almost immediately and reached a new peak by mid-October. Currently, the 7-day average is almost four times our last writing and the death toll has eclipsed 330,000. By now, almost all of us know someone who has been personally impacted, lost a job or a loved one.

Talking about the stock market in such a context seems in very poor taste, and yet that’s the assignment. If you told us at the beginning of the quarter that pandemic trends would become materially worse or that the economic reacceleration would slow due to mobility restrictions, we would have hoped for flat at best. Yet the S&P 500 is up 11% for the quarter and nearly 18% for the year. In fact, November was the best November on record,
up 11%.

Reconciling a worsening pandemic and the human suffering it entails with a booming stock market takes a little doing. The most influential events in the fourth quarter were a quasi-well-functioning election and the release of clinical trials data for not one but two COVID vaccines. In a year full of uncertainty, it was easy to imagine how a contested election might result in months of angst and judicial wrangling stretching into 2021. In fact, the cost to hedge the S&P 500 suggested market participants were more than a little concerned. Avoiding the direst of outcomes and allowing the market to get back to pricing in the policies of a new administration was enough to move many investors off the sidelines.

On November 9th, the clinical trials data for Pfizer and BioNTech’s vaccine were released, showing remarkable efficacy. This was echoed by Moderna and the NIH’s vaccine data a week later, which was equally impressive. Developing two vaccines for a completely novel coronavirus in record time is an achievement that warrants recognition and we’re grateful for the round-the-clock efforts of the life sciences community. While the discussion now shifts to one of logistics and availability, this is obviously preferable to having no vaccine. There are more questions to be answered before normalcy can return (how long does it provide immunity, can we make and distribute enough doses, will enough of the population get vaccinated, what happens if the virus mutates?) but it’s a very tangible cause for hope.

These two events, an election where the worst-case scenario was avoided and science’s answer to a devastating pandemic triggered a frenzy we would describe as ‘risk-on.’ The most economically sensitive companies experienced the strongest stock performance. The Russell 1000 Value index outperformed its Growth counterpart by more than 4% in the fourth quarter. Small caps, as measured by the Russell 2000 index and known for being more economically sensitive, returned almost 32%. Our clients’ portfolios, which tend to skew towards large, durable and high-quality franchises couldn’t keep up (and yet annual returns are still quite acceptable). While under-performance is never fun, knowing that we’re adhering to a process meant to provide resilient returns across a market cycle regardless of the strength of the economy can provide some consolation.

We’re all familiar with the adage, ‘be fearful when others are greedy and greedy when others are fearful.’ An extremely strong stock market combined with the fear triggered by worsening pandemic data suggests that the market may be experiencing both emotions simultaneously. The S&P 500 currently trades at 23 times forward earnings which exceeds both its five and ten-year averages. This, along with a frothy IPO market and the strong performance of securities we would describe generously as ‘speculative’ makes many fear that a bubble is forming. While we agree that the market is feeling its oats, it’s also against a backdrop of negative real interest rates (where inflation exceeds the return on risk-free treasuries) and, in our opinion, an extremely probable earnings recovery in 2021. Knowing the market is not absolutely cheap on an historical basis, but still relatively cheap compared to returns available elsewhere isn’t our favorite environment in which to invest. Bargains are scarce and expectations high. But we’re hired to navigate all capital markets, not just those we prefer. We would love it if clients only gave us capital at times of maximum pessimism, when fear is highest and money raining from the sky. You can be sure we’ll call when that’s the case.

Our expectations for 2021 are nuanced to say the least. A quick end to the pandemic has been the wrong guess since hopes of its containment were dashed in late February. We would expect fits and starts in a vaccine roll out, continued disruption to our daily lives and moments of both hope and anguish (obviously we prefer the former, but prospective returns are probably better under the later). We do believe that society is likely to make substantial progress against the pandemic. We would expect above-trend GDP growth in 2021, although not until the second quarter, largely from easy comparisons. We suspect interest rates will continue to rise and to experience at least temporarily elevated inflation as consumers try to spend their way to a sense of normalcy. Pent-up demand for travel, leisure and entertainment are likely headlines to expect next year. The market will also begin to price-in the new administration’s economic priorities. Higher taxes seem likely, hopefully muted by Republican control of the Senate and a fragile recovery. We anticipate a continuance of extremely lax financial conditions as the Fed will be loath to put the punch bowl away too early. Of all the potential outcomes for 2021, we expect ups and downs, but nothing of the magnitude we saw in 2020. It won’t feel normal. But it should feel more normal.

And in the meantime, we continue to adhere to the process, to identify securities with attractive growth trajectories, high quality franchises that can be bought at as close to reasonable prices as the market will offer. If the last decade has taught us anything, it’s that holding your breath waiting for bargains isn’t a repeatable investment strategy. We hope you and your family are healthy, we thank you for your business and as always, if you have any questions, please don’t hesitate to reach out to your relationship manager.

Bridges Investment Management Investment Committee

Bridges Trust Company Thought Leadership Disclosure