1Q, 2021: MSB: Money Seemingly Boundless

First Quarter 2021

April 1, 2021

By Mark Oelschlager, CFA

Within days of each other in March two Northeast Ohio legends passed away: Michael Stanley and Joe Tait. If you’re from this area you know who they are. If you aren’t, you may not. Both men became familiar to us via the radio; Stanley was a rocker, while Tait was a talker. “Michael Stanley Band” (MSB) broke attendance records at local venues in the early 1980s but never caught on nationally, which is still hard to understand. Tait was the radio play-by-play announcer for the Cleveland Cavaliers for the better part of four decades – and it’s difficult to believe anyone ever did the job of calling basketball games better than he did. What the two men had in common, in addition to talent, was humility, unpretentiousness, and approachability, which perhaps explains why they were so beloved.

Listen to me and you won’t be regrettin’

Humility might be lacking at the Federal Reserve (the “Fed”), considering its list of goals, role in the economy and confidence in its own abilities continue to grow. The Fed not only kept its foot on the gas in the first quarter but vowed to continue doing so for years to come – or until unemployment falls to a satisfactory level. Chairman Powell has assured the public that the Fed will act quickly enough to ward off inflation, even though 1) their approach has changed from acting in advance of such a threat to waiting until it has already happened, and 2) there are plenty of signs of inflation of not only goods and services but in the prices of items that fall outside the traditional measures. The Philly Manufacturing Survey Prices Paid Index climbed to its highest level in over 40 years. The prices of several commodities have spiked. Housing values have taken off. Junk bond yields dropped (meaning prices rose) below 4% for the first time ever. Stock prices of unprofitable companies skyrocketed in recent quarters until finally cooling a bit recently. Collectibles and something called non-fungible tokens are also red hot.

You say you’ve got your reasons, but I need more

It’s questionable at this point how much benefit there is to the economy from the Fed’s large asset purchases and even its maintaining interest rates near zero. The economic downturn was caused by a pandemic and not a decline in animal spirits, so spurring individuals and corporations to borrow at low rates likely isn’t having the same effect that it had in past downturns. There is also a sensible theory that all the Fed’s purchases of government debt are reducing the amount of high-quality collateral in the system that acts as the grease for everyday economic activity. Then there are the various side effects that result from these Fed policies. Powell has stated that the Fed isn’t concerned about asset bubbles – while it continues to pursue policies that inflate them.

He says he needs you, but you better pass him by

Of course, Washington enjoys such bubbles – until they pop and cause damage to the real economy, at which point they look for people to blame. The lines have blurred between the Fed and the federal government, as they are increasingly working together to support not only the economy but the capital markets. Former Fed chairperson Janet Yellen now heads the US Treasury and is very much on board with the Fed’s monetization of US debt as well as the dramatic rise in government spending that has taken place and is expected to continue. On top of the massive stimulus of 2020, the government passed a $1.9 trillion package in the first quarter of 2021 and is planning an infrastructure bill of $2.3 trillion. Numbers this large are difficult to conceptualize, so here is some context. The total amount spent in the two bills ($4.2 trillion) would equate to about $12,800 for every American. That's $12,800 of every citizen’s money that is being spent by the federal government – just in these two bills. It doesn’t include the outlays for Social Security, Medicaid, military, etc. For further context, the total outlays (spending) by the federal government in 2017, 2018 and 2019 were between $3.3 trillion and $3.5 trillion each year.

There’s got to be another way

As a result of the historic rise in spending, government debt has jumped and will continue to rise at a fast rate. As we have talked about in past commentaries this will eventually become a problem, but nobody knows when. At what point will holders of US debt demand a higher interest rate to compensate for the risk of lending to an entity with a rapidly expanding debt load? For many years the US government was at least somewhat conscious of keeping spending in check, as additional spending often had to be offset by revenue increases. But that has gone out the window, replaced by Modern Monetary Theory, which holds that fiscal spending rather than monetary policy is the appropriate tool with which to manage the economy and that inflation is not a function of the money supply. The authorities have used this to justify the spending blowout. Yellen has said that the rapidly expanding debt isn’t a problem because interest rates are so low, which is like saying the hole in your roof isn’t a problem because it isn’t raining. Interest rates on ten-year US Treasury bonds have risen from 0.91% to 1.72% just this year. So the borrowing cost for the government, at least on that maturity, has almost doubled.

Come on, let the provin’ begin

Inflation has been kept at bay for decades due to secular forces like global competition and technology, even though monetary policy has been accommodative for much of that time. But now the US is essentially engaged in a giant historical experiment in which it is betting that such forces, and the dollar’s position as the world’s reserve currency, will outweigh the effects of an unprecedented expansion in federal spending, an accelerating economy, and by far the highest growth in the money supply since the 1940s. We don’t know how it will turn out, but it’s a dangerous experiment.

They just come and go

The recent rise in rates has had a major impact on the stock market, with the “value” stocks outpacing “growth,” a trend that started in November. To a certain degree the various segments of the stock market have become dependent variables, with the independent variable being interest rates. When rates decline, growth stocks (companies whose sales are expected to grow at a fast pace) do well, and when rates rise, value stocks (companies that aren’t expected to grow as fast but trade at more attractive prices) benefit. As we have talked about, the valuation gap between these two groups was extreme last year, for a variety of reasons. It has narrowed quite a bit but may have more to go. There still seems to be quite a bit of froth in the high-growth segments of the market, and when we see ads for a tech-focused ETF all over the TV - a fund that brought in $5 billion in new money in one day recently - it’s probably a sign we are closer to the top of that trade than the bottom. The buzzwords of the day are “innovation” and “disruption,” and investors currently crave companies that embody them. But with the recent run in these stocks, which has been reminiscent of the late 1990s, their valuations have grown to 30-40 times sales. At that level, an awful lot needs to go right for the investment to pay off.

Have a good night, everybody

It’s been a strong start, performance-wise, for our strategies, but we are reticent to even make that comment, as we believe we, and any other portfolio manager, should be judged on our long-term track record rather than a few quarters. For more information please see our prospectus. The recent strong run we have had relative to the market is a result of the actions we took in 2020 to take advantage of market volatility, which presented opportunities for long-term investors willing to act. While many managers were frozen, we made more changes in the portfolio than usual. In retrospect, we should have been even more active, as the shift within the market (from growth/pandemic plays to value/pandemic casualties) has been powerful.

As alluded to, there are various segments of the market that are generating a lot of interest – and sky-high valuations. Uninterested in getting caught up in the speculative craze, we continue to look for good businesses that trade at attractive valuations, confident that such an approach will pay off for our clients over the long-term. We also continue to pay a lot of attention to risk, given our philosophy that the time to address downside risk is when things are good, not when prices have already been marked down.

Mark Oelschlager, CFA Oelschlager Investments

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