Will Covid Ever End?

 

By:  James C. Denton, CFP®, Managing Partner

October 1, 2021

We had a strong first half driven by the continued recovery from market lows in early 2020 driven by Covid factors.   The economy continues to perform well in spite of (and in many cases perhaps as a result of) Covid, but market performance[1] may have gotten a little ahead of itself and the third quarter has been a bit of a period of “digestion[2]” of earlier gains.  Now we are in the midst of historically normal seasonal issues.  For some reason September is almost always a down month into early October, and, usually, the market begins to recover in mid-October when the discussion turns to a “Santa Claus Rally” between Christmas and into the new year.  

Covid continues to be the greatest drag on our economy, yet after stumbling initially, the market has performed strongly throughout this difficult period.  Now, many of the major drug companies are working non-stop on preventatives, treatments, and remedies, and I think there is a real chance, even a likelihood, that we will see, sooner rather than later, a breakthrough treatment regimen, a game changer.  If this happens, the market could be primed for explosive growth.  But not without a little volatility in the meanwhile. 

For the past year and a half, many businesses have been severely inhibited for want of a better word by covid-related issues.  Personnel shortages.  Customer shortages.  Supply chain disruptions.  Raw material shortages.  And on and on.  And yet we have seen significant positive market performance, to the extent that we have had a succession of all-time highs in all the major indices including as recently as late August and early September.  I believe that the pullback we have seen since these highs has been normal “digestion” of earlier gains aggravated by the afore-mentioned normal seasonal behavior. 

As we have discussed previously, Covid drove a significant amount of “creative destruction”.  There are always businesses that survive simply on the persistence of their owners; unprofitable, unproductive, “zombie” companies that should not, and ultimately will not survive.  Covid was a death sentence for many of these enterprises, and when this happens, the strong get stronger.  At the same time, it contributed to an acceleration in growth of many new technologies, some of which already existed but perhaps had not yet achieved liftoff velocity, and others which were only gleams in the eye of their creators which thrived in the covid environment.  The result of this combined phenomena is, in many ways, a jumpstart to a new economy which might have otherwise taken years to develop.  

There are many economic and market-related statistics that analysts use to predict the performance of the economy, the overall market, and individual companies.  Some are very straight forward and easy to understand, often even intuitive, while others are very convoluted and sometimes esoteric.  To discuss all would go far beyond the interest if not the understanding of many of my readers, and in many cases, even my own understanding, and perhaps intelligence.  Three of the more basic, however, which I frequently refer to because everyone “gets it”, are Interest rates, employment, and inflation.  These three are fairly closely corelated in what drives them, and how they impact upon one another, and tend to be significant factors as well in those more advanced indicators.  All are presently at attractive levels for the direction of the economy, although there are potential red flags developing at the margins.

Interest rates have been in a continuous downward trend for the entirety of my time in this business.  The 30-year treasury bond, the benchmark for interest rates almost globally, hit an all-time record high of 15.21% in October of 1981.  It fell below 1% in 2020 and is presently at ~2%.  The 10-year treasury is probably more impactful for most of us.  It has been in a similar downward trend and is currently at ~1.5%.  The long-term trend for each seems to have stabilized and are showing signs of increasing, but they remain at significantly attractive levels both for businesses and for individuals.  It is very easy for businesses and individuals to borrow money, and this liquidity is very stimulative to the economy.  The Federal Reserve continues both to project, and current policy drives continued attractive rates, although at perhaps a bit higher than they presently are.

Employment (or the mirror-image, unemployment) is more difficult to characterize.  Businesses consistently complain because of unfilled jobs, and some would say no one is unemployed against their will.  On the other hand, many individuals would argue that there is not a job available which is appropriate for their skills, knowledge, and abilities[3], or that pays an adequate salary.  These factors notwithstanding, the statistical measure of unemployment is very near the historic definition of full-employment, and as stimulative unemployment compensation programs expire, many people currently sitting at home will be returning to work, further improving this statistical measure.  The current level of employment in the economy is more positive than troubling.

Inflation can be, at least theoretically, both a result of and a contributor to each of the foregoing[4].  As interest rates go down, consumer demand for products, goods and services increases as consumption is preferred over savings.  (It is hard to get excited about savings accounts, or long-term savings rates where they are right now.) Similarly, if people are drawing a salary, they have income to spend on those same products, goods, and services, similarly driving consumption.  This behavior (demand exceeds supply) drives the cost of those consumable items up.  The opposite is also true in each case.  As the cost of funds (interest rates), or as unemployment increases resulting in less disposable income, demand falls, supply grows and products are discounted to move them off the shelves, or to create income for service providers. 

Inflation has been especially benign for a very long time by historical comparison.  While high inflation is bad for the economy, so is the opposite – disinflation.  The Federal Reserve, the main arbiter of inflation policy, believes a 2% inflation rate to be optimal, and much of their practical efforts are targeted at achieving stable 2% inflation in the economy.  We are presently, and only very recently, experiencing inflation significantly above this rate.  The Fed in on record as believing that this phenomenon is “transitory”, a reflexive reaction to years of below target trends that will resolve itself, and claim not to be troubled.  They are, however, also adjusting their policies and beginning to reduce their stimulative actions.  This is the most potentially troubling red flag.  If the inflation genie escapes, he/she is very hard to get back into the bottle, and Fed actions to achieve this purpose would be negative for the stock market.

What does it all mean?   Insofar as our macro investment policy is concerned nothing changes.  We continue to expect the market to generally trend upwards, although certainly at a more measured pace than we have recently experienced.  All my discussion is common knowledge among investors.  There are no radical theories here and the market is performing as well as, or perhaps even better than one would expect/predict if we were not yet where we clearly are with respect to these very important factors.  Negative market performance is always a result of one of two factors: negative expectations of economic activity, or significant economic or political surprises.   The entirety of this newsletter addresses the former.  As for the latter, surprises are, by definition, unpredictable.  They occur from time to time, they sometimes result in major market dislocations, and they are painful when they occur.  But they are transitory.  Over time, they tend to blend into and ultimately lose significance if one is disciplined and systematic in the planning and execution of your strategy.  Rational, disciplined asset allocation continues to be the best strategy; not trying to time the next “crash”.

 

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[1] The direction of the economy and investment markets frequently diverge for many reasons.  Simply because the economy is performing well does not automatically imply that stock markets will reflect that fact.

[2] The market cannot, does not, and should not go continuously in one direction, either up or down, for many reasons.  When market analysts talk of “digestion”, it is merely a way of saying the market is taking a brief period of counter-cyclical behavior before it continues a trend in one direction or the other.

[3] The downside of the afore-mentioned “creative destruction”.

[4] Those 15.1% US Treasury rates in 1981 came about because of a condition called “stagflation” when both inflation and high unemployment coexisted.  Inflation was over 10% and unemployment was between 8 and 11% into 1982.  It is extremely unlikely (and unheard of historically) for high interest rates and low inflation to occur simultaneously.

 

The views expressed in this article are those of the author and may not reflect the views of LPL Financial.  This material is for informational purposes only and should not be considered as investment advice for any individual.  You should consult with your personal advisor before making any decisions based on this material. Past performance does not guarantee future results.  The economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful.