April 29, 2018

Excerpted from a letter sent to clients on April 27, 2018:

In our last quarterly update, we focused on the extreme stock market optimism that prevailed at that time in late January. At that point, the market was up almost 7% for the year and, as we discussed, investors were by some measures more bullish on stocks than they had ever been.

Before getting to the punch line, we want to further point out that the optimism had been boosted by the fact that volatility in the market had been at multi-decade lows throughout 2017.

From that moment of historical optimism and extended low volatility, the market has given up all its gains for the year, and we are now seeing headlines like this:
 
Here are some numbers to show just how huge the jump in volatility has been:

  • The S&P 500 has experienced 14 days so far this year with at least a 1% loss after only 4 such days in all of 2017.
  • There have been 7 days this year with over a 2% decline after no such days in 2017. (Source: Albridge Wealth Reporting)
As we noted in that prior letter, "investors on the whole always get optimistic after markets have done well, and they become pessimistic after markets have done poorly. This gets it backwards." So the experience of the markets since that last letter shouldn't really come as much of a surprise.  

Inflation shows signs of coming back to life


The world economic backdrop still looks pretty good:

So why all the market gyrations? It seems that one cause may be investor anxiety about the potential for rising inflation. We believe this is a valid concern. 

The chart below shows core inflation, which — after a lull last year — has picked up again rather abruptly:
 

The current inflation level is within the normal range over the past 10 years, but now there are signs that inflation pressure may be increasing. This is best illustrated by the Federal Reserve's Underlying Inflation Gauge (UIG), which attempts to measure the inflation trend based on a number of economic and price indicators:
 

Source: Investech Research

In the past, the UIG has tended to lead actual inflation at major turning points. And now, it has pulled away from current inflation to rise to its highest level since before the start of the financial crisis. History suggests that inflation could follow.

Looking at the economy, it seems plausible that inflation could start to pick up further at this point. Employees are hard to find, wage pressures are increasing, and confidence is high — all of which can lead consumers and business to loosen the purse strings. It has taken a long time to get here, after the financial crisis, but it seems like the economy may be entering that part of the cycle where inflation can start to be an issue.

This is without even considering the risk posed by tariffs or, worse yet, a potential trade war. The direct effect of tariffs is higher prices, and an all-out trade war could significantly increase inflation pressure. Hopefully this outcome will be avoided, but if it isn't, it will be occurring at a time when inflation pressures were already on the rise.
 

Inflation risk and our portfolios


Here's why this matters to investors: as inflation goes, in general, so go interest rates. Interest rates have been low for almost 10 years now, and the primary assets owned by most US investors are priced as if rates will stay unusually low forever. A sufficient increase in rates could lead to a major re-valuation (lower) for these investments.

One of the main rationalizations we hear for US stocks' near-record high valuations is: "They aren't that expensive if you consider how low rates are." The basic premise there is that stocks and bonds compete for investors' money, and if cash and bonds are returning next to nothing, people will be more attracted to stocks and push their prices up. There is some merit to this argument, but the problem is that it only works for as long as rates stay low. If rates were to return to more normal levels, stocks valuations might do the same — and that would represent a significant hit to most US stocks.

It's an inherent part of our process that we avoid highly-valued stock markets, regardless of what the rationalization for their expensiveness might be. So we already have low exposure to US stocks, and what exposure we have is mostly among "quality" stocks that (because of more moderate valuations and lower debt levels) are less vulnerable to rising rates. The bulk of our stock exposure is in international stocks, whose valuations are reasonable now, and would still be reasonable even if rates normalized.

On the bond side of the portfolios, we are generally avoiding longer-term bonds, which would experience the largest price declines if interest rates were to increase. Our exposure is mostly in short-term bonds (which yield almost as much as longer-term bonds, but with much less risk) and inflation-protected Treasuries (which, as the name implies, protect investors from inflation-driven rate increases).

Higher inflation and interest rates may yet be avoided, but they are a risk worth considering, and one that seems increasingly plausible. If it does come to pass, we believe our value-based approach will provide some good protections.