Diagnosing the Economy: Q3 2021 Review
The economy and markets are often described in medical terms, as if we were diagnosing every economic cycle and had a prescription for every market illness. So it’s not surprising that the current applicable term for the state of the world is that we are in recovery after suffering a severe illness, both figuratively and literally. All recoveries are different, but successful ones go through several stages. It is important to understand where we are in this one and what we can expect next.
The first thing a sick economy needs is to stop the bleeding and get a massive injection of new blood. In an economy, cash is blood. Central banks and world governments, the US most of all, have done a great job treating the patient in the emergency room with free money and government spending. Well done!
However, the side effects of this euphoric injection are always the creation of bubbles. Money flows into solid and risky assets almost equally, but the risky ones benefit more. That inevitably leads to a spiral of speculation creating a self-reinforcing mania. This explains why we have Bitcoin, SPACs, digital art being priced like Rembrandts, and lumber priced like it doesn’t grow on trees.
Now the policy makers, disguised as doctors, need to get the patient back on his own feet and get all the organs working again, not just the parts that are most easily stimulated. This is a tricky task. One that has failed in past recoveries because stimulus was removed too soon or the economy just wasn’t strong enough to make it on its own.
So far, it looks like the real economy is bouncing back well, maybe too well. Cargo ships are full, and natural resources and labor are in short supply. Corporate profits are hitting new highs after the worst hit since the last recession. The stock market is saying everything is better despite the ever-present worry of what happens when the economy has to walk without the crutches of free money and deficit spending.
We think that the economic prognosis is good. First of all, the illness was a very curable disease, not something structurally wrong with the economy or the financial system. A couple shots and we are back in business. Secondly, the patient was in good shape before the illness and looks pretty healthy otherwise. Personal savings, the leading indicator of future spending, is off the charts. Corporate balance sheets are even more flush with cash and they must invest it once confidence is fully returned to the executive suite.
In the first half of the year our portfolios have benefited from performance of cyclical stocks, many of which we bought when they were given up for dead, but that game is probably out for the deep cyclicals like energy and retailing. Now we should see the recovery broadening out and anticipate a return to a more normal, slow growth economy.
Of course, inflation is spiking because of all this cash sloshing around and the unexpected strength in the economy putting pressure on labor costs and supply lines, but it was just a few months ago that the dominant theme was deflation. Be careful what you wish for!
Our portfolios are balanced to take advantage of the recovery and in particular this stage, when the real economy accelerates, and speculative sectors become less attractive. We believe that large cap companies offer the best risk reward in decades because they are best positioned to benefit from increased consumer spending worldwide and have diversified supply chains that can sustain inflationary pressures. For that reason, we are holding and adding to our positions in Pepsi, Google, Comcast, Siemens, CVS, JP Morgan, Broadcom, Microsoft, and Weyerhaeuser. All household names, outside the speculative bubble that has formed around many of the social media and tech stocks. All great companies we hope to hold for years while their earnings grow and their stock prices compound.
As always, we will diversify our portfolios with smaller stocks and even some speculative issues that we feel are worth the risk, but in this stage of the recovery, we feel most comfortable in large core holdings.
At some point, there will no doubt be something to derail the recovery temporarily or permanently. Likely candidates are inflation, a weak dollar, economic or shooting wars and a sudden bursting of a speculative bubble that brings down the financial system. All worth worrying about. But none are predicable. In the meantime, we will position portfolios for the recovery and control risk by avoiding the speculative excesses.
And oh yes, we own some bonds, which are really not much better than holding cash at today’s yields but still vital to protecting our client’s assets. We favor short term, good quality bonds that we can hold to maturity so we won’t be forced to sell them if interest rates spike. How long we have to suffer these low bond yields is anyone’s guess given that the ten-year Treasury is less than 1.4% when everyone expected it to be north of 2% by now and headed to 3%. Maybe it’s just another example of too much cash around competing with the Fed for product, but that must change before very long. When it does, we look forward to rolling our maturing bonds into higher yields…someday.
Compass Wealth Management LLC is a SEC registered investment advisor, clearing transactions primarily through Pershing Advisor Solutions and Pershing LLC subsidiaries of Bank of New York Mellon Corp. This letter is written by Compass for the benefit of its clients and does not necessarily represent the opinions of its affiliated organizations. It is based on information believed to be reliable, but which is not guaranteed to be correct. Nothing herein shall be construed to be a solicitation to buy or sell securities, indicate that past performance is predictive of future returns, or recommend individual investments.