Low rates, yields and inflation keep fueling markets
While there has been some intra-month volatility, and some very interesting rumbles under the hood, the S&P 500 and TSX managed to accelerate 2.8% and 1.8%, respectively. However, European and emerging market strength combined with US dollar weakness helped the MSCI World Index race ahead by 3.9%. From a sector and style perspective, large cap growth and technology paced the Nasdaq (+8%) as it sprinted past the 10,000 marker for the first time.
The lifestyle changes and the consumer response to the Covid crisis has intensified many of the long-term trends that were unfolding. Nevertheless, it is still astonishing to observe the degree to which valuations are being extended. For instance, it was noted that the combined market cap of Square, Shopify, Spotify, Zoom, and Tesla are now equal to that of Warren Buffet’s Berkshire Hathaway. To put this in perspective the combined trailing annual revenues for the five companies are equal to Berkshire’s normalized net income. For reference, Berkshire’s portfolio of companies include GEICO, Duracell, Dairy Queen, BNSF Railway, Fruit of the Loom, and significant minority holdings in Kraft Heinz Company and American Express.
As our readers and investors know, our priority is to safeguard capital. So, while stock markets are rallying, we are on alert for obstacles. First, rapidly rising Covid case counts in Texas, Arizona and Florida are worrisome. More recently, Germany and Japan have also recorded a spike in infections. Some are calling this the Second Wave, but the First Wave hardly abated. Optimistically, afflictions will diminish before the Fall’s traditional flu season otherwise investor sentiment will be rattled along with the fragile recovery. Further, US-China trade issues are a lingering disturbance.
Gold seems to have escaped its consolidation pattern. It flirted with $1,800 before ending the period at $1,792, rising 4.3%. The metal’s year-to-date return is now over 18%. Gold tends to outperform in periods of falling real yields. Accordingly, the strong case continues to develop due to economic uncertainty, hints of rising inflation, and depressed bond yields that are happily confined by the Fed.
Elsewhere in commodities, the chart below highlights the appreciation of lumber, copper, and oil since April. The trend is supported by a falling US dollar (USD), which peaked in March and dropped 3.1% this month. The potential for a shift to a persistently weak USD, though far from confirmed, would have significant influence on the deflation versus inflation narrative.
Support for the deflation scenario comes from an over-leveraged economy and the government intervention that is required to limit increases in yields and the costs to carry the ballooning debt. Meanwhile, the unprecedented monetary and fiscal stimulus could stoke sleepy embers of inflation. The extreme growth in US M2 is also inflationary. M2 is a gauge of money (cash, savings, money market instruments) in the US financial system. After growing 6% per year from March 2010 to March 2020, M2 soared 18% from March to June in 2020. Since 2008, monetary stimulus has caused inflation to show up in asset prices. Yet, with fiscal support invited to the party in 2020, the manifestation of consumer price inflation may become an economic reality that was absent over the past decade.
Oddly, long-term bond yields in the US are stubbornly low. The inflationary signals listed above have not been priced into 10-year yields. After briefly touching 0.91% in early June, the yield has reversed to 0.71% as of 24-Jun-20. The rate is still within the rising channel that began in April, but one key factor to consider is that The Federal Reserve has been buying Treasury Bonds to maintain low yields and a low borrowing rate. This has been exceptionally important because over the same period, foreign ownership of US Treasury holdings is declining. Without foreign buyers, The Federal Reserve’s motivation to intervene is heightened because it needs to support the economy and stabilize financial markets. But for how long can the Fed keep buying the debt issued by its parent, The Treasury? Interestingly, Ken Rogoff, Professor of Economics at Harvard University declared in March 2019, that this favourable condition will become flawed when fiscal policy is needed to “fight a financial crisis, respond to a large-scale natural disaster or pandemic, or mobilize for a physical conflict or cyberwar”. Perhaps, we are on the threshold of inflation becoming unhinged.