I don’t suppose that I need to spend a lot of time reminding you that 2020 and Q1 2021 have been tumultuous in the financial markets. But the markets are arguably at a critical juncture as we emerge from the pandemic. Now would be an excellent time to look forward.
It is time to stop and take stock of what happened to YOU specifically over the past 18 months. If you are like most people, you began 2020 thinking that it was going to be a pretty good year. Pundits agreed. If you recall, I speak often of the five things (and only five things) one can do with all the money received each year: 1) pay taxes, 2) pay on debt, 3) give some, 4) save some, and 5) spend the rest. It’s pretty easy to know the first 4 with a reasonable degree of certainty. That means if you know how much came in (hint: check your tax return) you can solve for how much you must have spent by simply subtracting the first four. (If you have seen cash build up in checking accounts be sure to claim that increase as savings.) This little exercise will likely reveal that you didn’t spend as much as you do in more “normal” years. That makes sense. Millions of Americans are in the same boat, spelling pent-up demand. More on that in a minute.
One Harvard economist estimates that there is $1.8 trillion of accumulated disposable income since the start of the pandemic. This should make for a very robust increase in GDP in the second quarter. Like most, our data collection tool measures economic details in year-over-year comparisons as well as month-over-month growth or decline. The year-over-year numbers for the next couple of quarters compared to last year are going to look outstanding. Take a long view.
Now, add in 1) an administration that is ready and willing to provide stimulus, and 2) an accommodative Federal Reserve (keeping interest rates low and buying bonds), and the stage is set for some hearty growth. But this situation is not without its risks. By almost any measure, stocks are overvalued. And just consider what has happened to home prices. Over the past three months, we have spoken to many about either buying or selling a house. Nearly everyone has been shocked that actual selling prices are routinely above the asking price. This provides what economists call wealth effect.
“Speculation has replaced investing in many circles.”
— Scott Neal
Back to risks. The greatest threat is likely to be rising interest rates. Even if the Fed is successful in maintaining low short-term rates, ultimately, the Fed and President Biden will learn that it is the bond market that is in charge of long-term rates. Big deficits don’t necessarily mean higher rates. The bond market will stand behind (i.e., keep rates low on the long end despite huge deficits) as long as it can see a positive rate of return (properly determined) on projects being funded by the debt. Inflation remains a key variable.
Suppose for a moment that inflation kicks up to 3%, or 4%, or higher. Will the bond market continue to buy bonds that pay 2% and suffer negative real return (net of inflation)? Not likely. Bonds are bought at auction. Interest rates will be bid up in the face of inflation. The question of whether inflation will be temporary or permanent is on a lot of minds. One noted British economist has deduced from demographics that the next major round of inflation will occur in the U.S. between 2025 and 2050.
Some have pointed to the flow of money into the economy and have said that it must be inflationary. That is not correct. We just need to look at the period since 2008 for proof. Very large deficits were combined with unparalleled stimulus and extremely low unemployment, yet no inflation. The one cause of inflation/deflation is the movement of supply and demand. If the demand curve moves out faster than the supply curve, inflation will ensue. Without a doubt, the pandemic has negatively affected supply of many goods, notably computer chips, causing the supply curve to move backward just as huge pent-up demand is being unleashed. Expect inflation, but do not expect it to be permanent. At least not for now.
One risk to a full recovery is the likelihood, perhaps small, that the vaccines are not as effective as we thought they would be in the long run, and that variants to the virus will derail herd immunity. I trust that this readership knows a lot more about that than I do, and I welcome your input.
Another risk that we see a lot of today is the desire of investors to take on more risk at just what could become the wrong time. Speculation has replaced investing in many circles, especially young investors who follow Reddit or some other social medium. Buying on margin and participation rates of IPOs for companies that aren’t even profitable carry substantial risk.
So what do you do? In the short run, keeping an eye on the ball is crucial. Know where you stand. We continue to monitor stock prices. As they hit new highs, we move up our alerts. When prices pull back a bit, the alert fires and we must decide whether to take profits or continue to hold. Whatever you do, do not fall into a complacency trap.
Scott Neal, CPA, CFP is the president of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm with offices in Lexington and Louisville, KY. Questions are always welcome. Call him on 1-800-344-9098 or email to scott@dsneal.com