August 2021: Good vs. Bad
Good vs. Bad
August 4, 2021
So many of the decisions we make in life are tradeoffs, both the big decisions and the little decisions. We evaluate the pros and cons of where to live, where to work, what career to choose, etc. As investment professionals, we do the same thing when making an investment decision. Often, we are evaluating many variables on both the good side and the bad side. We also have to assign a certain weight to each variable; what is more important to investment success, and what is less important? We also have to evaluate the certainty of our judgement on each factor. If we expect a likely outcome, how certain are we? If we are wrong, is the downside risk large or small? It’s complicated.
There are significant crosscurrents of good and bad affecting the markets and the economy right now. Most immediately concerning is the Delta variant, resulting in rising cases across many countries. Viruses often mutate, typically becoming more infectious but less deadly, as appears to be the case with Delta. From an economic point of view, our behavioral reaction to the Delta variant is as important as the medical consequences. Even a semi-voluntary, significant reduction in mobility and economic activity can have wide ranging consequences. If people choose to travel less, stay home more, and spend less out of fear, there will be economic consequences.
So far, the surprising strength of the economic recovery is outweighing the fear and uncertainty generated by the Delta variant. Air travel has recovered to 80% of pre-pandemic levels, restaurant visits have fully recovered, and gasoline consumption has recovered to more than 95% of pre-pandemic levels. Consumer confidence going forward is still a concern; the percentage of individuals in a recent Gallup survey that believe the COVID-19 situation is getting better has dropped significantly. As we saw in 2020, when confidence in our political, health, and journalistic institutions is at odds, the societal fabric frays.
The economic and market news has continued to be better than expected. Both revenue and earnings have continued to surprise on the upside each of the last four quarters, with the magnitude of the surprise increasing. This probably explains the positive return of the S&P 500 through earnings season in the month of July, after a 15% gain in the first six months of the year.
Why worry? The level of debt and borrowing is exploding, and it is being monetized through purchases by the Federal Reserve. The Treasury issues debt and the Fed purchases a significant portion of it. They also are the major buyer of debt in the home mortgage market. This is effectively “printing money” and distributing it through various government programs. Few have stopped to think that the $20 bill in their wallet is actually an IOU. It is non-interest bearing government debt. We work for two weeks and receive a paycheck; that chit can be exchanged for something of value we want to consume in the future, be it seven days or seven years from now. Governments throughout world history have succumbed to the seduction of printing money. It has ended badly for all of them.
The generally shorter effective maturity debt we utilize in many of our fixed income strategies reduces risk and exposure to changes in expected inflation and interest rates. This is the best investment approach we found to mitigate risk in fixed income investing. High-quality bond investments have proven to be the best way to mitigate equity investment risk.
Even if a ‘return to normal’ move continues after the Delta variant subsides, we now know we are not going back to the normal we had before the COVID-19 pandemic. Life and work in 2022 will be different from life and work in 2019. Many have used this period to evaluate their work/life balance, seemingly to the benefit of both the companies and their employees. Real GDP is now higher than it was pre-COVID-19 with five million fewer individuals employed. Higher GDP is the good, and we have made a positive step in overall economic productivity through this period. Fewer employed is the bad, and we need to continue to work to find a place for all who can contribute.
Random thought:“I have dreamt of this moment since I was a kid, and honestly nothing could prepare you for the view of Earth from space” –Richard Branson, Virgin Galactic Founder