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Headlines are once again in a tizzy over inflation after May’s faster-than-expected US consumer price index (CPI) reading. But, just like April, we think there is little sign of lasting faster inflation in these data, which markets seemingly see. In our view, investors should follow their lead.
Headline CPI rose 5.0% y/y in May, accelerating from April’s 4.2% and logging the biggest uptick in 13 years, a fact the Bureau of Labor Statistics (BLS)—and seemingly everyone else—pointed out.[i] But like last month, that big year-over-year gain from deflationary lockdown levels is largely a garbage stat. Month-over-month data are somewhat more informative. In May, CPI rose 0.6% m/m, decelerating from April’s 0.8%. Even on this basis, though, we see plenty of signs the uptick is temporary—the effect of reopening and related supply chain issues.
Hence, in our view, the Treasury market’s telling “meh” reaction. Inflation and inflation expectations heavily influence longer-term Treasury yields. Why? While yields fluctuate in the open market, every given Treasury bond pays a fixed rate over time. The more inflation you get, the less buying power those fixed rates are delivering you. Hence, investors expecting hotter inflation typically demand higher yields.
Three weeks shy of 2021’s half birthday, Energy is still the MSCI World Index’s top-performing sector year to date. Its 35.6% return through Monday’s close is beating global stocks’ 12.4% by a country mile as investors continue rewarding oil prices’ rise.[i] We have written before of our belief that this phenomenon will probably prove temporary, and our opinion hasn’t changed. But setting all that aside, this seems like a good time to answer a couple of frequently asked questions about the sector.
1. Why isn’t Energy having a bigger impact on global returns? Should I own more to get some extra oomph?
The answer to the first half of this two-parter explains why the answer to the second is “no”: Energy is only 3.25% of global market capitalization as of Monday’s close.[ii] That is down from 10.17% on Halloween 2007, the day global stocks peaked ahead of 2007 – 2009’s financial crisis. Not coincidentally, even with this year’s rally, global Energy stocks are still down -16.3% since then.[iii] The shale boom may have lifted US oil output to generational highs and added big economic tailwinds for oil-rich regions in the 2010s, but it tanked oil prices, which hit Energy companies’ earnings hard worldwide. That hammered returns and the sector’s global market clout. Last year made it even worse when the pandemic wrecked demand for jet fuel, gasoline and other oil-intensive goods and services. So what we are seeing now is a fledgling rebound off of a very, very low base.
UK trade negotiators have been busy. Last week, they finalized a hard-fought fishing rights accord with the EU and a trade deal with Norway, Iceland and Liechtenstein. Next up: a UK-Australia trade agreement set for mid-June. Talks are also in progress with New Zealand, most of the Pacific Rim, India and America. Note: We still don’t know if all or any of these deals will happen—the EU fishing and the Norway (et al) deals still need ratification, for example. But the symbolism is noteworthy: Post-Brexit Britain doesn’t seem to be retreating from the world, confounding a popular view of Brexit as a protectionist, isolationist move. That is a good lesson, we think, in not taking political rhetoric at face value.
Five years ago this summer, in the wake of Britain’s referendum to leave the EU, many pundits proclaimed the vote meant the UK was turning its back on the world and global trade. Others went further, suggesting it was a sign globalization was in retreat. Meanwhile, the negative thinking went, the UK was shooting itself in the foot, there was no upside to severing EU ties and calamity would result. We always thought such sentiment was a weeee bit overstated, considering leaving the EU freed Britain up to pursue new deals of its own. Now that seems to be happening in full swing, and we suspect those still waiting for protectionist disaster may be disappointed.
The UK has been making every effort to embrace trade with the rest of the world. Even before Brexit took effect, there was the main EU trade agreement struck Christmas Eve and deals with 67 countries to preserve the trade agreements Britain was party to as an EU member-state. Then there was the UK-Japan trade deal reached last September and signed the next month. But now activity is really picking up speed. Last Thursday, the UK agreed on fishing rights for the next year with the EU, a point of contention they punted on in last year’s broader trade deal. Then on Friday, it announced a trade deal with Norway, Iceland and Liechtenstein—the non-EU members of the European Economic Area (EEA), which allows them to participate in the EU’s single market.
A “landmark deal.”[i] That is what many are calling a global minimum tax agreement G7 finance ministers reached over the weekend, endorsing a 15% corporate tax rate and agreeing to tax multinationals’ profits where they are earned regardless of whether they have a physical presence in that country. But before you pencil in the hike, we think a little perspective is in order—and not just because President Joe Biden and Treasury Secretary Janet Yellen face tough sledding getting tax changes through Congress. You see, as the name implies, the G7 is just seven nations, all of whom stand to gain more than they lose from this agreement. An actual global deal, whether via the G20 or OECD, is another matter entirely. That is but one reason this weekend’s agreement isn’t a game changer for any one country—or for giant Tech and Tech-like companies.
Like all G7 communiqués, this breakthrough is a political agreement, not a new law. But if the participating nations pass the relevant legislation, it would establish a minimum tax rate of 15% for all multinational companies doing business in these nations. That includes big US Tech and Tech-like firms, which would have to start paying taxes in all nations where they sell goods and digital services, not just the countries where they officially domicile. This coordinated regime would replace national digital taxes, ending the US’s separate tit-for-tat battles with France and the UK. Yet it isn’t clear that this will raise a ton of revenue for these nations or be a giant headache for businesses, considering the tax applies only to companies whose profit margins exceed 10%. The huge Tech, Consumer Discretionary and Internet Media companies this tax targets could ensure their margins never meet that threshold, avoiding the tax altogether. But if they don’t, paying 15% in France, Germany, Italy and Britain, instead of booking all European profits in Ireland at 12.5%, isn’t exactly going to destroy after-tax earnings. If anything, it might raise barriers to competition from smaller companies, which we suspect is a big reason some Tech-like giants actually supported this effort.
But that is where the significance ends. The G7 consists of the US, UK, Germany, France, Italy, Japan and Canada. Their corporate tax rates, respectively, are 21% (plus varying state rates), 19% (with a scheduled increase to 25% in 2023), 29.9%, 34.4%, 27.8%, 29.7% and 26.5%.[ii] What do all of those numbers have in common? You guessed it: They are all a lot higher than 15%. A global minimum doesn’t require any of these countries to raise their own rates to level the playing field for all. Instead, they all get a bit more of the global tax pie. Therefore, this agreement was always the easy part.
May purchasing managers’ indexes (PMIs) have rolled in, and some readings are historic. While we enjoy a nice milestone as much as anyone else, PMIs are still backward-looking, and the latest batch reveals basically nothing new or surprising. We think markets are looking far beyond what these data show—and investors should, too.
PMIs are surveys in which services and manufacturing businesses indicate whether activity across a range of categories rose or fell from the prior month. Readings above 50 mean over half of responding companies reported growth, implying broad expansion, but that isn’t airtight since PMIs don’t measure growth’s magnitude. So while we don’t know how robust May’s manufacturing growth was, PMIs suggest factory activity was very broadly growing, with a couple of exceptions.
Exhibit 1: May and April Manufacturing PMIs
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The Office of the US Trade Representative (USTR) announced retaliatory tariffs against six nations’ digital taxes yesterday, concluding a process begun last summer. But it then immediately suspended these levies—against Austria, India, Italy, Spain, Turkey and the UK—for six months, during which the Biden administration hopes to finally hash out a global digital taxation regime. Now, the announcement of small, delayed tariffs that are ostensibly a negotiating tool generally isn’t a huge deal for stocks, and we don’t see anything here to make us say this time is different. But it does help flesh out President Joe Biden’s general trade policy, which looks a lot like his predecessor’s. To us, this illustrates a timeless investing lesson: Always watch what politicians do, not what they say—or what pundits say they will do.
Trade policy didn’t loom large in Biden’s campaign platform, but that didn’t stop many from presuming his trade doctrine would be a 180-degree turn from former President Donald Trump’s tariffs and tough talk. Pundits seemingly salivated at the possibility for Trump’s tariffs on China and others to go away, followed by a US return to the artist formerly known as the Trans-Pacific Partnership (TPP). But four-plus months in, what little action Biden and US Trade Rep Katherine Tai have taken largely extends the status quo. In a March interview, Tai logically pointed out that it would be an own goal to surrender a negotiating tool when the relevant negotiations aren’t over yet. Sky-high resources prices haven’t yet inspired Biden to lift Trump’s steel and aluminum tariffs. Ditto the tariffs on Canadian lumber, which Biden’s Commerce Department recommended doubling last week. He did suspend tariffs on UK goods tied to the ongoing dispute with the EU over Boeing and Airbus subsidies. But only because the UK isn’t in the EU anymore—the broader EU tariffs remain.
A few weeks ago, we pointed out that some central banks have started to taper their quantitative easing (QE) bond purchases without any ill effects, which shouldn’t be surprising since there weren’t any when they tapered over the past decade. But it seems the chorus of doom has only grown now that some Fed people have publicly alluded to taper talk being on the docket later this year. It could get louder, too, given the Fed’s announcement yesterday it will sell the (paltry) $14 billion worth of corporate bonds and corporate bond ETFs it amassed through its 2020 emergency facility by this year’s end. We think you can tune it all down. There is little reason to think tapering—or emergency credit programs ending—is bearish, as we will explain.
The main fear stems from the belief stocks’ recovery and subsequent new heights are due solely to central banks’ extraordinary policies. Supposedly, without the flood of liquidity the Fed (et al) unleashed, stocks would be struggling. As evidence of stocks’ artificial elevation, bull market critics point to allegedly sky-high valuations and outsized leverage. The implication: If central banks withdraw their monetary support, the house of cards will collapse. Hence, taper fears. Just talking about it is apparently cause for concern, breeding uncertainty and volatility, which attracts further attention—and dread.
While central banks’ financial lifelines may have helped calm the initial panic last March, don’t overrate them. (The Fed may even have precipitated some of that panic itself.) As we said then, beyond just being a lender of last resort, the Fed’s programs were a mixed bag. To the extent they allowed otherwise solvent institutions access to funds, we think they helped boost confidence. Verbally backing the corporate bond market—which they did more than through actual buying, as the tiny amounts in yesterday’s announced unwind shows—may have helped steady markets a bit. But it is a mistake to consider that monetary “stimulus.” (Similarly, emergency fiscal support has mostly replaced lost income.) Greasing the wheels to allow financial markets to function normally doesn’t automatically equate to overheating.
Throughout 2021’s great inflation scare, we have seen a few pieces arguing stocks will disappoint investors hoping their returns will outpace accelerating consumer prices. Some use rhetoric, arguing rising input costs will zap corporate earnings (and, in our view, ignoring that companies can raise prices of whatever goods and services they sell, preserving margins). Others purport to support their case with data showing a strong link between “rising inflation,” whatever that even means, and weak stock returns. But we have yet to see any show their math or data in transparent detail. There are embedded assumptions in every single one we have seen, and absent that transparency, you can’t really judge the accuracy. So to help you out, we ran a bunch of numbers. As we will show you, they suggest stocks do well in inflationary environments more often than not.
The most recent article that caught our eye on this front was in The Wall Street Journal last week. Citing a study from a UK asset management firm, it stated that “from early 1973 through last December, stocks have delivered positive inflation-adjusted returns in 90% of rolling 12-month periods that occurred when inflation—as measured by the consumer-price index—was below 3% and rising … But that fell to only 48% of the periods when inflation was above 3% and rising.”[i]
Upon reading this, we had a host of questions. Why start in 1973, considering the inflation everyone associates with the 1970s started in the late 1960s? What constitutes “rising inflation”—if CPI jumps one month, slows the next, then inches higher, is that in the dataset? Why exclude periods of decelerating double-digit inflation—don’t people still worry about fast-rising prices eroding their purchasing power in that environment, too? Alas, we nosed around, looked up reports, watched videos and found little that provided an answer.
Another day, another round of inflation chatter—and, inevitably, bitcoin chatter. For there is a rumor going around that bitcoin has stolen the title of Best Inflation Hedge from gold.[i] We have seen a steady stream of articles arguing that because of its limited supply and immunity to government and central bank chicanery, bitcoin is a hard currency that will keep its value—or gain value—when inflation rears its head for real. But that logic doesn’t pass basic scrutiny, and historical data don’t exactly support it either. Now, we don’t think big inflation is imminent. However, this bogus theory seems to be worth nipping in the bud now.
For something to be a genuine inflation hedge, it should ideally have a strong positive correlation with prices—as in, when prices rise, returns increase. The faster prices rise, the faster the hedge’s price rises (and, theoretically, vice versa). That correlation should also be a long-term phenomenon that holds cycle after cycle. Bitcoin doesn’t have a long term. It is only 10 years old, and most of those 10 years were one of the longest low-inflation stretches in recent memory. During this span, bitcoin drifted sideways for years, boomed, busted, boomed again and now seems to be busting again. Notwithstanding cumulative returns, that behavior is not what one would logically expect of a hedge during a period of overall modestly increasing prices.
Exhibit 1: This Isn’t What Inflation Hedges Look Like
Source: Global Financial Data, Inc. and St. Louis Federal Reserve, as of 5/27/2021. Bitcoin price in USD, 7/18/2010 – 5/25/2021, and year-over-year percent change in monthly CPI, July 2010 – April 2021. Linear scale used instead of logarithmic to avoid taming bitcoin’s booms and busts.
Earlier this month, the Centers for Disease Control and Prevention (CDC) reported the number of US births fell -4% in 2020 to 3.6 million—the lowest since 1979. This, plus similarly dreary birth data from other nations, rekindled a recurring concern: Will falling birthrates in the developed world and China set up future economic and market trouble? We don’t think so—recent demographic trends aren’t destiny, and they aren’t hugely relevant for stocks.
The 2020 data are the latest in a longer-running trend: Populations worldwide are graying. Besides the dip in births, America’s general fertility rate (the number of births per 1,000 women aged 15 – 44) and total fertility rate (the expected number of births a woman would have over her lifetime) each dropped by -4% last year, too.[i] These generational lows, which confounded many folks’ expectations for a lockdown baby boom, extend a longer-running decline—see the general fertility rate’s ongoing slide since 2007.[ii] Similar trends reign abroad. The EU’s total fertility rate has been falling over the past decade, while Japan has long been the posterchild for declining births—to the point some parts of the country give parents a cash grant for each child they have.[iii] Many experts now sound alarms about China’s slowing birth rates even with the abolition of the one-child rule in 2015.
Last year’s baby bust has spurred mostly pessimistic outlooks among the punditry. With birth rates below replacement levels (i.e., the number of births needed for a generation to replace itself), some worry economic growth will fizzle out eventually. If there are fewer young people, the thinking goes, who will produce tomorrow’s goods and services—and who will buy them? Where will ideas and innovations come from to tackle new problems? Who will take care of tomorrow’s elderly?
