Vise 2021 Mid-year investment outlook: Part 2
The US economy forever changed when the pandemic struck. The “new normal,” characterized by near-zero interest rates and low inflation, suddenly became the old normal. After lying dormant for almost a decade, inflation turned into the economic boogeyman that some people remember from the 1970s.
What can investors make of all this change? In part two of our mid-year outlook (see part one here), Vise's investment strategy team tackle the big economic and policy questions that are top of mind for many investors. Whether conventional wisdom around interest rates and inflation still holds, when the red hot housing market might cool down, what to do if a second pandemic drawdown occurs, and much more.
The Economy at a Glance
Conventional wisdom suggests that the market is due for a pullback. The Fed has indicated it will raise rates as soon as next year, and high inflation threatens to undermine returns. Is there a better way to think about the relationship between the two economic indicators and the market?
Dave Twardowski: If you think of prices as the discounted value of future expected cash flows, what the statement says with respect to a potential market downturn is that inflation will drive up the discount rate, making market prices drop. So that's one part of the concern right now.
The other thing to think about is expected future cash flows.According to the research we've done with Andrea Eisfeldt, cashflows can be affected by inflation as well. We've had a massive amount of stimulus over the past 15 months, which has encouraged spending and driven up inflation. But when inflation goes up, it can also lead to higher cash flows across all companies. Interest rates and inflation combined can also push cash flows up. So if you think about the changes to the numerator and denominator of the expected future cash flows equation, you can start to ask whether prices will go down or up.
The answer there is we don't know. We did hear a lot of doomsday scenarios for prices going down in the summer of 2021. While the summer isn’t over yet, we haven't seen any of those scenarios play out. That's not to say we won't; it's just now clear whether rising interest rates or inflation will precipitate that freefall.
Let's dig into inflation a little more. What are the potential allocation decisions investors may want to consider to offset higher inflation?
Travis Fairchild: Similar to our positions on active tilts and market premiums, we advocate for a long-term investment horizon and to not try and time the market based on any short-term indicator. Inflation is difficult to predict or forecast. What we have seen recently is that it is even hard to measure on a trailing basis. There are two reasons why recent inflation reports have shown elevated readings: the base effect and supply constraints.
The base effect refers to the effect that the choice of a basis of comparison can have on the result of the comparison between data points.he recent inflation numbers compare today's situation to the same period last year, which we all remember as recording rock-bottom inflation numbers. Commodity prices crashed, and oil prices dipped into negative territory. So it was inevitable that inflation would appear high when compared to a deflationary period.
We've also seen supply constraints play a role in the high reported inflation of late. The best example of that is used cars. A large percentage of the increase in CPI is from the used car market, where there is an acute shortage of semiconductor chips. It made it difficult for dealerships to keep up with new car demand, thereby increasing the value of used vehicles. On top of that, larger buyers of used cars like rental car companies helped bid up the price of used cars.
We believe the supply issues will resolve themselves, and as a result, we expect inflation to be transitory. That's the main reason why we wouldn't change allocations based on inflation predictions. The recent spell of inflation, in our opinion, is fleeting and our view on investing is a much longer one.
Is there a point where if we see runaway inflation next year, we start to reconsider our approach and how we position clients?
Travis: There are minor tweaks investors and advisors can make to their portfolios. Just take a look at the duration of the bond portion of their portfolio. If the Fed were to raise interest rates to stave off inflation, advisors might want to reduce the duration of their client's bond holdings. We may also recommend that clients look at their overall allocation, ensuring they hold a globally diversified portfolio. Having a globally diversified portfolio, where interest rates and inflation aren't a universal concern, would be a good option in this situation.
Houses in the country are selling within a week of listing and well over the asking price. When will the red hot housing market cool down?
Christian Boinske: Housing was the easiest market to cover last year because everything just went up. There were a couple factors causing the rise in prices: personal preferences raised demand and low inventory and high labor costs pushed supply down.
City dwellers, trapped inside their 500 square foot apartments during the pandemic, began seeking more space and better working environments. This was accompanied by decade-low mortgage rates. As a result, demand for single-family homes increased. We also saw input prices rise and a labor shortage prop up prices, both at least partially caused by the global pandemic.
The past year of housing activity has been an interesting case study in the short-term supply and demand dynamics. At the peak of the mania last year, the monthly supply of new single-family houses fell to around 3.5 months, an entire month lower than the previous low set in 2015 of 4.5 months. But we've started to see supply return to normal. The most recent reading on the supply of houses is about six months, which is closer to the long-term average. On the demand side, the monthly number of houses sold began to fall year-to-date in 2021. It declined from over 80 thousand in March to around 60 thousand in June.
So like all supply and demand issues, you eventually find equilibrium. It's just about how long you have to wait. An interesting thing I saw recently was that new housing inventory was at its highest since 2008, but only 10% of that outstanding inventory was completed. What that suggests is that supply should start to catch up to demand. There just happens to be a lag between the time it takes to build a house and when you move in.
Dave: There's a value analogy in many asset classes, and real estate is one where you can look at rent to house prices as your value metric. Based on that metric, you could say the housing market looks frothy right now. When will the reversal happen, and can you time it? Some studies show that timing valuation ratios are complex, not just in equities but other assets too, including real estate. So it's easy to say housing prices are running hot right now, but that does not necessarily portend a drawdown.
The Pandemic and Policy
Fears of higher capital gains rates still linger. How can investors position themselves should capital gains increase?
Christian: There are two important lessons here. The first is the question of whether capital gains tell us anything about future expected returns. There's limited empirical evidence that suggests higher capital gains tax rates predict lower equity returns. So from that standpoint, I don't think there's a big asset allocation conversation to have.
On the flip side, there is a benefit to higher capital gains. No, paying more taxes is not fun, but as long as they exist, tax-loss harvesting has value to investors that can take advantage of harvesting opportunities. In a recent paper, we showed how the benefit of tax-loss harvesting increases as capital gains tax rates go up. Those tax-loss harvesting opportunities only increase when you hold individual securities. Take the Russell 1000, for example. The index is up 17% this year, but about a quarter of its holdings are negative for the year. When you hold single securities, you have an opportunity to offset gains in the portion of the Russell 1000 that increased with the portion of the index that struggled. This is different from holding an ETF or mutual fund, which limits investors’ ability to harvest losses to when the entire index has negative performance.
Surging cases of the Delta Variant have been a cause for concern in the country. Will the newest pandemic strains lead to a downturn, not unlike March 2020?
Travis: Predicting downturns is extremely difficult and we advise against trying to time the market based on these forecasts. For example, there are many studies that show the persistent difficulty investors have when attempting to successfully time the market. These studies will typically look at the difference between a mutual fund’s return and the return of the average investor over the same time period. The average investor typically experiences a much lower return due to a behavioral gap that we call the "timing drag."
The most popular of these studies is the Dalbar Study. It has recently shown that in the 30-year period ending in December 2020, the average timing drag was 4.5% in equity funds and 5.4% in fixed income funds on an annualized basis. In other words, investors are buying into these funds at near-term highs and selling at the wrong times. Their attempts at timing the market robbed them of four to five percent of returns versus what they would have received had they followed a buy and hold strategy.
We took those timing drag metrics a step further and looked at the common questions retirees ask when planning for retirement. When can I retire? Will I outlive my money? How much can I spend in retirement? We wanted to quantify answers to each of these questions with and without the average timing drag. If you received the average timing draft instead of the average market return, your chances of your money lasting you through retirement decreases. What's more, you would have to pare back your annual budget to account for your lower returns and therefore have a much lower standard of living in retirement.
What we see is the timing drag has real-world consequences. Take the 4% rule, for example. This is the standard withdrawal rate that retirees can use to maximize their chances of not running out of money. It's based on the Trinity study and decades of academic research, which observed a 50/50 portfolio for every 30 year year rolling period going back to 1871. The study found that a 4% withdrawal rate gave retirees a 99.6% chance of not running out of money.
If we apply the timing drag instead of the average market returns, the chances your money lasts through retirement decreases to 15.1%, or about an 85% chance of running out of money. We feel these examples help to illustrate that, with respect to the pandemic, and even inflation or interest rates, investors should stay invested and take the long view, whether the market experiences another significant drawdown or not.
August 10, 2021