June 2021 Newsletter to ClientsSubmitted by Moneywatch Advisors on June 10th, 2021
Enjoy this month’s edition that features a look at inflation, bonds, U.S. stocks, and international stocks.
The Bureau of Economic Analysis’ personal consumption expenditure inflation measure (truly a name only its mother could love) rose 3.6% in April over April, 2020. That’s the largest gain in 13 years. Stripping away food and energy prices and that core price index rose 3.1% - the largest since 1992. So, are we truly experiencing extraordinary inflation the likes we haven’t seen since the 1970s or are these merely unusual numbers as a result of emerging from a pandemic?
The Federal Reserve believes the latter and expects inflation to average 2.4% this year and decline to 2.1% by 2023. Inflation at that level would be a tad higher than in recent years but, historically, about average. So far, the bond market doesn’t seem to believe we’re about to experience runaway inflation either as the 10-year U.S. Treasury only yields about 1.6% - historically quite low.
Some economists, however, believe the inflation rate could jump to 4% or even higher over the next few years. Former Treasury Secretary Larry Summers and Ray Fair, an econometrician at Yale, have both predicted higher inflation. Dr. Fair has placed a 30% chance of inflation being over 4% next year if, and this is a big if, the Fed does not raise interest rates to combat inflation. What happens if the Fed does raise interest rates to help control inflation?
First, the U.S. stock market could get a tad volatile for a while. In 2013, when the Fed discussed reducing their bond holdings, stocks briefly fell. Jeremy Siegel, the University of Pennsylvania economist and author of “Stocks for the Long Run,” said he believes stocks will prosper over the long haul after this initial volatility. He also believes heightened inflation is already “baked in” by investors.
Next, prices of bonds fall when interest rates rise and that could affect our bond mutual funds. Over time, however, the mutual funds would replace low-yielding bonds with bonds with richer income streams, helping to stabilize returns. Kathy A. Jones, chief fixed income strategist for the Schwab Center for Financial Research, says bond funds would serve as a buffer to stocks if they decline sharply. This is what they are intended to do in our portfolios and how they performed in March of last year when the pandemic hit and the stock market crashed.
Finally, as you know, owning a diversified portfolio can help smooth out the ride when economic bumps cause financial turbulence. Owning international stocks through a mutual fund can be a good diversifier relative to U.S. stock mutual funds. First, international stocks are currently less expensive than U.S. stocks. A major international stock index currently trades at a Price/Earnings ratio of a little more than 17. The S&P 500 trades at over 22, meaning international stocks are trading at a 23% discount to U.S. stocks. Remember buy low, sell high?
Second, the international index is more diversified than the S&P 500 because the U.S. index is dominated by its 5 largest companies – Apple, Microsoft, Amazon, Alphabet (Google), and Facebook. Those 5 now add up to over 20% of the index. Comparatively, the 5 largest companies in the international index only make up 7% there.
The U.S. stock market has performed well this year with the S&P 500 index up over 12% so far and the index of smaller companies, the Russell 2000, up even more at over 15%. If the market earns a double digit return this year it will be only the 5th time in history that has occurred three years in a row. As always, we’re keeping an eye on the horizon and preparing investment strategies for our clients to meet their individual circumstances.
Thank you for your continuing confidence.