Q3 2020: PFM Quarterly Commentary
As we enter the home stretch of 2020, we find ourselves searching for the words to aptly summarize this year. The Grateful Dead may have phrased it best in their 1970 single, “Truckin’”, penning the lyric “What a long, strange trip it’s been.” There have been plenty of unpleasant twists and turns since the ball last dropped in Times Square and while many of us may not be eager to revisit them, we believe summarizing the more notable events may help us understand the state of today’s markets.
It seems like ancient history now, but 2020 started strong on the heels of a fantastic 2019, a year when nearly every asset class appreciated smartly and downside volatility was virtually nonexistent. Despite rumblings of an unknown virus thousands of miles away, the S&P 500 hit an all-time high on February 19th. This milestone was short lived, as we next witnessed the S&P 500 violently fall an astonishing 36% over thirty-three days, eclipsing the famed crash of 1929 in terms of speed and ferocity. Then, six months and $25 trillion in global stimulus later, the S&P 500 was once again making new highs after rising 65% from its March 23rd low to its latest peak on September 2nd. Through three quarters, unfathomably, the S&P 500 had returned a positive 5.6% for the year.
As this year’s dominant storyline unfolded, we urged calm and reason. Many practitioners in our industry and media types alike espoused the opposite advice and contributed to the hysteria. We in no way are downplaying the hardship and loss the global community has endured; we just fundamentally believe that a combination of healthy optimism and rational decision making is the most effective approach to navigating a crisis. We wrote previously that calamity breeds opportunity, and that investors must look to the past to reveal the blueprints for the future. Fortunately, we relied on these core tenets and Peak’s time-tested, data-driven investment process to guide us during the COVID crisis. Not only did we stay the course and keep our clients invested, we selectively added risk to portfolios near the bottom of the market in areas like technology, small cap stocks, and emerging market equities.
In hindsight, many of our decisions proved fortuitous; however, it wasn’t only our faith in humanity and the proven resiliency of investment markets that served as the foundation for our bullish posture. As we had communicated at length, our expectation was for central banks around the globe to flood the financial system with trillions of dollars to combat the sudden economic downturn and as a result, for the U.S. dollar to decline sharply. These actions in effect would act as a salve to the ailing markets. It bears repeating that central banks far surpassed our expectations by injecting $25 trillion of stimulus via direct payments, loan guarantees, asset purchases, and engineering the lowest long-term interest rates in our country’s history. The U.S. dollar followed the script by falling nearly 11% as measured by the Dollar Index from its peak on March 23rd to its bottom in early September.
We have often highlighted the importance of understanding the investment markets’ key drivers. To that end, our continued focus on the actions of central banks, the direction of the U.S. Dollar, and the inflation rate as the principal forces shepherding asset prices has been spot-on. In late August, Fed Chairman Jerome Powell demonstrated that the Federal Reserve also understands the influence these forces have on the investment markets. Mr. Powell and the other Fed governors unanimously decided to abandon the institution’s long-standing 2% inflation target in favor of a new 2% average inflation target. Though the change may appear as a distinction without a difference, we interpret this otherwise. The Fed is communicating a strong message to market participants that it will let inflation run above 2% for an extended period with no set upper bound. In the same statement, the Fed also committed to keeping interest rates at zero through at least 2022, while continuing its voracious asset purchase program (i.e., increasing the money supply and providing liquidity).
The signal could not be clearer: the Fed and other global central banks are going to continue their experimental monetary policies in order drive inflation higher. Unfortunately, it may not be quite that simple as there is a second ingredient to the inflation recipe besides increasing money supply which, historically, central bankers have had minimal direct control over: the velocity of money. This is a measurement of how quickly a dollar (or any currency) moves through a financial system. When you multiply velocity by the quantity of money, inflation is the result. Since the Great Recession of 2007-2009, the Federal Reserve increased the money supply by a staggering 134%, which should have sent the Consumer Price Index (CPI) soaring. However, despite the continued increase in money supply over that twelve-year period, inflation actually weakened. The reason is that the velocity of money declined by a greater amount than the money supply increased. Velocity is predominantly a psychological phenomenon that lies just beyond the Fed’s reach. Velocity will only rise when people spend their dollars more quickly in expectation of the same goods and services costing more in the future. In this regard, the Fed has been largely ineffective in altering consumers’ perceptions despite their unprecedented efforts.
Many theorize that the Fed will be unsuccessful in its mission to further increase inflation in light of their utilization of the very same methods that kept its previous 2% inflation target elusive for over a decade. Given the Fed’s recent track record, we can hardly blame those who have disregarded this new inflation mandate as just lip service. Normally, we are first in line to question the efficacy of monetary policy. This time may be different however, and we are increasingly confident that the Fed may eventually be successful in its bid to raise our cost of living. In fact, the Fed and other central banks may find it difficult to put the inflation genie back in the bottle once released, courtesy of the $52 trillion in newly minted global currencies since the end of 2008.
Success of the Fed’s new policy would presumably mean higher inflation, a weaker U.S. dollar, and potential outperformance for many investment areas that have been largely shunned during this decade-long economic expansion, such as commodities, precious metals, emerging market equities, stocks in the materials sector, and foreign currency denominated assets. Most investors may be caught off guard by the return of higher inflation and slow to rotate into these areas that may benefit. However, Peak has been steadily preparing over the last several quarters for this change in the inflation regime by actively maintaining and at times increasing exposure to these inflation-friendly investments. Looking back at the third quarter, perhaps investors are starting to align with our point of view, as evidenced by many of these assets outperforming the S&P 500. For example, we observed precious metals, materials sector stocks, and emerging market equities return 12.5%, 11.9%, and 10.2%, respectively.
Many of these monetary policies may create negative long-term side effects and exacerbate near-term issues such as wealth inequality, over-indebtedness, and lower real growth (defined by a country’s growth rate less the inflation rate). That all said, Peak isn’t the one dealing the cards. It is the elected and appointed officials around the world who are responsible for enacting policy; our goal is to position portfolios to best take advantage of whatever that may be, and whenever possible, to stay a step ahead. As Jerry Garcia intoned in “Truckin’”, “You’ve got to play your hand”, which is precisely what we intend to do.
Regards,
Peak Financial Management
