Into the Next Frontier Into the Next Frontier 2021-1 (May)With some apology, this is going to be longer than my normal commentary. As we know all too well, this is an uncommon time – and for the past 6 months, I have been quietly listening and observing as the transition toward a full reopening of the economy has gradually unfolded. There is a lot to unpack – the scope of the interrelated themes is rather mind-numbing – but this one may be important to read through to the end … It is no secret that the economy is in most respects resurgent, and optimism – or a measure of relief – is rebounding in concert. Though few envision a quick return to the full “normal” that we left more than a year ago, the comparative increase in freedom of movement and ability to engage in more of the activities we both enjoyed and took for granted is deeply energizing.Economically, a lot of big positive numbers are appearing in front of us now – monthly, quarterly, and/or year-over-year gains in retail sales, hospitality sector activity, corporate earnings, overall GDP, and more. It is a refreshing change of direction.With all of that said, from an investment perspective, we must not let the sense of economic relief lull us into complacency, as circumstances remain exceedingly dynamic. As we proceed, exciting opportunities should continue to develop, but they present themselves in an overall environment of exceedingly high risk. Let’s begin with the economy…• Manufacturing, though only a small part of the overall economy, has become a consistent source of strength since its rebound early last summer. There are areas of concern – disrupted supply chains, shortages in key components (Ford and General Motors announced cuts in vehicle production in early April due to a worldwide shortage of semiconductors), a shortage of raw materials that supply the huge plastics industry, major logistical problems with both supply and location of shipping containers worldwide – and demand growth appears to have peaked. Despite all this, manufacturing production in broad terms has recovered and is for now running at or above pre-COVID levels.• Retail sales were resurgent last summer and have remained generally strong. A period of weakness in February was largely attributed to the winter storm that impacted much of the country; March sales accelerated again by a huge 9.8%, fueled by the $1.9 trillion Federal relief package and strong gains in jobs. Though April sales were unable to sustain that momentum, retail is expected to remain robust for the foreseeable future.• Services, particularly in the hospitality and travel sectors so devastated by the pandemic, are responding to the economy’s reopening as was anticipated, with pent-up demand expected to sustain a powerful surge. Given the optimistic projections, the ISM Services Index surprised many by dipping in April, but that was a slight decline in a very strong set of numbers over the past two months.• Housing, perhaps the most vital area of strength through the heart of the pandemic, is now lagging, slowed by tight inventories, escalating home prices, and higher mortgage rates. Purchase applications are declining, and mortgage demand has progressively declined in recent months.• Corporate earnings are booming. As of May 21, with 95% of S&P 500 companies reporting, the blended year-over-year earnings growth rate was 51.9%, a level of growth not seen since Q1 2010. Up the road is the potential for a corporate tax increase, and companies are carrying a lot of debt that may ultimately weigh on profit margins if interest rates materially rise – but for now they have been able to extend loan terms at low rates and are generally showing good overall balance sheet liquidity.• Employment has been in more ways than one a very bifurcated story of haves and have nots – the nature of the pandemic arbitrarily cutting much of the economy in two, with employees falling victim to the capriciousness of the circumstances. Jobless claims remained persistently high through mid-February at extremes exceeding the worst period following the Financial Crisis of 2008, but they have since mid-February maintained a steady and significant pace of week-toweek decline. New jobs are a different and more complex story, which we will address in more detail below.• GDP has begun what is expected to become a powerful rebound. After growing at an annualized rate of 4.0% in Q4, GDP came in at 6.4% for Q1, and projections for the current quarter are generally in double digits. After the year we have endured, the substantial headline indications of recovery are certainly welcome. At the same time, from the perspective of economic analysis, we must remain aware that the top line numbers may not always reflect the full context. As an example, two very strong quarters of growth still leave GDP slightly below the level of December 2019; in the April 8 Federal Open Market Commitiee minutes, despite forecasting the strongest near-term growth in 40 years, “participants agreed that the economy remained far from the (Fed’s) longer run goals and that the path ahead remained highly uncertain”. In a further insight from Hoisington Investment Management, “GDP measures new output, but it has no capability of subtracting from the output measure the destruction of wealth caused by the pandemic and the economic shutdown response.” Thousands of businesses are simply gone; realistically, it may take longer than many are suggesting for much of the economy to fully recover. As a further complication, many parts of the data are still deeply distorted. Economic data can sometimes be difficult to interpret even under the best of conditions – the numbers are filled with things like “seasonal” adjustments, “mix” adjustments, “heuristic” adjustments (look that one up if you’re not familiar and don’t mind keeping your brow knotted for a while) – and the adjustments can be substantial. The intent of all the adjustments is to smooth out aberrations and place the month-tomonth data into a more consistent context, but the result often leaves something to be desired – one of the most oft-cited examples being the fact that food and energy prices are not included in the “core inflation” data because of their volatility. Add to these “everyday” complexities (a) the abruptness and severity of the pandemic-induced downturn, (b) the extreme dichotomy between segments of the economy which were largely unaffected and others which were deeply damaged, and (c) the epic scale of stimulus funding that has been infused into the system – and any analysis of the data being presented as we emerge from it all becomes subject to considerable uncertainty and potentially significant errors in interpretation. As if we needed a further twist, this economic cycle has been greatly accelerated by the unique nature of the event itself and the scale of the government response – so everything is coming at us at a pace we have never experienced before. The bottom line – we are still a long way from a truly clear picture of our economic reality. Moving from an economic perspective to an investment management perspective, an initial question is the degree to which the economic resurgence we are currently experiencing is “old news” – and has thus already been priced into the market. Market direction from here is as complex to assess as the economic picture, with strong and in some ways compelling arguments on both sides. There are numerous interrelated themes to consider … Employment – A reopening economy added well over 800,000 jobs in March. Most observers expected even larger gains in April; the actual number came in shockingly low at just 266,000. A part of the shortfall has been attributed to the apparent reluctance of some of those receiving unemployment benefits to return to low-paying jobs; data from Bank of America suggests there is more to this than meets the eye, as average pay being offered returning workers is in many sectors lower at present than before the pandemic. However true, these issues are reasonably expected to balance out over the next few months. Another theory is that there may be data-adjustment issues, which is also plausible for reasons noted above. However, it could be a mistake to overlook more systemic issues. It appears that a subset of those who were laid off have decided after the experience of being away for a year that they want to move in a different direction with their lives and simply are not coming back; this becomes an incremental addition to a very concerning shortage of immigration labor that continues to build across a wide range of fields, regardless of one’s personal opinions surrounding the politics of it all. The particular dilemma we could be facing became evident with the release of the JOLTS (Job Openings and Labor Turnover) report on May 11: there are now 8.1 million job openings, nearly as many as the entire base of unemployed persons. In the blink of an eye, it seems the narrative has flipped from a shortage of jobs to a shortage of workers. That is a very different problem with different implications. Again, things are quickly evolving, so this gap should begin to close, but there is an apparent disconnect between available jobs and available workers – some of it an inability of the worker pool to deliver the skills needed by employers, some of it an unwillingness to work for the wages being offered. A persisting failure to materially close this gap would raise the risk of a significant acceleration in wage growth; we’re already seeing numerous reports of major employers increasing wages and offering other incentives. Some observers feel this will be merely a temporary adjustment; we shall see. Inflation and Interest Rates are two different things, but particularly in a world economy dominated by central banks, they are intimately related. In combination, they are at present a critical issue and a source of considerable debate. In the minority are those like Hoisington, which argues that the wealth destruction and business closings caused by the pandemic are overlooked deflationary forces, creating a void that could take years to fill, and that the even more massive government debt we have accumulated is a further deflationary drag on the overall economy. Much more prominent are those on the other side, arguing that the tremendous expansion in the money supply, rising commodity prices, and emerging wage pressures will almost inevitably trigger a surge in inflation unlike any we have seen for the past 40 years. Downplaying both sides of the argument, the Federal Reserve maintains that they expect any inflation increase to be “largely transitory” as the economy readjusts, and market bulls tend to agree. Transitory or not remains to be determined, but cost increases are clearly emerging across much of the economy. Wage growth in particular is being closely watched. The market delivered a nasty reaction during the week of May 12 to the release of economic data showing that wage costs appear to be heating up. It is notable that total wages as of March 31 were already 1.16% higher than the last pre-COVID tally from February 2020 … with over 10 million people still out of work. Also worth noting – in a typical recession, wage growth for those who remain employed slows and sometimes reverses; we are emerging from a recession in which wage growth never fell. Over the next several months, potentially 5 million more workers will be getting back onto payrolls, which will without question raise income from employment in absolute terms. Market reactions to inflation data are not typically due to inflation itself, but to its likely effect on interest rates. Economically, rates are critical to demand – for cars, houses, corporate finance, and more – and much of the market’s climb to new highs has been justified by historically low interest rates. Any suggestion that rates may be poised to materially increase is unsettling to the market. Treasury Secretary Janet Yellen’s announcement on May 4 that “it may be that interest rates will have to rise somewhat to make sure that our economy does not overheat” triggered an intraday selloff of over 1.5% in the S&P 500 before she quickly backtracked, saying she was “neither predicting nor recommending” a rate rise. However, if I may be forgiven for repeating her original statement, the reality is that it may be that interest rates will have to rise somewhat to make sure that our economy does not overheat. Should any market reaction begin to snowball, particularly as a consequence of a rise in interest rates, two other themes come into play … Valuations are another hot topic. There are so many ways of illustrating the extremely stretched valuation of the overall market, it can be exhausting to even consider. To “summarize” using one simple and well-known metric, the forward 12-month price/earnings ratio of the S&P 500 as of May 21 was 21.2, as compared to a ten-year average of 16.0. Current market commentary is filled with dozens of other illustrations, from every imaginable perspective. Not all agree with the assessment that the market is “overvalued” – market bulls argue that valuations are not unreasonable given current interest rates. It’s true that valuations are not extreme in every segment of the equity market, and they have tempered a bit over the past few weeks as the market has paused and earnings have continued to exceed expectations. It is also important to recognize that valuations alone do not typically cause market declines … but they can materially affect the magnitude of declines that are triggered by other events.Leverage is a less prominent topic than inflation, rates, and valuations. People don’t tend to worry a lot about excess leverage while markets are rising – but nasty surprises can emerge when things start to unravel. In simple terms, leverage is using borrowed money to buy securities; the benefit of leverage to investors is that it compounds gains – however, the reverse is also true – it compounds losses as well. The math on the downside can get ugly. If you have used leverage buy securities worth 5 times your own investment, and the security price drops by 20%, it wipes out your entire investment; if the price drops by 40%, you have lost your entire investment and also owe your lender an equal amount (doubling your loss), and that debt is normally due immediately.FINRA recently reported margin debt at record highs; at the end of March, it reached $822 billion, compared to $479 billion at this time last year – and margin debt is merely one very small component of the leverage currently embedded in financial markets.The recent GameStop spectacle was a highly publicized example of the use of borrowed money in the form of margin debt to leverage returns. It was followed by the sudden late March collapse of the little known Archegos family office portfolio; Archegos, which had managed to run up $50 billion in margin debt spread across several major international banks and brokerage houses, incurred almost overnight losses of $10 billion when prices of several securities materially dropped.As recently stated by one of our portfolio managers, “I don’t think people are grasping the significance of GameStop and the implications for everything else – the derivative markets for everything have become astronomical and publicly traded options used by retail and institutional alike are now a major part of that … Don’t underestimate how quickly this could all unravel, but not in an expected way.”Over the years, many hedge funds have successfully used leverage to turn investments in low yielding securities into very high yielding outcomes – but it can all go terribly wrong. The classic example is Long-Term Capital Management, with two Nobel prize winning economists on board, which in 1998 nearly brought down the U.S. financial system when a presumably “safe” but significantly leveraged bet went wrong. In summary, should labor conditions and/or various other factors spark a sharp uptick in inflation, the potential for a rate increase expands – and it does so in an environment of already quite stretched and deeply rate-dependent equity and debt valuations in a significantly leveraged market. Whatever the assurances being voiced by the Federal Reserve and many market participants, this is a very fragile set of circumstances, with conditions in place for a sudden downdraft and the potential bottom a long way below. March 2020 was an illustration of how quickly and dramatically things can change and might reasonably be considered a warning shot in credit markets. This is not a prediction – but we should be clear about our reality. When one is sailing higher and higher in a hot air balloon in the wake of a hurricane, it is wise to give careful consideration to the circumstances. This brings us to a review of the role that has been assumed by the Federal Reserve… The Federal Reserve Effect on the Stability of Markets – Correctly or not, “the market” has, particularly over the past 12 years, come to believe that the Fed can be relied upon to support it with low rates in good times and to bail it out in the event of catastrophe; correct or not, it at least appears from the nature and timing of various actions that the Fed feels considerable pressure to do exactly that. Whatever the truth, perceptions matter – a lot – and the perception that the Fed is there to ride to the rescue encourages professionals and others to take on greater risk and – with the availability of such low interest rates – more leverage. "Whatever the truth, perceptions matter - a lot..." This perception is based in large part on a progression of events that some would date from the 1998 Long-Term Capital Management (LTCM) crisis that was noted above. In the midst of the crisis, the Federal Reserve Bank of New York organized a bailout of LTCM by a group of major investment banking firms. That precedent was greatly expanded by the Fed’s bailout role during the 2008 Financial Crisis, when in the estimation of many the world financial system very nearly collapsed with a breathtaking suddenness. Among the initiatives launched by the Fed in the aftermath of the initial bailout was “quantitative easing” (QE) – direct purchases of Treasuries and other debt securities in the open market to increase the money supply in hopes of spurring economic activity. Historically, the Fed would simply have lowered interest rates to stimulate bank lending for this purpose, but with interest rates having been already lowered to nearly zero (in stages we will not explore here), normal interest rate policy tools had been largely exhausted.By 2013, the Fed had through two rounds of quantitative easing tripled its balance sheet from roughly $1 trillion to $3 trillion. When the Fed announced in mid-2013 the mere possibility of beginning to taper these asset purchases back, there was a sell-off in the bond market, popularly referred to as the “taper tantrum”. Hurried Fed assurances calmed markets, and the Fed actually resumed purchases, launching an additional phase known as “QE3” and expanding its balance sheet by another $1.5 trillion. (If we may digress, I would note that, prior to the then-epic, nearly unimaginable $700 billion bank bailout approved by Congress during of the 2008 crisis, the word “trillion” was in most contexts other than astronomy a nearly inconceivable mathematical abstraction. Now we toss it around in the area of public finance with nearly the casualness of something we might carry in our back pockets.)Skipping ahead to the present, the Treasury and the Fed, in concert, seeking to address the financial crisis precipitated by the COVID pandemic, have arguably crossed another divide. In the Federal Reserve Accord of 1951, the U.S. Treasury and the Federal Reserve reached an agreement to separate government debt management from monetary policy. Phil Miller, head economist at Strategic International Securities, makes the case that, with the Fed holding interest rates essentially at zero, the added government deficits created to fund the pandemic-related stimulus payments could not be sufficiently financed by demand from foreign and domestic buyers. As a result, the Fed has had to step in as the “’buyer of last resort’, … using its presumably infinite balance sheet to underwrite trillions of dollars in Treasury debt, essentially shredding its recent historical independence” and causing the money supply to explode – effectively monetizing the debt to keep interest rates below what would otherwise be natural market levels. Whatever the potential errors in interpretation of the details, the point is that this latest step was not merely another isolated response to a crisis – it was by default another step in at least a 23-year progression. Over this period, we have moved – particularly since 2008 – more and more deeply into uncharted territory. This is not meant as a specific criticism of policy – not an argument that actions taken, especially in 2008 and 2020, were not needed in one form if not another. This is intended merely to look with clear eyes at our current reality as we assess our potential path forward. If inflation does surge – materially and persistently – the Fed is in a trap. Keeping rates artificially low for two decades has directly facilitated the accumulation of historic levels of debt by the government and at the same time encouraged the accumulation of debt by corporations, by the financial system, by investors seeking to leverage returns – and the cost of debt is now more crucial than ever not only to all of the above, but also to the level of economic activity by consumers in the form of mortgages, car loans, etc. The Fed controls inflation by raising rates, but at this point, any meaningful increase in rates by the Fed could tank both the markets and the economy. "If inflation does surge - materially and persistently - the Fed is in a trap... " Unfortunately, potential Fed action alone is not the only concern. Market rates could suddenly rise regardless of the Fed’s target rate. The credibility of the Fed – the market’s confidence in its ability to maintain both the stability of the financial system and conditions favorable to investing – is critical to the risk-taking appetite of investors. This is a simple belief system. If a critical subset of the market concludes that the emperor is wearing no clothes – that the Fed’s ability to genuinely control such an overextended monetary system is a mere mirage – market rates could react – and a sudden rise in market rates could trigger some kind of credit event. We can’t simply assume the Fed will always be able to pull another rabbit out of its hat. From a fully considered perspective, conditions are in fact far more complex than many popular narratives would have one believe. Market forecasts at present are little more than guesses, and risk is far greater than most appear to appreciate. Once again, nothing about this is intended as a prediction. There are compelling alternate views; there are a variety of paths potentially leading out of this maze, including some likely not yet conceived. “Uncharted territory” does not by definition assure “disaster”; it does, however, suggest one should be particularly attentive.Taking an alternate view from the “glass half full” perspective, as we have consistently noted in prior commentary since much earlier in the pandemic, it is also true that … The painful but often profoundly productive process of “creative destruction” is in motion. It is launching improved business models, enhanced efficiencies, creative new solutions and new areas of economic development. A world of opportunity awaits because of the awareness and thought processes this crisis has forced upon us. Change – particularly very painful, undesired change – can be a powerful creative stimulant. So, among the legitimate variables in this very complex equation is the possibility that we could explode out of this crisis into a wave of economic progress unlike any we have seen in a couple of decades or more. That is a very different perspective from the one to which I have devoted much of this commentary – and I would add that the “risk” and “opportunity” perspectives are not mutually exclusive, as elements of both will likely manifest themselves over time, whether sequentially or in interrelated ways. As always, we do not know the future. Investment management seeks – sometimes projecting false confidence, in my view – to at least peer into the mist in an effort to gain some advantage in portfolio positioning. As we do so at this particular moment in time, we simply should remain aware that that the variables are far greater than normal and that we conduct our investment activity in an environment of significantly elevated risk – it is not business as usual. "All - professionals and individual investors - have no choice but to play this game. Any who think they can simply “stand aside” are deluding themselves.” All – professionals and individual investors – have no choice but to play this game. Any who think they can simply “stand aside” are deluding themselves. Inflation, should it materially expand, changes everything – changes the nature of how and where one must position accumulated savings to protect and hopefully grow its value.It will be important that we, together, continue to thoughtfully and carefully assess your portfolio positioning as elements of added visibility emerge, with attentiveness to the particular opportunities and risks most directly pertinent and potentially impactful to you. Given the scope of this commentary, it is also worth acknowledging a different set of risks. Our investment activity proceeds in the midst of an American culture that is deeply fractured. In one sense, this is the nature of our democracy – it was there in the often-bitter debates and mutual mistrust between Jefferson and Hamilton as each sought to imprint a very different stamp upon the form our government would assume – and such has it always been, as even the most well-intentioned and mutually respectful will passionately disagree in the search for consensus. But some eras have posed greater danger than others to the founding principles – imperfectly executed as they have always been – and it seems we have at this moment in time become dangerously fractured in an array of clashing social narratives. While seemingly beyond the scope of investment management, it is at the same time part of the environment in which our investments have the opportunity to continue to thrive or decline.Perhaps this is a topic we will try to unpack from an investment perspective in a later edition – if I muster the courage to subject myself to the inevitable crossfire from the corners of the political spectrum …For now, a few parting editorial thoughts on the matter… As my own children were growing up, and particularly as they came of age, I taught them to “question everything and think for themselves”. That requires doing some homework; it requires looking at all sides of an issue; it requires an uncommon degree of intellectual openness and honesty – so none of us truly has time to question “everything”. But it seems we cannot at the present moment afford to be intellectually or morally disengaged, because deeply important issues are in play. We will differ on particulars, and that is as it should be. But there is a lot of spin out there, on all sides of every emotional issue, and various groups seeking to gain control of the narrative – in the process changing the rules, redefining words, in some cases restricting access to information. Some of this proceeds from the standard culprits – economic self-interest, thirst for power, personal egotism, and the like – but much of it, even at the highest levels, appears to proceed from simple fear.I normally prefer to tune out most of the chaos and discord, but we as a nation may be in the midst of another defining moment – it seems we should all be informed and intentional rather than simply trusting others to tell us what we should think. As we engage with one another – hopefully with a greater focus on kindness and respect – it seems important that we try to talk less and listen more – deeply listen – to one another, and particularly to those who don’t already share our point of view.What is “right” can look different – can in certain cases be different – through the refraction of a different lens, from the legitimate perspective of a different life and set of circumstances – and so-called “facts” can be greatly dependent upon the context in which they are presented. That can be uncomfortable to us, because we like our “facts” in black and white. However, very often they are not.The good news, if we choose to see it this way, is that between black and white are not only “shades of gray”, but all the colors of the rainbow – and the shadings look different – are different – from different points of view. That is the reality of our world, and it is likely better that we together constructively embrace the beauty and opportunity represented by the complexity as we proceed – bravely and expectantly, I hope – into our next frontier. Fear is not the path forward. Gordon T. WegwartPresident, Chief Investment Officer This material contains forward looking statements; there is no guarantee these outcomes will be achieved. All investing involves risk of loss, and there is no guarantee that strategies which may have been successful in the past will be similarly successful in the future.