April 27, 2021

Over the last year, we have all dreamed of getting back to pre-pandemic life, but it seemed as though that might never become a reality. And yet, sentiment has recently changed for the better and a return to what we all think of as normal could be occurring soon. Vaccines in the U.S. have rolled out faster than expected, with projections that most adults who want to be vaccinated will be able to do so by late Spring. The economy has also begun to widely reopen at a faster pace as hospitalizations have meaningfully slowed, another significant Federal stimulus package recently passed, and more stimulus is likely on the way in the form of the proposed infrastructure bill. Forward looking measures of the services and manufacturing industries suggest that a strong rebound is ahead. Furthermore, job growth has picked up and has become more broad-based. As euphoric and welcoming as all of this sounds, it nonetheless begs the question—could this all mean that we may be on the verge of experiencing too much of a good thing? Are the growing fears of asset bubbles and uncontrollable inflation warranted?

Asset bubbles have often begun as the natural byproduct of extremely stimulative policies. Moreover, they are often fueled by a strong underlying fundamental theme and high accompanying investor confidence. The late 1990s were a classic example of how an over-exuberant environment can develop, and then persist, for quite some time before it ultimately unravels. In the current environment, signs of easy money abound with record-breaking fiscal and monetary stimulus available all around the world. Access to capital is high, particularly for early to mid-stage companies, and this is clearly demonstrated by record-setting SPAC (Special Purpose Acquisition Company) issuance, as well as general merger activity and traditional IPOs (Initial Public Offerings). The overall result is an environment where many young companies have gone public, which is in stark contrast to the environment just a few years ago when companies were staying private much longer. And for awhile, almost every recent SPAC and IPO seemed to trade at premiums to estimated values. More recently, though, sentiment has begun to shift. By mid-April, key measures of SPAC performance—such as the CNBC SPAC 50 Index—suggest that they have declined in value by almost one-fifth from their highs; and many stocks of newly public companies have had similar outcomes. Indeed, even though this area of the market continues to garner great attention, we are frankly encouraged to see some of the froth come off this space.

There has also been a lot of speculation in companies within the renewable energy industry. In the lead up to last year’s U.S. elections, alternative energy stocks remarkably outperformed traditional energy stocks by roughly 100%, according to an analysis by Schwab. This was driven by Europe’s Green Deal, along with President Biden’s emphasis on promised renewable energy initiatives. But the market’s exuberance for green energy began to wane in late January as oil prices rose, and as the market became more focused on potential inflation. Money then shifted away from renewable energy towards more traditional energy themes, with the energy sector leading the overall market with a return of over 30% during the first quarter. Meanwhile, many individual stocks in the renewable energy sector are still trading at elevated levels, but they are down 50% or more from their highs.

These certainly are not the only examples of excessive risk-taking that we have seen this past year. Just recently, the impactful collapse of family office Archegos Capital caused a major ripple through Wall Street and resulted in significant losses for several banks. Earlier in the year, many heavily shorted stocks—such as GameStop—experienced unprecedented volatility as retail investors and hedge funds alike speculated in the options market. Yet, through all of this, the broader market remained relatively unphased as sector participation actually increased, and the VIX—a measure of market volatility—steadily declined.

Inflation has also become a constant worry against the backdrop of the most significant ongoing stimulus effort that the country has experienced since World War II. Of course, this has been in response to the most dramatic and deliberate decline in economic activity and employment that the global economy has ever experienced. Nevertheless, as we now find ourselves in a situation where the data is showing great signs of improvement and more stimulus is likely on the way in some form of infrastructure spending, it further begs the question: at what point will an increase in economic activity lead to higher prices?

Many parts of the economy—such as consumer goods and building materials—have already experienced substantial rising prices, and this has led many to question the validity of typical measures of inflation (which have not moved much). However, these specific increases have occurred during significant COVID-19-related supply chain disruptions—mostly in form of labor shortages—and they were coupled with an unexpected surge in demand as home building, remodeling activity and general demand for goods increased as consumers shifted their consumption away from prohibited services, due to lockdowns, and towards goods. This could certainly reverse itself in the coming quarters as we all begin to participate in many of the service-related activities we have sorely missed over the last year. In turn, port congestion could lessen and prices could also decline as demand for these goods declines.

This does not mean that we will not see inflation begin to increase; but we expect that this is still further down the road than many are expecting. At the end of March, an estimated 9.9 million people were still unemployed in the U.S. This compares to 5.8 million who were unemployed in February of last year (just before the pandemic). Even though recent reports suggest that great progress is being made as the economy reopens, this will all need to continue and persist well after the massive stimulus goes away, before we anticipate that we will see any true signs of real inflationary pressure.

Collectively, in our view, many pieces are in place to facilitate both excessive risk-taking behaviors and eventual inflation; but thus far, we are not seeing signs that are so troubling that they will upset the current market. As always, we are paying close attention to all of the data, and we recognize that “main street” continues to need a lot of support to facilitate a broad recovery. At the margin, we have been positioning our clients’ portfolios for modestly higher inflation and have generally avoided areas of the equity market where excessive risk-taking has occurred, and we plan to continue to take this approach in the coming quarters.