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Eureka Wealth Solutions February 2021

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Quote Of The Month

Fixed-income investors worldwide – whether pension funds, insurance companies, or retirees – face a bleak future… bonds are not the place to be these days.

-- Warren Buffer, in Berkshire Hathaway's annual investor letter

Economic Highlights

  • The COVID-19 vaccinations continue, with the third vaccine approved, and expectations of economic recovery accelerate.

  • Personal Income jumped 10% in January, and consumer spending was up 2.4%, as a result of December legislation.

  • Business equipment spending and housing activity continued to increase in signs of economic improvement.

  • Payroll employment was essentially unchanged in January.

  • Commodity prices and especially oil are on the rise.

 

Market Highlights

  • US Equities rallied in early February, but gave up some of the games, with the S&P 500 Index closing up 2.8%.

  • Foreign Developed Markets also added 2.2%, as did Emerging Markets, up 0.8%.

  • US high-grade bonds lost -1.4%, while the high yield was flat for the month. Foreign bonds were mostly down, with high-grade and Emerging Markets bonds down -2.6% and -1.3%, respectively, but high-yield bonds managed a 0.7% gain.

  • Commodities led all asset classes, up 6.5%, helped by the suddenly surging oil, up 18.0%, while gold lost another -6.1%.

  • US Dollar added 0.3%, stabilizing after last year’s slide.


 

Observations and Expectations

Last month, we noted that consolidations as well as corrections are inevitable and healthy parts of market cycles.  The long-term trend remains bullish, but the market may be vulnerable in the short term.  It is, in fact, what appears to be happening in the markets.  As broad indexes of S&P 500 and Dow Jones Industrials show, the overall market had a slight hiccup and went straight back up to the new highs.  It’s the NASDAQ index that is down and even briefly dipped into the correction territory.

The three major forces moving the markets in the last month or so can be identified as follows:

  1. Consolidation of equities that benefited the most from the pandemic-induced structural changes, mostly technology

  2. Rotation into pandemic-affected equities such as basic resources, travel and leisure, with the rapid vaccine rollout increasing confidence of impending return to normalcy

  3. Rising rates and inflation

More on the last point in our Question of the Month.  Looking forward to March, we look past the recently passed COVID-19 stimulus bill.  The only impactful potion of the bill on the economy appears to be the highly publicized $1,400 individual checks.  While some families will get the much-needed financial relief, there’s a lot of anecdotal evidence that that last such check went, by and large, straight into the market.  It is reasonable, therefore, to assume that the same situation will play out again, boosting equities or having already had the effect of such an expectation.  The next items on the Biden Administration agenda appear to be a tax hike and an infrastructure spending bill that could have profound effects on the economy, depending on the specifics.  We’re watching for promising cyclical recovery plays, especially in financials and real estate, as well as industrials and basic materials, while keeping an eye on the over-corrected technology plays.
 

Sector Update

Technology is rarely found in the red spot. While its long-term hegemony is hardly in doubt, the recent market activity suggests that technology stocks as a sector may have gone too far too fast.  As a result, a period of retracing and consolidation is both expected and warranted.

Financials as sector had the second-best month and the best on the risk-adjusted basis.  In addition to the cyclical recovery, the sector is the single biggest beneficiary from the rising rates and inflation. Banking and insurance companies are as healthy as they have probably ever been and continue producing steady profits for shareholders.

Impact Investing remains firmly in the spotlight.  With the US officially rejoining the Paris Climate Accord, more ETFs, private funds and SPACs continue to form to absorb a huge investor demand.

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Question of the Month

This is where we answer the best investment question we’ve heard all month. If you’d like your question to be considered, please send it to us.

Question

What causes rates and inflation to rise and how does it affect asset prices?

Answer

With interest rates and inflation remaining at unprecedented lows for over a decade now, every time there’s even a suggestion of a possible increase the markets seem to go into a cardiac arrest.


All this time, several short periods of time notwithstanding, the Federal Reserve has been setting its policy to be highly accommodative, keeping the rates very low.  Yet, in February the long-term Treasury yields started climbing.  Why?

The main issue is the expectations of rising inflation.  Inflation means that the future payments of bond coupons won’t be able to buy as much in the future as previously thought, making the bonds less valuable and, in turn, push the yields higher.  The reason the inflation expectation has changed is partially because of the speed of the COVID-19 vaccine rollouts and also because of the newest $1.9 trillion stimulus bill. Globally, the IMF now expects growth this year at 5.5% vs. 3.5% last year.

Now, the bond situation may be fairly straightforward, but what often baffles even seasoned investors is how does this affect stocks.  In simplest terms, the capital markets theory states that the fair value of equity is the sum of its discounted cash flows.  So theoretically, you can add all the earnings that a business projects to make in the future and return to shareholders via dividends or reinvestment into the business, discounted at a certain interest rate, to arrive at today’s present value.  You can debate the practical rigors of modeling these future earnings.  However, when the only part of the equation that changes is the discounted rate going up, the present value of equity unequivocally goes down.  A more intuitive way of looking at it is that the future earnings of a company look more appealing on a relative basis if the rates are low and less so if the rates are rising.

However, the actual impact on equities depends a lot on some business specifics, starting with the sector.  Below is the chart of the typical equity price effect of the rising rates.  Financial institutions are typically the biggest beneficiaries of rising rates due to the improvement of their lending rates.  Other cyclicals are also typical beneficiaries, since rising rates and inflation usually mean an economic expansion, and the rise in their growth rates are expected to trump the rise interest rates.  Real estate sector is more nuanced. Different types of REITs react differently to rising rates, as we explained back in November 2018 newsletter.  Finally, the slow-growth defensive stocks that pay out steady dividends will be most negatively affected, since their dividends will become less attractive, much like bond interest.

Fixed income investors should consider the following hedges against rising rates and inflation:

  • Floating rate bonds and bank loans, which will increase the payouts as the rates rise

  • Short-duration bonds, which will minimize the effect of rising rates

  • Bond ladder, which stacks fixed income instruments of various duration with the same idea of minimizing the rate risk

Another common hedge is real assets, including residential real estate and precious metals.

However, it’s worth noting that while a threat of inflation and rising rates is real, it is by no means a guarantee, and there’s certainly no reasonable expectation of a hyperinflation. Inflation also doesn’t come without some positives. Knowing the risks and benefits can help investors avoid rash decisions and align their investments with their long-term goals and risk tolerance.

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The materials presented above serve informational purpose only and do not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. The author, Eureka Wealth Solutions, LLC, and/or its clients may hold positions in the ETFs, and/or any investment assets mentioned above. Folio portfolios that may be presented are created by Eureka Wealth Solutions, LLC, and are available for purchase through Folio site.  Indices and trademarks are the property of their respective owners.  There are risks involved in investing including possible loss of principal.  Performance results of individual securities and portfolios are not indicative of overall client account performances. Past performance does not guarantee future results.
 
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