Gill Capital Partners Early-May 2021 Market Update

We hope that all of our friends, clients, and partners are healthy and well as spring is bringing a return to normal activities for many. We have plenty of global developments to discuss, including inflation, corporate earnings, and the continuing economic recovery. We will get into all of these issues, and of course, provide our views on them, but first, a bit of humor.

Inflation

You may have noticed that recent financial headlines have been dominated by inflation-related stories. Input prices on items such as lumber and agricultural commodities have skyrocketed recently, which has been driving up prices on many finished and consumer goods. Why are prices moving so dramatically?

Let’s take a look at lumber. As shown in the chart below, the price of lumber soared this week to an all-time high of $1,359 per thousand board feet, and is up nearly 300% since the pandemic began.

Why? Quite simplistically, there is a global supply shortage. Homebuilders and consumers of lumber are scrambling to get product for upcoming summer projects, as homebuilders are building at a strong pace and low interest rates have driven up demand for remodel projects. The supply/demand mismatch was ushered in by the pandemic. During the early days of the crisis, sawmills halted production and unloaded inventory. At the same time, Americans, at home with nothing to do, rushed to Home Depot and Lowe’s to buy up materials for their do-it-yourself projects. Before sawmills could respond to the increased demand, another demand spike was initiated by the recession-induced, low-interest-rate housing boom and refinance home project boom. Existing home inventory is at staggeringly low levels and has pushed homebuyers to look for new construction. As of March, new housing starts were at their highest level since 2006. All of those new homes and backyard projects require lots of lumber. Why can’t sawmills just produce more lumber? Lumber producers only have so much capacity and increasing it requires time, investment, and confidence that prices will remain high. This was the perfect storm, so to speak.

Our view – Lumber is the most glaring example of the current raw material and commodity price spike, but similar stories are playing out with aluminum, copper, corn, wheat, cattle, etc. We are already seeing the impact of rising prices. If you buy groceries or are in the market for a new home, a remodel, or a new car, you are seeing the impact of rising prices. There is no question as to whether inflation is coming; it is already here. The questions that remain are “How high will it go? For how long? And, what will the reaction of the Federal Reserve be?” An old economics adage says, “The cure for high prices is high prices.” This is due to the law of supply; at higher prices, sellers will supply more of an economic good, thereby increasing supply, which will lead to reduced prices. Furthermore, the law of demand says that at higher prices, buyers will demand less of an economic good. Quite succinctly, when prices are high people will make more, and buyers will buy less, both of which will help bring prices down. Pretty simple, right? Well, yes, but in practice it is not quite that simple. Producers don’t always have the ability or the confidence to increase supply quickly or at all, so it can take time for incremental supply to come online. Demand, however, can change quickly, so we would anticipate this being more impactful over the near term. That being said, while we don’t care to speculate on prices, given the backdrop, we would be surprised to see input prices drop meaningfully in the near future.  Which brings us to the next and possibly more important question; What is the Federal Reserve going to do about it, if anything? Why do we care about this? Remember the Federal Reserve controls interest rates and the supply of money. These two important levers can have meaningful impacts on economic growth and the supply/demand equation. We haven’t seen a significant inflation shock in this country since the 1970s, which saw double digit inflation and led then Federal Reserve Chairman Paul Volcker to take dramatic steps to reign in inflation. Chairman Volcker worked relentlessly to bring prices under control; he raised the Fed’s benchmark interest rate from 11% to 20% by the late 80s. These were tough times for the economy and investors. We do not bring this up because we think we are headed for a Paul Volcker-style inflation fighting scenario; in fact, quite the opposite. We see very little appetite today by fiscal leadership, constituents, and, most importantly, the Federal Reserve itself, to embark upon a painful inflation fighting journey. The Federal Reserve has been clear that they are okay letting inflation run a little hot while the economy recovers from the extraordinary events of the past year, and that they view the inflationary issues of today as largely transitory in nature. We do anticipate them slowing their asset purchases at some point in the not-too-distant future, which could let interest rates for mortgages, loans and bonds drift higher, but for now they seem content on letting the market forces of supply and demand sort this out on their own. This continues to be an area of focus for our investment committee and we are watching closely.

Corporate Earnings and Recovery Check-In

Corporate Earnings - We are in the heart of corporate earnings season, with more than half of the companies in the S&P 500 having reported earnings for the first quarter. Among those companies that have already released results, 86% reported that their earnings per share were better than analysts expected. That is the highest positive surprise percentage since 2009.

Economic Recovery – With a significant portion of the country now vaccinated, the economy is coming back to life. The chart below, courtesy of our friends at JPMorgan, is one of our favorites. It shows “high-frequency” data such as hotel occupancy, TSA traffic, and navigation app usage. As you can see, many of the data points are at or near pre-pandemic levels, with airline, hotel and restaurant traffic still working their way back.

Our view – The economy is healing and corporate earnings are strong. As we have outlined previously, economists anticipate seeing the strongest pace of economic growth that we have seen in some time. Higher prices and supply chain issues might put a dent in the pace of growth, but the recovery is in full swing. Continued good news and growth is already priced into the market, so this economy and individual companies will need to continue to deliver to justify the current stock prices. So far, they have risen to the challenge.

As always, please let us know if you have any question or concerns, or if we can provide assistance with any other financial planning matters including education, taxes, insurance or estate needs.