This past month when our Investment Committee reconvened after the Fourth of July holiday weekend, we could not help but notice that many of us were recalling our various dinner/picnic conversations with family and friends, which had inevitably touched on this idea that we, as a society, may be embarking on a path that is altogether new. The data is showing that 54% of employees would like to continue working from home1, the number of births in the US dropped to its lowest level in forty years2, and 1 million more people retired over the past year than was expected. The quarantine has affected us in ways that will ripple on into the future3.
Unsurprisingly, this “new normal” narrative is also starting to be applied to the stock market given its unprecedented performance. The S&P 500 has now increased by more than 5% for five consecutive quarters. This has only occurred one other time since 1945.4
Yet, in an environment like the one we find ourselves in, when both optimism and trepidation abound, it is helpful to try, as much as possible, to isolate our emotions from our investment strategy. By looking at the fundamental data points, we can create a diversified portfolio that can achieve our goals over the long-term. We believe that with this pragmatic approach, we can answer three of the most pressing questions investors face today:
Will Interest Rates and Inflation Rise?
- Yes, interest rates will rise over the next year. Currently, the Federal Reserve is purchasing around $80 billion in US treasuries each month.5 This has created an artificially high level of demand for the government’s debt which has held interest rates at low levels. As the economy continues recovering and inflation continues to creep up, the Federal Reserve will be forced to decrease the amount of debt they are buying and allow interest rates to rise higher.
- We will not experience the same type of rampant inflation and high interest rates that we saw in the 1970s. Unlike the 1970s, we are witnessing negative demographic trends (shrinking workforce, aging population) and this inflationary force appears to be temporary. For example, more than half of the total increase in inflation over the past two months has been due to price increases in cars, hotels, and airfare.6 As supply chains improve, these categories will return to more normalized levels.
- Although we do not expect to see persistent inflation that will last more than a few years, we do believe that it will be an important factor over the next 12-24 months. This period of time will potentially be very painful for individuals that are holding a significant amount of cash above and beyond their safety net in a bank account because these funds will continue to lose real value over time.
What Effect Will Tax Increases Have on the Market?
- Looking at the political environment, we expect that Congress will pass legislation that will result in both an increase in the corporate tax rate (from 21% to something closer to 25%) and an increase in the income tax rate of the wealthiest Americans (to 39.6%). While the tax revenue from these increases will help finance the country’s infrastructure improvements, it is important to realize that the positive benefit of such projects will be spread over multiple years because historically it takes a long time to start and complete large projects like highways, etc. This contrasts with the negative (and more immediate) impact that the tax increases will have on the stock market.
- The proposed tax increase on corporations will move the United States from having the 12th highest corporate tax rate in the world to the 4th.7 We expect companies within the technology, consumer discretionary, and healthcare sectors to be hit the hardest since they often pay the lowest average tax rates today.
- The top 1% of income earners in the United States own over 40% of all equities in the stock market.7 As a result, the proposed income tax increase on the wealthiest Americans will lead to an increase in demand for municipal bonds (which pay investors income that is tax-free at the federal level). We would also expect wealthy individuals to allocate more of their money into Roth IRA accounts which provide tax-free growth on investments.
Are We in a Real Estate Bubble?
- Although many news pundits have looked at the continued rise in real estate prices and made comparisons to the real estate crisis of 2008, those comparisons are misleading. The real estate market, although highly valued, is not in an unsustainable bubble. The problem stems from the fact that the United States has underinvested in its housing market for the past decade. For example, in the 1970s, we were building over 50,000 homes per 1 million people. During the last decade, that number dropped to less than 25,000 homes.8 To make matters worse, the current supply chain issues and rapid increase in the price of home-building materials, such as lumber, have discouraged builders from constructing as many new homes.
- This lack of supply is being met with a rapid increase in demand not only from individuals looking to escape congested cities in a post-quarantine world, but also from millennials who now compose the largest group of home buyers. Over the past five years, the percent of 18-34-year-olds (millennials) that were living with their parents rose to above 30%, the highest percentage ever recorded.3 As the economy recovers from the pandemic, these young professionals will begin earning higher incomes and adding even more demand to the real estate market.
- As a result, we do not expect the real estate market to crash but rather the growth in prices to decelerate over time. We think that specific areas of real estate (ex: multi-family home REITs) may perform very well over the next year while also providing a hedge against inflation.
The one remaining question that we have not answered above is, “Will the stock market enter another recession soon?” While no one has a crystal ball, us included, we think it is worth noting that since the COVID-crisis began, American households have been able to add $2.6 trillion in excess savings.3 As the world continues to reopen, this money will be spent on goods and services, which will help increase corporate earnings, and add further support to the stock market.
Despite this reduced risk of any near-term recession, however, we do expect continued volatility in the market. This will be particularly true as we enter the fall season and Congress comes back from their summer recess and the Federal Reserve meets to decide what to do with interest rates.
The Glen Eagle team wishes each of you a happy, safe, and relaxing summer season with your family and friends,
The Michel Team
Susan, Rob, and Carol Ann
Disclosure: This commentary is furnished for the use of Glen Eagle Advisors, LLC, Glen Eagle Wealth, LLC, and their clients. It does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific objectives, financial situation, or particular needs of any specific person. Investors reading this commentary should consult with their Glen Eagle representative regarding the appropriateness of investing in any securities or adapting any investment strategies discussed or recommended in this commentary.
1) MFS Research “By The Numbers” 2) MSN News “US Births Fell During Pandemic In Largest Drop Since 1973” 3) Apollo Research 4) Barrons – The Stock Market Is Historically Strong. Not Even the Delta Variant Can Stop It. 5) Nasdaq “Fed tiptoes towards the taper stage months before the curtain call” 6) Guggenheim Research “Inflation Is Spiking, But You Only Reopen Once” 7) BofA Global Research “The RIC Report” 8) National Association of Home Builders, Madison Hoff/Business Insider