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Michael Godwin HeadshotBy Michael Godwin, CFA®

In early September we held our annual panel event where we discussed the market returns since the depths of the pandemic, the current macro-economic environment and where we see the markets headed going into 2022. Additionally, many clients submitted poignant questions on a host of key issues, and in this blog, we are sharing some of the most common inquiries and answers. Once again, we thank those of you who attended this virtual event, and if you missed it, you can view the replay here.

 

Q: What are your views on inflation and how will higher inflation impact portfolios?

A:
A recent spike in inflation figures has pitted many investors and policy makers against one another with some making the case that inflation pressures will subside as the economy normalizes and others fearing that we’re headed for a 1970s style era with low growth and high inflation.

Our current view is that near-term inflation will likely come in above the 2% long-term Fed target and certainly above the average inflation rate we’ve seen over the past 10 years, which was 1.8%. However, we believe that once the bottleneck constraints are addressed, inflation will settle at a reasonably low level, and it shouldn’t pose much of a problem for either fixed income or equities—especially as the Federal Reserve finally begins to take action.

Nevertheless, it is prudent to prepare for scenarios where inflation may end up being persistently higher than Fed expectations. In that event, asset prices may be impacted in a few ways:

  • Stocks
    • High inflation can reduce earnings as companies struggle to raise prices enough to offset higher input costs and higher employee costs, resulting in reduced profit margins.
    • Price-to-earnings multiples can fall as rates rise and bonds begin to look more attractive in comparison.
  • Bonds
    • Most bonds offer a fixed payment (coupon) that is paid to investors twice a year. If the fixed coupon is less than the inflation rate, then the investors’ “real rate of return” is negative. This negative return naturally gets worse the higher the inflation rate.
    • Bond prices fall as interest rates rise in response to inflation.

We look at managing this risk in several ways. First, we generally favor the stocks of companies that can pass on cost increases to customers. Second, be wary of long duration bonds, which lose more value than short-term instruments as interest rates rise. Another option might be floating-rate bonds whose coupons adjust with prevailing interest rates. Finally, consider assets that tend to do well in low-growth, high-inflation environments should the current outlook prove too optimistic.

Q: Should cryptocurrencies play a role in my portfolio?

A: Like art, collectibles, precious metals, and foreign currency holdings, cryptocurrencies should not play a major role in investment portfolios. Simply put, because the expenses and debts of most investors require payments in U.S. dollars, most portfolio holdings (stocks and bonds) should produce income in U.S. dollars.

There are a few additional cautions that apply cryptocurrencies. Despite the meteoric rise in prices for some of these assets and a decade of history, the market is still in its very early stages. Technologies are changing rapidly, and a vast majority of cryptocurrencies have little to no mainstream usage. Instead, the market is still dominated by speculators purchasing the assets primarily for their potential to appreciate in price. Regulation also poses an existential risk—China is attempting to outlaw crypto transactions altogether! Many cryptocurrencies are likely to lose 100% of their value over time even if the asset class itself continues to grow.

That said, this does not mean that one should never purchase a work of art, stock in an early-stage business, or a cryptocurrency. A good (or lucky) selection could produce spectacular gains, as in the case of bitcoin since its inception. Rather, such speculations should be limited and diversified relative to the core investment portfolio.

Financial advisors and portfolio management professionals at Fragasso Financial Advisors cannot advise on or invest in cryptocurrencies on your behalf. This purpose of this content is to purely educate those interested in this popular topic and asset class.

Q: Will government spending and the proposal to increase taxes have a material impact on the markets?

A: We don’t see an increase in taxes and spending alone as materially impacting the investment outlook. For example, Biden has proposed an increase in the top marginal tax rate to 39.6%, a rate that prevailed for most of the Clinton and Obama years when the stock market performed well.

However, we are aware that at some point the U.S. could reach a fiscal tipping point. The explosion of debt-to-GDP over time is one potential cause for concern. Typically, if a company or government has a significant amount of debt, investors would demand a higher interest rate on the bonds that are issued. Post-global financial crisis, this has failed to materialize in the U.S. as interest rates remain at historic lows due to a variety of factors including demand from foreign investors and the Federal Reserve’s purchase program.

But, as we move into 2022, the Federal Reserve will begin to pare its purchases of U.S. Treasury bonds. The country’s relationship with China—a large buyer of bonds—is increasingly antagonistic. Budget fights might also impact opinions of U.S. credit quality. Therefore, a failure to raise the debt ceiling and pay debts could be catastrophic. And while a tax hike would ordinarily help reduce debt, proposed spending increases more than offset the near-term benefit.

As with many issues affecting the market, a modest (and predictable) swing in tax policy is no reason to make rushed changes to portfolio positioning, but it does highlight certain fiscal risks that have been present for years.

Q: With the recent surge in real estate pricing, are we in a “bubble”?

A: We don’t believe we are in a housing bubble at the moment. Low interest rates, an exodus to the suburbs, and strong consumer balance sheets (personal savings rates were close to an all-time high last year) all combined to drive real estate prices higher.

Another reason for the increase in housing prices is because there has not been enough supply created to offset the demand. Post 2008, homebuilders significantly decreased the number of new homes being built. COVID accelerated the surge in home prices over the past year. Going forward, we believe home prices will begin to cool. First, homes are beginning to sit on the market longer. Second, sentiment surveys are showing that consumers are finding it to be a terrible time to buy a home. So, we expect home prices to cool, but certainly not burst. Despite high prices, most current homebuyers are gainfully employed with meaningful down payments and good credit scores and are purchasing homes to live in rather than flip—vastly different conditions from the last housing bubble.

As 2021 comes to a close, we recognize that challenges are likely to remain prevalent both in our daily lives and within our portfolios. We’ll need to continue applying the practices of pivoting and remaining flexible that we all have become accustomed to over the past year and a half to work toward our financial goals. Rest assured, as a client of Fragasso, you have the consistent oversight and the proactive management of our in-house portfolio management team on your side.

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