All is Good Except For This M2 Chart
Another crazy quarter and another quarterly letter. What’s new is that the value space and particularly the small value space is finally getting its 15 minutes of fame with a 20%+ year-to-date gain in the Russell 2000 Value. While it is admittedly tough to predict the future, it is sometimes also hard to believe the past. Our strategies are performing well, and here’s a link to our recent performance. A discussion of our top and bottom contributors to performance follows this commentary.
With the market up so much, and GDP revisions moving higher, I am pleased to report that everything is great. The market itself is the best predictor of a strong economy ahead, and that’s what we see. It is a great awakening of productivity from the boundaries of daily commuting for billions of people, and the realization that all the knowledge of the world is connected in real time to fuel new ideas. New ideas drive productivity which lead to better lives. It’s a time when less incremental capital is needed to drive the capacity and distribution of goods and services that are increasingly digital and idea driven just at the time that value added ideas are evolving faster and spreading at a faster rate and at lower cost. Capital is increasingly abundant and therefore cheap, while great ideas remain scarce, raising the cashflow multiple on high conviction annuities. The U.S. 10-Year Treasury bond yield of 1.5% means a 66.7 multiple on the pretax coupon, for example.
So, everything is looking pretty good. Except for this money supply graph we dug out.
Isn’t that an interesting chart? Inflation that erodes the future purchasing power of investors is one of the few things that could creep into the landscape of our good times and cause some bad feelings among asset owners. It turns out that adding money to the money supply at a faster pace than the dollar growth in GDP is viewed by some as potentially inflationary.
A reason to mention it even though everything’s great according to the stock market, is that there is a pretty good inflation forecasting metric, namely the 10-year breakeven inflation rate* published by the Federal Reserve, that has been going straight up. A good economy and an uptick in inflation certainly do not have to be mutually exclusive, as 10-year inflation could tick up a bit, now estimated around 2.2%, and returns over that period could still overcome that hurdle, or maybe not. If the current trend continues, history suggests that could be a little headwind to equity markets due to pressure on real returns.
The 10-yr B/E metric turns out to be a pretty good predictor, at least up to the most recent 10-year prediction in 2011, with an r-squared of 27%. And therefore, unfortunately, it is also a pretty good predictor of real equity returns.
It’s been an interesting time to navigate equity markets, and inflation is the kind of thing we worry about. When we think about the themes that are apt to deliver good returns over the next decade, our attention is drawn to companies that sell products that, in addition to being proprietary, are also necessary. These tend to be the type of products that can raise prices faster than their factor input costs rise. Products that improve productivity will tend to gain share faster during inflationary periods, in our view, so we look for that. Sometimes small companies are quicker to benefit from one or two great products gaining share and are also easier to identify, since the gainers can more quickly become a reportable percentage of total revenue.
Our portfolio is always filled with companies that we believe hold proprietary niches, and we find there is typically a permanent margin advantage because of it. Owning companies that earn long term sustainable excess returns based on economic competitive advantages is a theme that has helped us earn good returns for clients over time, and which some data suggests may be even more important in the years just ahead. Thank you for your interest in Sterling Partners Equity Advisors.
Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average, Percent Change from Year Ago of (Index 1982-1984=100), Monthly, Seasonally Adjusted
Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate [T10YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10YIE, April 22, 2021
The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average.
See attached PDF for a discussion of our top and bottom contributors to performance.
Kevin E. Silverman, CFA
Chief Investment Officer
John A. Schattenfield
Head of Distribution