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  • Writer's pictureNate Baim, MBA, CFP®

What's Moving the Markets?

Enjoy this week's edition of the Planner's Beta

Beta (n) - climber's jargon that designates information about a climb

Video Transcript:

So far, 2021 has been very rewarding for investors. Markets have also been uncharacteristically calm. In today's video, I want to help you understand the crucial variables the market is digesting and help you become a more informed investor.

Over the past three months, markets have been primarily concerned with COVID-19, government policies, valuations, and inflation. Each of these items showed to move markets as new information became available. Let's look at the numbers and begin to understand better what the market expects.

Markets are closely watching and analyzing the global pandemic. Global cases of COVID-19 increased for the month of July. And in conjunction with the increase in global infections, the delta variant has concerned investors. We saw market participants de-risk in mid-July due to the uncertainty surrounding the delta variant.

Markets are continually looking at the confirmed cases, deaths, recoveries, and vaccine doses. This data helps us understanding if the pandemic is subsiding or growing out of control. As vaccines are distributed, and cases mount, more and more individuals will develop some form of immunity. Many Western countries, such as United States, UK, France, and Germany, are approaching where 50% of their population has had at least one vaccination dose. And here in the United States, 57% of Americans have received one dose, and nearly 50% are fully vaccinated.

When 60 to 70% of the population reaches immunity, either through vaccination or exposure, the spread of the virus should subdue. Increased vaccination rates should be welcomed news and an optimistic note for markets. However, cases are growing, and markets are looking closely to see how efficacious vaccines are to new variants. There is a concern for new variants emerging, as large population segments have not gained immunity from the virus. Any unwanted surprises resulting from the pandemic could change the tone in markets.

If you have been an investor this year, you have reason to be celebrating. The S&P 500 Index provided double-digit returns year to date. Such a return is reason to be optimistic. Excellent returns suggest that the markets expect the broader economy to continue to improve. However, a 17% return is something that we don't often experience for a full calendar year (and we are only about halfway through the year). Over the long-term, the market historically returned, on average, between six and nine percent per year.

Such returns will give seasoned investors pause. Market participants are looking at valuations. Investors use valuation ratios to help determine if an asset is cheap or expensive. Valuation ratios should not be solely used as a tool to make any investment decision, but they can help inform investor expectations. When we look at the price-earnings, price to book, price to sales, price to cash flow, and dividend yield ratios, all these measures today are beyond the range we had seen in the S&P Index back to 2003.

Now a couple of things can happen from here. These evaluation measures may correct themselves. A correction may happen through prices declining. Or suppose the denominator, the earnings, the book value, the sales, the cash flows increase, and prices remain constant. In that case, these ratios may decrease over time. Or in other words, the fundamentals of the companies catch up with the stock price. Such valuation levels do warrant hesitation and reflection before making significant investment decisions. With high valuations comes high expectations. And it is possible that the wild returns we experienced recently may not continue to happen until companies' fundamentals catch up with their share prices.

The S&P 500 isn't the only index that we should keep an eye on. The S&P does not represent all the investment opportunities investors face. And valuations and returns can be different for other asset classes. When we look at asset class performance, we can see the S&P has performed well compared to other asset classes. Still, small-cap and commodities have performed very well year to date, too. And even developed markets, such as the MSCI Europe, Asia, and FarEast Index, performed well. Emerging markets are lagging since the beginning of the year.

One of the critical things to take away from this asset class performance table is that we can see certain asset classes do very well each year. In other years that same asset class may perform poorly. Remaining diversified is essential because the more diversified investors are, the less likely they will be going from the worst performer to the best performer. Spreading out investment exposure helps investors become diversified and manage the volatility in their portfolios.

Investors are digesting government policies. Last year, the federal budget deficit increased significantly, and the deficit ran about 15% of GDP. The federal government spent about $3.1 trillion into the red in 2020. Last year's stimulus helped enact policies to keep the economy afloat during the pandemic. Those policies included the one-time stimulus checks that individuals received, rescue packages for specific industries, the paycheck protection program, and healthcare resources to combat the virus.

However, there doesn't seem to be as much fiscal stimulus planned moving forward. The infrastructure bill working its way through Congress started as a $2.3 trillion initiative by the Biden administration. However, this bill, titled the Invest in America Act, sits at about $1 trillion to be spent over the five-year time horizon. In addition to the infrastructure bill, the House and Senate Democrats are looking to expand the budget. They're looking specifically to expand social programs such as education, child tax care credits, healthcare, and climate-change-related programs. Congress is looking to offset the increased expenses with increased taxes. If spending increases and taxes increase, that doesn't necessarily result in a net increase in stimulus for the economy. And it's unclear the budget the Democrats are currently discussing will even make it to the president's desk for signature into law. I wouldn't be surprised if there will be typical Washington in-fighting. The initiatives put forth in the budget will likely be tempered much the same way that we've seen the infrastructure bill tempered if moderate Democrats remove support.

Next, investors are looking closely at inflation. 2021 may be known as the year of inflation. The consumer price index is a measure of how prices change year over year. The index is a basket of goods tracked by the Bureau of Labor Statistics, which comprises items consumers typically purchase. In June, the CPI increased to the highest levels since 2008. The headline CPI reached 5.4%, and the core CPI read 4.5%.

When we look at the headline number, we can see that energy was the significant share of the increase. Energy increased 24.5% year over year. Food increased significantly less. Although food still rose 2.4%.

The Core CPI excludes food and energy. Used cars and truck prices increased 45.2%. Airfares were up 24.6%, and motor vehicle insurance was up 11.3%. These are the sectors where the economy was hit hardest by the virus last year. And now, the economy is opening up. Some of these product categories are working through complex supply chain issues due to the economy's whiplash from closed to open in such a short period. Additionally, these same product categories are seeing increased demand. This environment is a perfect storm for inflated prices in these categories.

We can also see prices have increased to a much lesser extent in other products inside the CPI basket. Increases in prices for these categories are most likely due to increased demand due to an economic opening and base effects. Looking at these categories (including services and products), it is not clear that prices across the board are rising at an uncontrolled rate.

The Fed believes inflation will be transitory. And honestly, in my opinion, when I look at the numbers too, it appears to be transitory in nature. Now that doesn't mean that there should be no concern for inflation. There could be something on the horizon that we are unaware of that may change the nature of price increases. However, it seems the Federal Reserve is controlling prices.

Congress tasks the Fed with managing prices and employment. The Fed does this by controlling the amount of cash or money supply in the economy. One of the essential programs in place right now that the Fed uses to manage the money supply and stimulate the economy is its quantitative easing (QE) programs. The central bank does this by purchasing securities in the open market. The Fed exchanges cash for those securities with banks and other financial intermediaries, expanding the money supply. Inflation hawks have been calling on the central bank to begin thinking about thinking about tapering its QE programs. The June Federal Open Market Committee notes, a subcommittee to the Fed Reserve, discussed the prospect of laying out the items needed to begin tapering their quantitative easing programs. These notes suggest that the Fed is open to limiting the money supply. And this week, the FOMC met, and the announcements confirm the Fed is considering the prospect of reducing the scope of its QE program. The central bank is looking closely at inflation.

Market participants concerned about inflation welcomed this news from the Federal Reserve. And, we can see inflation expectation measures are cooling a bit. The TIPS breakeven rate is a gauge of bond market participants' expectations of what inflation will be in the future. The breakeven rate is determined by subtracting the current yield on TIPS from the U.S. Treasury bond yield for the term in question. The difference between the TIPS yield and the Treasury yield shows us the bond market inflation expectations.

Currently, inflation expectations sit at 2.5% for the next five years. We can also see that we may be settling into a new normal where market participants believe inflation may be sitting between two and three percent. So it doesn't seem like when we look at this measure of inflation expectations, market participants are concerned about reaching any form of 1970s or early 80s inflation numbers.

To confirm the breakeven data, we can look at consumer inflation expectations for the University of Michigan's Survey of Consumers. When we look at the one-year timeframe, consumers in the survey expect inflation to be about 4.8%. And when we look at the five to ten-year timeframe, consumers expect inflation to be closer to 2.9%, which isn't too far off from what we see in the bond market.

Why is looking at inflation expectations important? In theory, individuals and businesses set prices and wages based on what they expect inflation to be in the future. And thus, if individuals and companies believe inflation will increase, those same consumers and businesses, in turn, demand higher wages or increase the price of the products they sell. In other words, inflation expectations can result in a self-fulfilling prophecy resulting in a spiral of rising wages and prices. However, from this data, it doesn't appear that those expectations are out of control. For now, the Federal Reserve seems to remains a credible guard of the integrity of the dollar.

Now all investors and savers need to review and remain apprized to what is happening in the markets. And I encourage folks to stay educated and learn. I discouraged folks from becoming timers of the market and using headlines and data to make snap decisions on what they should do with their portfolios and financial plans. I encourage folks to remind themselves that financial planning is a process. Households need to monitor their financial situation continually. And they need to update their plan as their situation or environment changes in a thoughtful and process-driven manner.

If you want to learn more about financial planning and investment management, feel free to follow or subscribe. And, if you have questions about your situation and your financial plan, feel free to visit to learn more about my firm and my services. I hope you have a great rest of your week and thank you!


Have something on your mind? Schedule a free call with Nate.


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