Inflation was one of the main topics of discussion in the second quarter of 2021 and most economists expected inflation to rise, but few foresaw a Consumer Price Inflation (CPI) reading of 5% in May 2021 which was the highest rate in almost 15 years – just look at the higher price we are paying to fill our cars with gas since the last election. Two months of higher-than-expected inflation added fuel to concerns that the United States is on the precipice of a secular shift in the inflation paradigm. The majority of economists agree that some proportion of inflation is transient, but the disagreement among them is how much and I am particularly concerned about the underappreciated outlook for rising labor costs, a non-transitory inflationary force that hopefully will abate as the handouts from government ends in the coming months.
I am hopeful that the marginally above-target inflation is unlikely to accelerate dramatically as the economy continues to open up and supply chain issues are resolved. In addition, I believe investors should be concerned about the potential for higher long-term interest rates and how rising bond yields in the future could change the environment for savings and investment which I am also monitoring closely. The bond market surprised many with a strong rally in prices in the second quarter coming off a horrific first quarter performance. However, even with a big rally in bond prices in the second quarter, the bond market performance, based off the iShares Core US Aggregate Bond ETF, is down year-to-date 2021. There are large US government bond auctions starting off the 3rd quarter of 2021 and how bonds trade in the next few weeks will provide key insights into how equities and other markets may trade for the rest of the year. There is a real growing concern by the “smart market (bond traders)” that the economic recovery has peaked and is expected to slow considerably in the second half of the year.
However, a recent JP Morgan Fund Managers Survey found that commodity trading advisors (CTAs) are massively short Treasury securities which increased in prices in the 2nd quarter as shorts were forced to cover their positions buying bonds and driving up prices even further and it appears to have been a classic short squeeze. It was reported that the squeezing is not done just yet according to Morgan Stanley derivatives strategist Chris Metli, who said that CTAs still have to buy roughly $95 billion of Treasury debt in notional value. Morgan Stanley noted that this “could continue the bond price rally and put pressure on stocks as equity investors fear the bond market knows something they do not about future growth prospects.” However, I think the cat is out of the bag and bond prices do rally further, but eventually trend lower going forward barring a risk-off event that drives investors back into perceived safe-haven US treasury securities. The fact is bonds are a lousy investment when we factor in rising inflation and dramatically increasing global debt loads that will drive down bond issuer ratings and ultimately drive interest rates higher in the future.
The focus on inflation comes as the tide has turned decisively against COVID-19 in the United States (thank God and the developers of the vaccines and former President Trump for fast-tracking research), and it is accompanied by a particular focus on the potential for re-openings of economies globally to drive growth. However, the United States is still emerging from a recession. Some 7.5 million people who had jobs in February 2020 are no longer working, about the same number as during the depths of the global financial crisis in 2008 and 2009. Accordingly, while it is important to consider the various risks to the economy, including inflation, the biggest risk of all is an anemic recovery that could lead to years of disappointing growth akin to the 2010s and we will be watching developments very closely.
In the United States, massive fiscal stimulus combined with a largely successful vaccination campaign has raised questions for investors in three areas. First, at what rate will jobs return and will the labor markets tighten further? Second, how will excess savings and changing consumption patterns drive the economic recovery? And third, what path will inflation and interest rates take in the short-to-medium term, and how will this change asset allocations? Accordingly, we will also continue to monitor developments in these areas along with the US dollar trading patterns verses other currencies and a plethora of other market trends and data points.
Blockchain Technology, Cryptocurrencies, Cannabis and gold – new opportunities to build wealth and the currency of the ages.
The buildout of the Blockchain technology space and acceptance of utilization of cryptocurrencies is rapidly gaining momentum. The President of El Salvador announced the country's Bitcoin Law, which makes cryptocurrency legal tender, will come into effect on September 7th 2021. In addition, Colombia's capital, Bogota, announced a $2.8 billion investment program to support finance Blockchain companies as part of its $8 billion initiative to make the capital a "smart city." Also, investments of between $10 million and $50 million will be made into 100 companies that will be advised on implementing Blockchain technology into their business models. Citigroup launched a digital asset unit within its wealth management division (The Block) and many other major financial institutions are either already in the space or building out operations and divisions to participate in the sector. For example, Fidelity Digital Assets plans to increase its headcount by around 70% in anticipation of growing institutional demand for crypto services. The asset manager's president, Tom Jessop, said the firm is looking to add around 100 staff in Dublin, Salt Lake City and Boston to develop new products and expand its services beyond bitcoin. Swiss Bank, Sygnum, becomes the first banking institution to offer staking services for Ethereum 2.0.
More than $1 Billion had been spent using Crypto-Linked credit cards in the first half of 2021 and the momentum is growing as reported by payments giant Visa. The company has teamed up with more than 50 cryptocurrency-related companies, including exchanges FTX and Coinbase, to allow its clients to convert and pay with digital assets at millions of merchants across the world and the merchants do not have to change anything and it will appear to be the same as any other Visa transaction. In addition, there is a growing number of consumers trading and holding cryptocurrencies. However, there are still millions of merchants who do not really understand crypto, so the growth potential is enormous. Speaking on CNBC, Visa CFO, Vasant Prabhu, said that the company aims to "create an ecosystem that makes cryptocurrency more usable and more like any other currency." We are witnessing phase two of the internet with the Blockchain technology and cryptocurrencies.
Cryptocurrency prices rallied in the 1st quarter of 2021 only to give back those gains in the second quarter of 2021 and crypto appears to be now trending lower in prices going into the third quarter of 2021. However, the stars continue to align for a bright future for Blockchain technologies and cryptocurrencies and the million dollar questions are what cryptocurrencies will emerge for greater profits in the future. On Tuesday, July 6th 2021, US Senator Cynthia Lummis, a Republican from Wyoming, said she encourages investors to buy Bitcoin as a way to help them diversify their retirement holdings. At the CNBC Financial Advisor Summit she stated “I buy Bitcoin and I hold Bitcoin and, for me, I see Bitcoin as a great store of value”. Lummis was quick to add, I don’t want everybody putting all their money in Bitcoin just like I don’t want everybody putting it in dollars and hiding them under a mattress. The senator has taken a bullish approach to Bitcoin and has even pushed for the Federal Reserve to create its own digital currency to serve as a check against inflation. She has also partnered with Senator Kyrsten Sinema to create the Financial Innovation Caucus. In a statement to The Post newspaper an aide stated for Senator Lummis, the digital asset push is a recognition that we need to bring our financial system into the 21st Century. Many others in Congress have also admitted to owning cryptocurrencies and Fed Chair, Jerome Powell, has referred to Bitcoin as digital gold.
However, Cryptocurrencies have bred skepticism among the financial advisor community, but some are starting to come around. A Grayscale paper found that 10% of advisors were recommending crypto for portfolios, and a Financial Planning Association (FPA) survey found even more optimism about the emerging asset class. The 2021 FPA survey, released in June, found that 26% of advisors plan to increase their use or recommendations of cryptocurrencies in client portfolios over the next 12 months, up from less than 1% a year ago. However, at Castle Financial, we manage risk with a small allocation to the space and we have already reduced client crypto holdings by realizing gains back when prices were higher.
I do not expect a major trend change in cryptocurrencies until the regulators announce the authorization of the launch of a US Crypto Exchange Traded Fund or ETF. At this time, we have about 1% of client accounts allocated to Bitcoin and Ethereum through the publically traded Grayscale Trusts which have been trading at a discount to the public share prices, so we are getting some good bargain prices. Grayscale has applied to convert their Trust shares to an ETF and many other major fund companies have also applied for crypto ETF launches in the USA (Canada has already approved Crypto ETF funds). Blockchain technologies, cryptocurrencies and the emerging cannabis sectors are the newest areas of investments that I believe afford some of the best opportunities to build wealth in the future. As long as interest rates do not begin to scream higher, the inflation outlook remains stable and does not begin a meaningful decline, and the dollar rally does not accelerate, gold can move higher. However, all of those factors remain threats to the emerging rally in the price of gold. Bitcoin and gold are both being viewed now as alternatives to fiat paper currencies and gold is consolidating after earlier run-ups in price. Cryptocurrencies are in a downtrend.
The two birds in the above cartoon are not “stoned” – LOL A prominent analyst, Owen Bennett with Jefferies Group, LLC, the largest independent global full service investment banking firm with headquarters in the USA, described the future of the cannabis industry as a “generational wealth opportunity” for investors. The comment was part of the initiation of coverage of seven U.S.-based marijuana companies of which he expects their shares prices to double over the next 12 months spurred by growth in the industry as the U.S. inches closer to federal legalization. The cannabis company share space appears to be in downtrend after a huge really in the first quarter of 2021. However, federal legalization is now looking more likely to happen in the future with the new leadership in Washington while the lower share prices are becoming more appealing to long-term investors.
On a “high” note, stocks rallied in the first half of 2021 on the back of numerous positives. The pandemic easing up (at least for most of the developed world), another trillion dollars in stimulus in the USA, increases in corporate earnings and still-dovish Central Banks creating money out of thin air and buying bonds to keep interest rates low. However, some of those factors were one-time positive hits, and while they clearly were simulative, they will not likely be repeated in the next six months. Instead, in the back half of 2021 markets will need to negotiate the following issues: 1) Will corporate margins compress given cost inflation and does that hurt corporate earnings in the future? We will get insight into this when Q2 earnings season begins. 2) Will markets have to deal with negative tax headlines? The first half of 2021 contained mostly perceived positives from Washington, i.e. more stimulus and spending.
The second half of 2021 will likely be centered around infrastructure and tax hikes, both for corporations and the wealthy. As of this writing, it does not appear that those tax hikes will pass, but that does not mean markets will not need to contend with headline volatility along the way. 3) When does the Fed reduce and taper Quantitative Easing or QE? In contrast to the first half of 2021, where until June 2021 most of the conversation around the Fed centered on its undying support for the economy, the next six months will be dominated by the tapering timeline, and if the Fed has to taper sooner than expected that will cause volatility. 4) Inflation spiked in the first half, but it was easy to dismiss it as temporary, no matter how high it got.
However, the next six months will be a “prove it” period, because if inflation metrics remain high, the “temporary” inflation excuse that worked in the first half will not in the second half of 2021. 5) COVID is essentially over from the mindset of many U.S. investors. Accordingly, there is only one way for the headlines to go from here which is hopefully not negative. Based on the data, it does not look like any variants (including Delta) post a material threat beyond what already existed, but that won’t necessarily stop policy makers from re-implementing lockdowns out of an abundance of caution. Point being, if the first half of 2021 contained mostly positive COVID headline risk, the second half contains the possibility of negative headline risks.
I remain constructive on stocks and inflation-linked assets more broadly, but do think it is prudent for everyone to prepare for more volatility in the coming months (and less-spectacular gains in the broad indices). As noted earlier, the market expects the Fed to announce reducing bond purchases in August or September of 2021 and commence tapering in December or January at a pace of around $15 billion per month (which would eliminate FED bond purchases in eight months). If the FED implies that timeline is being accelerated, that will cause volatility in the financial markets. The Fed has been creating about 120 billion dollars a month out of thin air to buy US Treasury and Mortgage backed securities in the open markets to keep interest rates low. This Ponzi Scheme is known as Quantitative Easing or QE and has led to the Fed balance sheet approaching 9 trillion dollars in addition to the US National debt nearing 29 trillion dollars. Total US unfunded liabilities are now over 150 trillion dollars, so rest assured higher taxes are in all of our futures. . . .
As always, we will remain “tactical” in our approach to managing money focusing on sector allocations and great security selections as markets and new technologies continue to evolve. We continue to send our valued clients timely updates, videos and newsletters via email, so please call our office if we do not have your current email address and also advise us of family, friends and co-workers who you feel will benefit by also receiving our timely and informative email updates. As a Certified Financial Planner, my responsibility is to keep track of your investments and to develop appropriate investment strategies in an ever-changing world to help our valued clients to be in a better position to reach their long-term financial goals. I am focused on preserving principal, providing dividend yields and interest above bank earnings rates while still maintaining the potential for capital appreciation. When it comes to client investment portfolios, I believe the most prudent strategy is to maintain a long-term perspective, but be flexible and open minded in an ever changing financial environment. Castle has strategically partnered with some of the leading global money management firms in the world with tens of trillions of dollars under investment management and this quarter we have chosen to send the BlackRock 2021 Midyear Global Outlook which covers the world markets in great scope and detail.
Al Procaccino II, MBA, CFF®, CFP™, CFS®
President & CEO