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Second Quarter 2021 Review – Inflation on the March

Equity markets continued their strong march upward in the second quarter, though leadership among sectors and asset classes shifted somewhat as investors grappled with conflicting data on the pace of economic recovery, as well as mixed signals on monetary policy from the Federal Reserve.  Nevertheless, every asset class in client portfolios once again notched positive returns for the quarter:  

Our Q1 comments noted that smaller and value-oriented stocks had opened a performance gap to larger growth stocks beginning around the November 2020 election (Figure 1.1). Though the U.S. was still enduring the third wave of coronavirus infections at the time, promising vaccines were already in the pipeline, and investors discounted better times ahead. 

As the winter Covid surge abated and vaccine rollouts commenced aggressively in the spring, analysts raised their estimates for 2021 GDP growth, driven by a re-opening economy and pent-up consumer demand. Smaller companies, which benefit more from the improved fortunes of the domestic economy, rallied hard once it became clear that the U.S. was on track for widespread vaccination by the summer.

Additionally, leadership shifted somewhat to sectors that had lagged during the initial months of the market recovery in 2020. Rising home prices and the promise of a return to in-person dining, shopping, and office work buoyed real estate stocks. Meanwhile, pent-up tourism demand boosted the prospects for airlines, hotels, and rental car companies—increasing demand for energy (particularly oil, up more than 80% over the past year) and other commodities.

While small value stocks are leading the U.S. market YTD, Q2 saw a bit of a counter-trend rally favoring large-cap growth stocks (Figure 1.2), as the emerging delta variant led to another surge in Covid infections and resurfaced fears that economically-sensitive companies could suffer if health officials are forced to implement more stringent mitigation measures.  

Figure 1.1 – S&P 600 (Small Cap) vs. S&P 500 (Large Cap)

 Figure 1.2

Inflation Spike: Transitory or Permanent?

Seemingly everywhere we looked in Q2, prices were on the rise—for homes, used cars, rental cars, gasoline, and food, among others. For the year ending in June, the Consumer Price Index (CPI) registered a 5.4% increase, the largest 12-month spike since 2008:

Source: BLS, July 2021

This isn’t especially surprising, given that Q2 2020 saw a steep drop off in economic activity tied to stay-at-home orders and travel restrictions. Measured from that low base, prices would have to rise quicker than average to regain their long-term (pre-Covid) trend.   Still, the pace of the CPI increase raised enough eyebrows at the Fed that its Board of Governors felt the need to clarify earlier dovish statements about the trajectory of eventual rate increases. After reiterating as recently as March that interest rates were not likely to rise until 2024, Fed chair Jerome Powell pivoted in June, saying that the Fed was increasing its forecast for 2021 inflation and raising the possibility that rate increases could commence in 2023, if inflation runs too hot.  

Powell’s comments reassured the bond market—long-term treasury yields dropped about 30 basis points during the quarter.   Meanwhile, the Fed’s official position is that many of the factors currently driving inflation have their root cause in pandemic-related supply chain disruptions, which are likely to be “transitory.” One typical example: lumber prices. Even though the price of raw timber barely changed over the last year, many sawmills curtailed production last spring due to health-related shutdowns as well as an expectation of flagging consumer demand. Instead, low interest rates and a desire for more living space led to a boom in housing demand and home remodeling projects. The convergence of these simultaneous supply and demand shocks caused lumber prices to spike from around $350 (per thousand board feet) in May 2020 to a recent high of over $1600 in May 2021. 

As is often said in commodities markets, “the cure for high prices…is high prices.” Quadrupling lumber prices in a year led many customers to reconsider their needs or search out substitutes. Homeowners contemplating a suddenly much more expensive deck remodel might put that project on hold in favor of a family vacation. Similarly, homebuilders dealing with backlogs on a number of other critical housing components might pause construction altogether. By the end of June, lumber prices had fallen back down to just over $700, lending some credence to the Fed’s case.  

The U.S. vs. The World

As we write this review, the broad U.S. stock market (represented by the S&P 500 index) has approximately doubled from its low in the spring of 2020. And while analyst estimates of corporate earnings have also increased—reflecting strong GDP growth trends—the index nevertheless trades at a higher multiple of forward earnings today than at any point since the technology bubble of the late 1990s:

Source: JP Morgan Guide to the Markets, 6/30/21

Moreover, U.S. stocks have outperformed their developed-market peers (measured by the MSCI EAFE index) for the better part of the last 14 years, an unusually long stretch:

Source: JP Morgan Guide to the Markets, 6/30/21

Over time, this outperformance streak opened a valuation gap between U.S. and international stocks (measured by forward earnings multiple and dividend yield) that is higher today than it has been for most of the past two decades.  

Source: JP Morgan Guide to the Markets, 6/30/21

While there is no telling when the next “regime change” will occur vis a vis U.S. and international equities, it is fair to say that investors seeking out pockets of value in today’s market are finding more opportunities outside of the U.S. Clients of Bristlecone may have also noticed that recent trading activity in their portfolios often involves trimming U.S. equity allocations to rebalance international allocations to their desired target weight. Over time, we believe that these adjustments will improve your portfolio’s risk-adjusted returns—even if the timing is imperfect.   

Progress Toward Herd Immunity

Perhaps the most significant factor impacting financial markets over the next year will be the pace and efficacy of global vaccination for Covid-19. The U.S. fell just short of the Biden Administration’s goal: getting at least one dose of coronavirus vaccine to 70% of American adults by July 4. Still, progress has been remarkably swift since three different vaccines were approved for emergency use roughly seven months ago. An estimated 57% of Americans (of all ages) have received at least one dose, and nearly 50% are fully vaccinated. Globally, the U.S. is among a handful of wealthier nations that have fared much better regarding access to vaccines and the pace of administering them (Figure 1.3)—even though they remain well short of the level needed to convey herd immunity, in the opinion of most epidemiologists. Moreover, the persistent threat of viral mutations and widely unvaccinated populations in many parts of the world mean that a large systemic risk continues to threaten the global economy. Nowhere is this risk more apparent than in the way covid outbreaks have continually snarled the global supply chain over the last 18 months, leading to shortages, price inflation, and superfluous logistical expense (not to mention untold human suffering). 

Figure 1.3

Large Cap Value Portfolio

(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the size of the overall portfolio, and the client's objectives and constraints.)

The median Large Cap Value (LCV) account lagged the S&P 500 index (8.5%) but outperformed the Morningstar Large Value Index (3.2%) during the 2nd quarter. Relative to S&P 500 sector weights, the LCV portfolio’s underweight to information technology and overweight to basic materials detracted from performance, while an overweight to financials and consumer discretionary stocks generally helped. 

Trading activity was modest during the quarter. We trimmed the position size of long-term holding AGCO for the second time in the last 12 months, as the share price increasingly reflected the company’s improved prospects.  AGCO sells heavy farm equipment and as such is very exposed to the cyclical economics of the agricultural industry. We originally acquired shares in late 2014, after a downturn in sales following a cyclical peak in 2013.  AGCO sales (and earnings) declined for the next two years before finally bottoming out in 2016. Amid the dislocations wrought by the Covid-19 pandemic, U.S. farmers received an estimated $46 billion in direct government aid in 2020, boosting net farm income to $136 billion (the highest since 2013). Combined with a rebound in crop prices (corn and soybean prices are up 70-80% over the past year), this has farmers feeling relatively flush and more willing to make major investments in equipment (AGCO’s Q1 operating earnings increased 94% over the same quarter in 2020).   

For similar reasons, we also reduced our long-term investment in Weyerhaeuser (WY) for the second time this year, taking advantage of the rally in lumber prices.  We originally purchased Weyerhaeuser in 2008, at which point it was a vertically integrated timber and wood products company whose fortunes had taken a dramatic dip following the bursting of the U.S. housing bubble. Over time, the firm re-organized its business to focus more on timber harvesting, selling off poorly performing subsidiaries and eventually converting to a more tax-efficient REIT structure. In 2016, WY acquired fellow timber REIT Plum Creek, thereby becoming the largest timberland owner in North America, by a wide margin.         

As mentioned in our earlier discussion on the dynamics of lumber pricing during the pandemic, the initial consensus was that health-related shutdowns would slash demand for most physical commodities, including lumber. Instead, constrained lumber production and a rise in new housing starts caused lumber prices to skyrocket. WY’s stock price followed suit as the company’s huge scale allowed it to maximize production during a period of peak demand:

Finally, we did make one purchase in the quarter, adding to our position in Bayer AG (BAYRY). As a reminder, we originally purchased Bayer in 2019, after a series of product-liability lawsuits tied to the firm’s 2018 acquisition of Monsanto cut Bayer’s stock price in half. At the time, estimates of potential damages from this litigation ranged widely, and the stock price reflected this uncertainty. Having followed similar product-liability proceedings with other companies, we had the sense that the worst-case scenarios being floated for Bayer were not the most likely outcomes. Two years on from our original purchase, litigation cost estimates have narrowed somewhat. Meanwhile, Bayer’s portfolio of pharmaceutical and crop science products generates roughly $5 billion per year in free cash flow, giving us further confidence that the company has the financial resources to weather this storm. 

As always, we welcome any comments or questions you may have and hope you are enjoying your summer to the fullest. 

One of Bristlecone Value Partners’ principles is to communicate frequently, openly, and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog. 

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

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