All Clear or Time for Concern?

 
Photo by Eoneren/iStock / Getty Images

I’ve always enjoyed watching the Olympics.  The athlete’s skill, dedication, and performance under pressure makes me feel like I should try pole vaulting.  One of my favorite moments is when the competition is based on a judge’s score, such as in Gymnastics or Diving, and the competitors carefully watch the scoreboard after every performance.  The anticipation builds as different competitors take the lead.  Often the camera will focus on a gold medal contender at the precise moment they clinch the gold.  Their expression goes from anxious and worried to overjoyed and celebratory.  I believe many investors today are like gold medal winners during competition: anxiously watching the scoreboard to see if things will turn out well or something unexpected will happen.  Will COVID variants, inflation, or a stock market crash ruin a period of great twelve month returns?  We think the economic and market trends are positive but higher valuations and the threat of higher inflation may mean investors should make some adjustments.

 

We believe major global economies are transitioning from an early economic recovery to a mid-cycle recovery. Consumers and business are likely to still spend strongly but the rate of growth and activity in the economy should moderate in 2022.  Inventory shortages caused by supply chains snarled by COVID shutdowns should ease. Companies that reported record earnings in 2021 may have tighter profit margins as their input costs and wage costs increase.  The graphic below highlights the global expansion and how different economies are recovering in an uneven way.  We believe this disparity is caused by vaccination rates and government policies.

Business Cycle Framework 9.21.2021.png

While corporate earnings have been strong in 2021 we believe higher wage costs could crimp profits and lead to higher prices for consumers.1 While we believe that inflation pressures will moderate in the near term as supply chain issues resolve, we are concerned that wage growth pressure could increase inflation in two to three years.

The stock market has been on a tear since the COVID crash in March 2020. The performance of equity markets since then has been incredibly strong.2

Equity Market Performance.png

This kind of strong performance is normal in the early stages of an economic recovery. 3 We anticipate greater stock market volatility if economic activity slows as we expect.

With this strong performance valuations have become stretched. Higher valuations do not necessarily mean that a stock market crash is imminent. It is more likely to lead to lower average annual returns for the following 8-10 years. At current valuations we are lowering our estimates of future average annual returns. For example we are projecting annual returns of 6.5% per year for US Large Cap stocks in our financial projections for clients. Historically they have returned 11% per year. 4 By using lower projected numbers we can help ensure our clients will not outlive their assets if future returns are lower. At current valuations we encourage investors to evaluate their exposure to equities carefully. It may be helpful to rebalance back to equity targets or focus on less expensive parts of the stock market such as International Stocks and Emerging market stocks

A recent concern for investors has been COVID variants such as the Delta Variant. The Delta variant is more contagious and may cause more serious symptoms in some patients. 5 This is one factor driving higher COVID cases, hospitalizations, deaths. If cases were to continue rising it could lead to more government shutdowns, economic contraction, and a stock market crash. While this is a possibility we don’t foresee this happening for two reasons. First, the current vaccines seem to be effective against the variants. 6 This should prevent the need for wide-scale shutdowns. Second, we believe that people will act in their own best interest. According to the CDC the unvaccinated are most at risk from COVID variants like Delta. We anticipate this will drive more people to get vaccinations and help drive down COVID cases.

The possibility of higher taxes could increase stock market volatility. President Biden has proposed increasing the top tax rate from 37% to 39.6%, increasing capital gain tax rates for those that make more than $1mm per year and for unrealized gains for those who pass away, and lowering the amount of inheritance exempt from estate tax. 7 While the future of Biden’s tax proposals is uncertain taxes are likely set to rise for the Wealthy regardless. Current tax rates were lowered with the passage of the Tax Cut & Jobs Act in December 2017. These lower rates are set to expire at the end of 2025. Successful families could still take action in 2021 to lower their risk of higher taxes. These actions include taking capital gains and income in 2021, selling a business or appreciated asset in 2021, or making gifts or implementing trusts to pass assets to loved ones.

The global recovery from COVID is progressing but uneven. Investors can be addressing risks such as higher inflation and high equity valuations by adjusting their equity exposures, focusing on less expensive areas of the stock market, and including alternative strategies that can provide protection from down movements in the stock market.

Are you comfortable with the way your portfolio is positioned?  If you’d like a second opinion please contact us at info@summithillwealth.com for a portfolio review and discussion of your risk tolerance with one of our Wealth Managers.

 

All written content is for information purposes only. Opinions expressed herein are solely those of Summit Hill Wealth Management, LLC and our editorial staff. Material presented is believed to be from reliable sources; however, we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual adviser prior to implementation. Advisory services are offered by Summit Hill Wealth Management, LLC a Registered Investment Advisor in the State of Colorado.


Sources

  1. “Corporate Profits Are Strong But Costs Pressures Brew” Fidelity Investments (AART), as of 6/30/21

  2. Koyfin.com.  Performance is calculated using passive indices.  US Large cap denoted by SPY, US Small Cap denoted by IJR, Developed International denoted by EFA, Emerging Market denoted by EEM, Real Estate denoted by VNQ

  3. Asset class performance by Cycle Phase (1950-2020) Fidelity Asset Allocation Research, 12/30/20

  4. Compound Annual Growth Rate for the S&P 500 from 1/1/1871 to 12/31/2020

  5. “Delta Variant: What we Know About the Science” 8/6/21, www.cdc.gov

  6. Ibid

  7. “Taxes Would Likely Rise for the Wealthy Regardless of Biden’s Tax Plans” Greg Iacurci, CNBC, 5/19/21 

 
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