A Roaring 2021
The US economy contracted by 2.3% last year as a result of the pandemic. Economic activity dropped precipitously in late March of 2020 and then rebounded strongly in the 3rd Quarter. Much of the contraction obviously related to the curtailment of in-person activities such as dining, travel, and entertainment. Consensus forecasts, which assume the vaccines protect against COVID variants and prevent another wave of infection, call for the economy to grow 6-7% this year. However, we expect the economic recovery to exceed expectations due to pent-up demand, high savings rates, governmental support, and low interest rates.
Humans are social animals. We congregate in small and large groups. We cooperate with strangers and share language and cultural bonds outside any familial relationships, unlike other mammals. Social distancing measures have produced feelings of isolation and a strong desire to reconnect with family, friends, and even strangers. As a greater percentage of the population becomes vaccinated, people will begin mingling again. For instance, MetroNorth Railroad (New York’s commuter rail that serves Westchester, Long Island, and Connecticut) has reported an uptick in weekend ridership. We believe there is an incredible amount of pent-up demand for restaurants, entertainment, and travel. This demand should begin to explode later this Spring and throughout the Summer.
Most employees were able to maintain their jobs, and many working in fields with tight labor supplies earned higher salaries. Investors also benefited as prices for stocks and real estate soared. For example, the stock market has appreciated over 75% from its low on March 23, 2020. Higher salaries in combination with more limited options to spend have produced historically high savings rates in the US. Households have typically saved 5-10% of their incomes over the past 40 years. After COVID spread last year, the savings rate has fluctuated between a high of 34% in April of 2020 and a low of 12.5% in November of 2020 . The latest reading from January 2021 is almost 20%. In dollar terms, aggregate saving increased to $2.8 trillion in 2020 compared to $1.2 trillion in 2019. Given these savings, consumers will have the resources to spend aggressively when they are able.
The government has also provided incredible amounts of relief and stimulus over the past year. Policy makers were not happy with the pace of recovery from the Great Financial Crisis. Therefore, both parties were committed to injecting large amounts of money into the economy. The following is a table of the major legislation that has passed:
For comparison, the US, as measured by GDP, is about a $21 Trillion economy. Therefore, these four acts alone supplemented the annual economy by 25% over the last year. Additionally, Congress is working on an infrastructure bill worth $2.0-2.5 Trillion.
Finally, the Federal Reserve plans to continue buying bonds and keeping interest rates low. Chairman Jerome Powell testified before the Senate Banking Committee on March 23rd that the Fed “will continue to provide the economy the support that it needs for as long as it takes.” It is unprecedented and extremely stimulative that the Fed keeps rates at 0% when the economy is expected to grow in the high single digits or faster.
Economists forecast the US economy will grow about 6-7% this year, which would be the fastest rate of growth since the economy exited the recession of the early 1980s when the economy grew 7.2% in 1984. However, many of the models do not include the boost that will come if consumers spend the accrued savings they have built up since the beginning of the pandemic. If this drawdown occurs, economic growth could reach or exceed 10%. We expect consumers to spend their excess savings due to the pent-up demand for in-person experiences.
If the economy grows faster than expected, earnings growth will also expand. However, we believe much of this good news is already priced into the market. We are not predicting a decade of exceptional growth as experienced by our grandparents and great-grandparents in the 1920s, but we do expect a strong snap back this year.
Inflation – Shades of the 1970s?
During a recent research meeting, we discussed current inflation expectations compared with those from the 1970s. Headline inflation was 1.7% in February. This rate was the highest since February 2020 (2.3%), i.e., the pre-COVID environment. Inflation hit a low of 0.1% in March 2020 and averaged about 1.3% for the 4th quarter 2020 and January 2021. Most estimates call for higher inflation going forward.
The increasing rate of inflation has led to concerns about the type of runaway inflation experienced in the late 1970s. The current inflation numbers are driven by food and energy prices. Year over year, food prices were 3.6% higher, and energy prices were 2.4% higher in February. These are shades of the late 1970s when inflation was driven by energy prices.
The current market thinking is that prices are being driven by short-term fluctuations in commodity prices, since core inflation (prices excluding food and energy) was only up 1.3% in February. However, more money is flowing into the economy through government stimulus as noted above. Won’t this lead to more inflation?
We believe that 2.5% inflation is tolerable, since the Fed can reduce price levels by tapering bond purchases if prices rise too quickly. We are also a long way from the inflation levels reached in the late 1970s. From 1979 to 1981, inflation averaged almost 12%. During this time, core inflation was about 10%, while energy prices surged 24% annually.
Energy inflation is possible, but less likely, as we are more energy independent than the 1970s, and our homes and vehicles are much more energy efficient. Also, energy makes up only 6% of the CPI index. So, while there are shades of the late 1970s, we are not close to an environment of persistent inflation. We understand that rising inflation would likely present a headwind to the stock market, but we do not view a cyclical bump in rates as an overwhelming risk.
Our Take on ESG
Environmental, Social and Governance (ESG) investing issues have taken on greater importance in our investment process. Though we did not manage strictly to the ESG acronym in the past, we analyzed these factors as part of our fundamental security analysis. Most of our research involved understanding the risks associated with a particular company. For example, we did not invest in cigarette makers or notorious polluters, since we wanted to avoid litigation or regulatory risks that would be detrimental to the company’s stock price. Last year, we began managing a dedicated ESG strategy. Following are the factors we target:
E – Climate Change
We believe that climate change is the most significant environmental challenge facing the entire world. Rising temperatures raise sea levels and may render fertile crop lands barren. The potential disruptions due to mass migrations and suffering caused by these changes are immense. To address this challenge through our managed portfolio, we only hold companies that have the lowest 50% greenhouse gas (GHG) emissions relative to revenue within their industry group of companies that report GHG data. These companies are probably significantly lower emitters than the median, since we are only comparing companies that report this data. The number of companies which report GHG emissions is growing, but those that do not are more likely to have poor GHG records.
By holding the lowest GHG polluters, we are “bending the curve” of carbon dioxide emissions. Median levels of pollution will decrease annually, so that the profile of the companies in the portfolio should constantly improve.
S – Forced & Child Labor
Coerced and child labor is still an endemic problem throughout much of the world. We screen against this social factor to avoid holding companies which rely on these labor practices. This research also requires an analysis of supply chains to uncover problems.
G – Governance
We believe that competence and diversity of expertise are key to running a successful company. Public companies are ultimately governed by their boards of directors. Therefore, we scrutinize boards closely to ensure that portfolio holdings are not being run by “an old boys” network. We also favor deep industry experience over consulting and financial backgrounds in board representation, since we want a long-term focus rather than emphasis on quarterly financial targets.
Investing in any company provides vital capital for that enterprise to grow and flourish. By investing in companies with better Environmental, Social and Governance profiles, we hope to make the world a better place. We now have better data and software tools to monitor many ESG criteria. Please indicate if this portfolio is of interest to you, or pass along your thoughts regarding values that you would like reflected in your investment portfolio.
Educational Savings Plans
The cost for putting a child through college has become one of the largest expenses a family may face. With college costs rising a whopping 72% since 2008 and the average tuition at a private four-year college up over $41,000 a year, families need to plan for funding at least a portion of this bill.
There are several ways to save specifically for education, and we have chosen one of them to highlight here. The 529 Plan, developed to cover education costs, has high contribution limits, no income cutoffs for eligibility, and offers money-saving tax advantages to the family.
One caveat to note before we dig into the 529 Plans: Saving for college should take a back seat to basic saving for the family emergency fund and retirement contributions. While none of us want to think of our children coping with huge loans in their twenties, we surely want to avoid scrambling for funds during an emergency or retiring on social security alone!
A 529 Plan is a state-sponsored, tax-advantaged savings account specifically for costs of education. The contributions are typically invested in a pre-set portfolio of stocks and bonds, with all the income and appreciation in the account remaining tax free. Most plans will shift from more aggressive (more stocks than bonds) to less aggressive (more bonds than stocks) as the beneficiary of the plan approaches college age.
A family can contribute up to $15,000 ($30,000 filing jointly) per year per beneficiary under the gift tax annual exclusion rules and can contribute up to $75,000 ($150,000 filing jointly) per beneficiary in a single year under certain circumstances. There are no income limits to take advantage of the 529, and contributions are not restricted to immediate family. Grandparents, aunts, uncles, basically anyone can contribute to this powerful savings vehicle.
There are a multitude of 529 Plans available, and choosing one for your circumstances can seem daunting. Start with investigating if your state gives you a tax break on contributions to its own state plan. Connecticut and New York, for example, give you a break on your state taxes on contributions to their respective plans. If your state does not offer a tax break on contributions to the plan, look at the investment choices and the annual fees associated with the plans. Morningstar rates 529 Plans on their website.
The 529 Plan offers savers a high contribution level, no income limit, and tax-free accumulation, specifically for education. It has become popular because of its power to provide meaningful advantages for families trying to address spiraling college costs. Eagle Ridge does not manage 529 Plans but is always available to give advice on what options suit your needs.