The stock market marches ever higher. After five positive months in a row through June and a strong start to July, the S&P 500 is up more than 17% year to date. High stock prices are consistent with low interest rates, and equities have the added advantage of being a good inflation hedge historically, with the caveat that they have tended to appreciate before the inflationary liftoff but have struggled while inflation rages.
Heading into a second quarter “earnings season” that laps the absolute depths of the 2020 pandemic, we expect supply chain inflation and labor shortages—which is wage inflation by another name—to be persistent themes. Keep an eye on gross margins. Companies who fail to pass along price increases are particularly vulnerable right now. On the other hand, companies whose competitive strength allows them to transform increasing costs into faster-increasing profits will be highly prized.
Investor affection for fixed future payouts has reached an extreme that looks downright unhealthy. Junk bonds are currently priced to yield under 5%, less than the prevailing rate of inflation. Considering that junk bonds have historically defaulted at a rate close to 4% annually, it will take a lot of future disinflation, or outright deflation, for investors to make a positive return from these levels. The yield on 10-year Treasuries is a paltry 1.4%. What makes the low yield on junk bonds even more alarming is that the 4% average default rate is only an average. If future defaults are higher than average—flip a coin—then junk bonds could produce negative gross returns even before the impact of inflation. At least the small coupon on Treasuries is money good.
The investor’s job is not to see the future. It is to provide against future risks, whatever may come. Equities should offer positive long-term returns, net of inflation. Bonds? Maybe not.
The rational conclusion is to reduce the role of bonds in the investment allocation while watching closely to make sure that one’s stock picks can at least tread water in an inflationary environment. The stocks selected in each issue of the Investor Advisory Service is one place to begin.
Reprinted from the August 2021 issue of the Investor Advisory Service. For more information, to download a sample issue, or to subscribe to the best investing newsletter in the U.S., visit Investor Advisory Service.