My father Frank Bragg is a country boy at heart. He spent his childhood summers on his grandparents’ farm in southern Virginia where he learned about the land and its amazing bounty. To this day he preaches the gospel about having a garden and eating locally grown seasonal fruits and vegetables. With great passion he tells his children and grandchildren, “It’s May. If you aren’t eating a gallon of fresh, locally grown strawberries per day, you’re not living!” He claims that he and my mother eat them for every meal during the month of May—breakfast, lunch and dinner. “You should too,” he says. “They’ll only be in season for two to three weeks…you better enjoy them!”
Whenever and wherever I see him he is pushing something fresh on me. “Try this fig. Eat a bite of this cantaloupe. Have a slice of this watermelon. You better be eating these tomatoes straight out of my garden. Let’s go pick some blackberries! Have you had one of these South Carolina peaches? Grab a handful of these muscadines. Why are you eating that banana shipped up here from South America when you could be enjoying these blueberries right off this bush?” He gets especially worked up about fruit-producing native plants growing wild on our farm. This time of year he has been dragging anyone who’ll listen into the woods to eat paw paws and persimmons right off the tree.
You may not know much about paw paws (Asimina triloba) or persimmons (Diospyros virginiana), but both are trees native to the Southeast that yield a sweet fruit in late summer to early fall. The fruits don’t travel well so you won’t usually find them in stores. It’s truly best to eat them right there in the woods standing under the tree. We’ve had a bumper crop of both on the farm this year. In fact, we’ve had too many paw paws and persimmons on the farm this year. I’ll explain.
Last weekend my father showed my son Charlie (14) how to find paw paws and persimmons in the woods. Reportedly they found an ample supply. Charlie loved the taste of the paw paws; he said they tasted like sweet banana pudding. We later learned that he’d been venturing out daily with his black lab, Mac, to scout for ripe ones to eat. Mac apparently enjoys paw paws too. This came to our attention when Mac had an unfortunate and explosive digestive incident in our mud room Tuesday morning right after (thankfully) I left for the office.
I was proceeding peacefully on I-77 South when my phone started blowing up with text messages from my wife Alice. Her messages, sprinkled with photos that you won’t find on the back page of this investment letter, made it clear that she was not happy about the mess she had to clean up or the energetic, overfed dog she had to bathe. “Why did you drive off and leave me with this HUGE mess! I didn’t sign on for this! Can we get rid of this crazy dog and move back to town?” And so on.
Alice eventually calmed down. She always does—after 25 years of marriage I’ve come to realize it’s truly one of her best qualities. She accepted Charlie’s plea of ignorance when he said, “I didn’t notice how many paw paws Mac was eating off the ground because I was busy getting ripe ones off the tree to eat myself.” And she didn’t blame Frank Bragg at all. When told about Mac’s digestive incident, Dad just said, “Hmmm, too much of a good thing I guess.”
Speaking of too much of a good thing, the stock and bond market of late seems to be telling us that we’ve had too much of a good thing. The good thing I’m referring to is the financial stimulus provided by Congress and the Fed to support the economy and financial markets during the virus crisis. According to the COVID Money Tracker created by the bipartisan Committee for a Responsible Federal Budget, the total amount of stimulus approved for combatting the crisis was $13.6 trillion, $9.1 trillion of which has been spent or dispersed. The breakdown of approved amounts includes $6.8 trillion of monetary stimulus provided by the Fed, $5.9 trillion of fiscal stimulus from Congress and $900 billion of administrative stimulus provided by executive order. That is a lot of money! For context, US GDP (total economic output) was $21.4 trillion and $20.9 trillion in fiscal years 2019 and 2020 respectively.
This unprecedented amount of stimulus was a good thing because it served a crucial role in supporting the economy and financial markets during the coronavirus shutdowns and likewise helped the economy and markets recover quickly following the shutdown. After suffering its greatest decline since the Great Depression, US economic output returned to pre-pandemic levels by the second quarter of 2021. Unemployment fell from 14.8% at its peak in April of 2020 to only 5.2% by August 2021, just 16 months later. A recent Census Bureau report highlighted by Greg Ip in the Wall Street Journal showed that including government transfers, the US poverty rate actually fell during 2020, the opposite of what usually happens during a recession.
As for stocks and other risk assets like real estate and commodities, it is no secret that prices have risen dramatically. The S&P 500 rose 100% (price basis) from its low on March 23 through its close on August 16 of this year and despite slipping during recent weeks, remains up 92% since the low. Corporate earnings, the long-term driver of stock prices, rebounded to record levels during the second quarter of 2021. According to the S&P Case-Shiller Home Price Index, home prices in major metropolitan areas rose 18.6% for the 12-month period ending in June, the highest annual rate of growth since the inception of the index 34 years ago. Finally, from March of 2020 through early October of this year, the Bloomberg Commodities Spot Index, which tracks 23 energy, metals and crop contracts, has risen more than 90%.
So, the recovery is real and the stimulus (fiscal and monetary) was a good thing in terms of bridging the gap in economic activity resulting from the virus crisis. But at what cost? Arguably, that question is impossible to answer since we don’t know how bad the recession (depression?) would have been had the government not provided support. I think we can agree that it would have been worse and possibly significantly worse. But we can also discuss some of the unintended and negative consequences of the stimulus, some of which are causing current market volatility. Here are a few:
Low Interest Rates: The Fed has kept interest rates artificially low. The yield on a 10-year US Treasury bond is hovering around 1.5% and other debt instruments and/or cash equivalents likewise provide very little yield. The Fed has kept rates low by aggressively buying bonds in the open market, thereby driving up the prices of those instruments which effectively drives yields down. Recall that bond prices and bond yields (interest rates) have an inverse relationship. The prices of risk assets like stocks and real estate are greatly impacted by the level of interest rates—lower interest rates result in higher asset prices. Arguably, investors in risk assets (that’s us!) are addicted to low interest rates and have been for a long time. The Fed hasn’t been able to raise interest rates without driving the prices of risk assets down dramatically. Bragg’s 2013 investment letter Muscadines and Ben Bernanke addressed this phenomenon. That was eight years ago! So the Fed’s dilemma is nothing new. But during the virus crisis, the Fed took its bond buying to a whole new level, both in the types of bonds purchased and in the amount purchased. In addition to buying Treasury bonds and government agency bonds, it began purchasing municipal and corporate bonds for the first time. As for the amount purchased, the Fed’s balance sheet increased by $4.3 trillion to $8.5 trillion in just 18 months. So, the Fed basically doubled down on what was already an unsustainable practice. And now the Fed really wants/needs to let rates rise, and it can’t without roiling the stock market.
Inflation: You’ve read about and likely experienced firsthand the inflationary pressures and disruptions now affecting the global economy. You can find more detail on the causes of inflation in the article by Matt DeVries, Market & Economy. I’ll just say that, as in all cases of inflation, there is a mismatch between supply and demand. As our 2013 Muscadines and Ben Bernanke article about low interest rates makes clear, it has been a long time since we have experienced inflation and this has allowed the Fed to keep interest rates artificially low. For the last 12 months the Fed has insisted that this bout of inflation would be a temporary spike which would subside as supply bottlenecks cleared and demand eased a bit. Unfortunately, this has not happened; supply-chain issues seem to be worsening and while the economy has cooled a tad, it is still humming along. The Fed has recently acknowledged that inflation may stick around for longer and as mentioned in the paragraph above, this puts the Fed in a tough position. Normally this is when the Fed would begin pulling away the proverbial punchbowl, allowing interest rates to rise which would tamp down demand, slow the overheating economy and ultimately relieve inflationary pressures. In recent speeches and Fed meeting minutes, Fed Chair Jerome Powell and other Fed representatives have tried to prepare investors for rates to rise sooner than earlier promised, and the market has reacted negatively.
Debt: According to the Treasury Department, for the 18 months ending June 30, 2021, total US public debt increased by $5.3 trillion to $28.5 trillion. As a percentage of GDP, it rose from 107% to more than 125%, the highest level of debt to GDP since the end of WW II. One silver lining of the low interest rate environment is that the interest payments as a percentage of outstanding debt are currently low. Despite this, interest payments are already the fifth-largest federal budget line item and this year will consume $300 billion, or 9% of all federal revenue collections. The average maturity of the outstanding debt is just over five years; were interest rates to rise in the future, this picture could worsen dramatically as interest payments on the debt crowd out other priorities.
As we go to print, Congress is debating bills totaling as much or more than $4.5 trillion in new spending, including the creation of large new entitlement programs. Sponsors of the bills project that the new spending will be mostly paid for with tax increases, but history has demonstrated that tax rates frequently change when administrations change, whereas new spending programs almost always become permanent and expand over time. As for the tax increases, the most significant would be surtaxes on small business owners, an increase in the corporate tax rate, higher marginal tax rates, an increase in the capital gains tax rate, surtaxes on those with incomes above a certain amount and on those who have accumulated large balances in IRA accounts. It is our hope that the proposed number ($4.5 trillion or more) is revised downward significantly and that if Congress must spend, that it will first consider fixing our existing entitlement programs including Medicare and Social Security, which, without Congressional action, are projected to run out of money in 2026 and 2034 respectively.
Risk/Reward Distortion: The actions of the Fed during the virus crisis were distortive in other ways. By wading into the bond market and buying up assets of all types, the Fed not only forced interest rates lower, it effectively bailed out investors who had taken great risk by owning junk bonds or other low-rated and riskier assets. The Fed became the buyer of risky assets. Effectively this distorted the risk/reward relationship which makes a market just that, a market. The Fed signaled that investors can make poor investment bets without worrying about a loss because the Fed will bail them out. One of my favorite Warren Buffett quotes, “You can see who has been swimming naked when the tide goes out,” arguably no longer applies since the Fed won’t let the tide go out. This distortion results in more risk-taking (more leverage) and less market stability.
I know what you’re thinking… “Wow, Benton sure sounds gloomy today.” I’m sorry! I’m just offering a little realism amid these days of frothy markets and a robust economy. Yes, we see too much of a good thing in some of what our government and our central bank have done over the last 18 months. We’ve enjoyed too many paw paws and persimmons and at some point in the future we may face some indigestion! Does this mean we think everything is going to end badly? No, it doesn’t. In fact, I’ll suggest that not only is it not going to end badly, it isn’t going to end at all. That’s right. One year, three years, ten years, twenty years down the road, we’ll still be worried about the market, worried about inflation, worried about energy, worried about China, worried about robots, worried about gene editing, worried about debt, worried about something.
We want you to know that as we build and manage portfolios at Bragg, these are some of the issues we think (worry) about, even as we remain optimistic about the future. And the future includes market declines just as the past includes market declines. There have been 25 bear markets (declines of 20% or more) since 1928 with an average decline of 33% and a peak-to-trough duration of just under a year. Each was bad, and each was caused by something investors were really worried about, but fortunately, each ended, and the market went back up and reached a new all-time high. Looking back at the letters Bragg has sent out over the last twenty-five years reminds us that there has never been a shortage of challenges facing investors. Looking back also reminds us that we can’t see the future. Finally, looking back reminds us that our straightforward approach to investing will likely continue to serve us well in the future.
I hope this has been helpful. I’m headed out to the garden to see if there are any tomatoes left. As always, thank you for trusting Bragg with your planning and investing.