Q1 2021: Time for a Complete Balance Sheet Review

With interest rates and inflation pressures on the rise, now is the time to review all assets and liabilities on your personal balance sheets and consider adjustments. In this commentary, we summarize the current environment, outline steps we are taking to mitigate inflationary impacts, and recommend additional actions you may want to take.

Our Position on Interest Rates and Inflation

Interest rates rose in the first three months of 2021 as investors responded to evidence of inflationary pressures and the perception that the federal government might be inclined to let those pressures build. Current and proposed government spending and a full re-opening of the economy will continue this trend. The government is actively engaged in another multi-trillion dollar spending plan. Money supply has exploded upward. Wage increases and full employment are seen as important in helping the marginalized in society. Covid has disrupted supply chains and caused production problems. These all exacerbate inflation, and inflation can cause cash-purchasing value to decline over time and adversely impact income-generating assets.

The good news is that while inflation is building, it is nowhere near the hyper-inflation levels that cause severe damage to an economy and to people’s savings. For most investors, real estate and stocks are larger assets on their personal balance sheets, and both experienced a strong increase in value. This has helped many people offset initial inflationary pressures so far.

In addition, the Federal Reserve will stay comfortably “behind the curve” on inflation by keeping rates below normal for longer than they may have in the past. Other factors could also reduce the pressures of inflation, including new Covid spikes, a slowdown in economic activity, or geopolitical issues.

Despite these protections, though, the indications are that the current environment may continue to trend towards increased inflation, with associated impacts.

Implications

Of the primary controls to fight inflation (monetary policy, control over the money supply, supply-side policies, fiscal policy and wage controls), we view only one as a potential governor on rising inflationary pressures: fiscal policy/tax increases. Or in other words, the only possible inflation-fighting policy we see on the table in the near term is taxation and the raising of taxes, which can counteract inflation by reducing spending and demand.

If our position is correct, and if inflationary pressures gain in strength, we expect to see a steepening yield curve with longer-term interest rates rising while shorter-term rates remain low. We also expect rising taxes for corporations and top bracket individuals, a reduction or tightening in lending, a reduction in some equity valuations, and a rotation in performance from lower quality growth to more traditional value securities; higher quality growth securities and investments into new innovations.

A Steepening Yield Curve: Longer-term rates rise while shorter term rates remain relatively unchanged. A steeper yield curve usually occurs during inflationary periods and periods of stronger economic growth. Long-dated bonds are often hurt the most when rates rise, and mortgages become more expensive, which can cause home prices to slow down or even fall in value. On the plus side for stock investors, banks and financing companies tend to do well when they can borrow at low short-term rates and lend out to longer-term, higher paying projects. Since a steepening yield curve can also reflect a strong economic growth environment, many sectors of the stock market may continue to perform well.

Rising Tax Rates: A change in corporate tax rates from 21% to 28% would reduce profits for corporations and impact stock prices. More broadly, we expect that Federal and state tax rates will continue to rise in order to pay for some government spending and will be the first “lever” pulled in the fight against inflation.

Reduction or Tightening in Lending: As rates rise, fewer and fewer borrowers qualify for loans, leading to either lower loan amounts or fewer total loans issued. When rates first begin to rise, corporations and individuals tend to rush to borrow funds before rates rise even further. Lower-quality corporate balance sheets that have significant debt tend to see their stock prices decline. So do companies with low pricing power for their goods and services.

Reduction in Valuation Multiples: Higher interest rates impact asset prices. Since many investors borrow funds to buy real estate, public securities, and private companies, when the cost of borrowing rises, the price buyers are willing to pay for these assets will drop. With equity market multiples near all-time highs, the combination of a reduction in profits from rising taxes and rising borrowing costs could combine to reduce the multiple on asset prices.

Sector Rotations In/Out of Favor: We expect that “value” stocks (defined as companies with strong balance sheets and where the valuation is based on earnings) may finally outperform “growth” stocks, which have dominated the top of the performance chart for several years. Rising rates will pressure price multiples, especially in lower-quality growth stocks. Government spending will focus capital on clean energy, infrastructure, and healthcare. Innovation in genomics, 5G, electric vehicles, and digital assets may also attract significant investor capital. We do not see all growth stocks diminishing. There is a distinct difference between “growth” stocks that are nothing more than a highly leveraged bet on a hopeful narrative and “growth” stocks that are powering innovation and producing extremely high free-cash flows while growing rapidly.

Portfolio Actions That We Are Initiating

If inflationary pressures continue to build, it will be important to review every aspect of a personal balance sheet. On our end, we are focusing on the following:

• Rotating equity exposure to own high-quality growth, high-quality value, innovation, infrastructure, and clean energy.
• Finding opportunities in the clean side of industrials, materials and energy sectors.
• Owning bonds that are variable-rate and income securities that can benefit from rising rates.
• Owning shorter-duration bonds that can replace cash and bank deposits.
• Adding high-quality income securities that can increase dividend payments, including real estate investment trusts and highest-quality companies that have shown a commitment to increasing      dividends year over year.
• Creating a reading list and an actionable group of potential investments into new innovations. The evolution of digital assets and emerging breakthroughs in areas ranging from genomics to non-     fungible tokens are important to understand, and fast-growing, early-stage technologies can be great ways to invest and offset inflation.

Other actions That Every Investor Should Consider

• Own assets that can grow faster than inflation and hold assets that tend to rise with inflation.
• Review real estate holdings for exposure to rising cap rates and falling valuations as a result of rising long-term rates.
• Review debts and borrowings. Replace adjustable-rate debt with fixed-rate debt, pay off credit cards, and analyze whether you have the right amount of debt on your balance sheet. Some have           too  much, some have too little. If borrowing becomes stricter and more expensive in future years, it will pay to have the right amount and right type of debt today.
• Move bank cash balances to interest-bearing securities to help offset the impact of inflation.
• Read up on the emerging innovations including new digital assets.

Conclusions

It is time to review every aspect of your personal balance sheet, from the cash held in bank accounts to real estate properties, from credit cards to HELOC’s and mortgages. We are rotating portfolios to reflect a rising interest rate and higher inflation environment. We will also help review any balance sheet rotations that need to take place as you move toward interest-bearing cash and real estate that can benefit from inflation and move away from adjustable-rate debt and holdings that will be reduced by declining cap rates. The bottom line is that inflation is damaging over time. The primary impact is in future purchasing power, which can lead to a standard of living reduction and negatively impact the ability to pay for essential services later in life. The best way to combat inflation is to own assets that can appreciate in value and then can be turned into cash in order to pay for life expenses when necessary.