Political theater obscures bigger financial risks

As published in the Minneapolis Star Tribune 1/16/2021.

The thing about historic news events is that they grab all the attention for themselves. Rioters storming the U.S. Capitol and a twice-impeached president have understandably been the focus of media — and our country — in the days since.

But while the political theater plays out on center stage, less awareness is given to matters that, financially speaking, could prove more significant. This is not meant to downplay the attack on our democracy but rather to acknowledge that as far as markets are concerned, rising interest rates matter more than rising political temperatures.

Here are some obstacles that could emerge in the year ahead and endanger the current stock rally:

Inflation. Here’s the higher inflation elevator speech: The Federal Reserve is printing more money than ever before. More dollars in circulation makes each dollar worth less. Inflation will happen (it’s just a matter of timing) and ongoing deficit spending by our federal government in the form of COVID relief will likely accelerate that process.

The fact that core CPI has only risen 1.6% year-over-year is due to the low velocity of dollars flowing through the economy. Once consumers feel safe leaving their homes, increased spending may well spark higher inflation. An inflation rate above the Fed’s 2% target would likely be good for financial stocks, while hurting yield-heavy sectors like utilities and real estate.

Currency movements. This is not so much an obstacle as a potential catalyst. The U.S. dollar has weakened from pre-pandemic levels and trades near its lowest point in six years. Massive monetary stimulus devalues the dollar relative to other global currencies, and this trend may have already triggered a new cycle in which international equities outperform U.S. stocks.

At the very least, it seems unlikely the dollar will strengthen significantly in the year ahead, removing a headwind that has hindered the relative performance of international stocks for much of the last decade.

Supply chains. Remember when the biggest headlines were about America’s trade war with China? Tariffs led to major changes in global supply chains in recent years. The global pandemic then brought another layer of disruption.

Even if the economy recovers rapidly in the second half of 2021, broken supply chains may not be able to meet the strong demand. That could hinder growth. Even if businesses and families are motivated to spend, our economic infrastructure may need more time to heal.

Investor sentiment. Equity prices trading near all-time highs while daily death tolls from COVID-19 set records sends a clear message that investors are willing to think long term when determining “fair value” for stocks. No matter how deep the pandemic cuts the economy, it remains temporary.

As strange as it sounds, there’s a risk of sentiment and market momentum worsening after we reach the finish line.

Once the population is vaccinated and the pandemic is behind us, we might realize our economy faces challenges — high unemployment, worsening inequality, sky-high debt — temporarily forgiven in the face of a global crisis. For now, the idea of facing those challenges with the pandemic behind us remains something to look forward to.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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