We’re Due for a Pause in Growth, but the Backdrop Remains Positive
“As long as the roots are not severed, all is well. And all will be well in the garden. Yes! There will be growth in the spring!”
– Chauncey Gardener, fictional character played by Peter Sellers in the movie, “Being There.”
This first quarter absolutely echoes the sentiments contained in some of the key dialogue in the hilarious but insightful 1979 film, “Being There.” As taken from the quote by the movie’s main character, Chauncey Gardener, we certainly have seen growth in the economy, earnings and stocks this spring and over the last 12 months.
Only a year ago, as the pandemic was just beginning its spread, headlines boldly compared the likely economic and market consequences of social distancing and restrictions on businesses to invest in our health to that of 1931 and the Great Depression. Yes, we did suffer a 34% market swoon in March 2020 and an associated sharp recession, but both were over in a blink of an eye. In fact, the recovery in the 12 months following the trough in the S&P 500 on March 23, 2020, is the strongest rebound off a bottom in that timeline in 75 years. The 75% price return in the S&P 500 that investors have enjoyed from that low point just over a year ago, is almost double that of most other bear market rallies we’ve studied.1 There is good reason for this.
As Chauncey Gardener also said, the roots of our solid economy going into the pandemic were not severed. The U.S. economy was not flagging as we began the economic shutdown for health reasons, it was growing and in good shape. As a result, we felt pent-up demand from the lockdown period would present itself in the reopening if policymakers would provide appropriate assistance, via fiscal and monetary stimulus. They have done that in spades, as we thought they would.
The federal government has provided massive stimulus in the form of direct payments to consumers, additional unemployment insurance, and other measures to aid the economy and get us through the rough patch. The annual level of support in 2020 and 2021 is four times that of what we saw over the entire Great Financial Crisis back in 2007/2008.2 Wow. As a result, for most people, the economy recovered swiftly and has kept chugging along after only brief interruption. The table below captures this well.
The table illustrates that the U.S. economy, as measured in real GDP (gross domestic product), is now back to roughly the same levels as it was before the pandemic. Inflation and rates are lower. That ugly flat two to 10-year yield curve that everyone feared would invert, is now signaling confidence that the economy will grow going forward and has steepened handsomely. Further, credit spreads remain tight, another sign of investor confidence. The March 2021 readings for consumer confidence surged, and personal disposable income levels fueled by stimulus payments are more than 10% above pre-pandemic levels.
The question is, of course, can this strength be sustained? Can we shift from growth and recovery that is supported by government borrowing and spending to organic growth that has runway? After all, government stimulus as a percentage of GDP is set to fall from a historically high level 11% in 2021, to a far lower 2% in 2022. Our short answer is yes; the economic strength is sustainable. But clearly there are some transition risks that may cause some investor angst and volatility while we make this pivot in source of growth.
Coronavirus Update—Part of the Green Shoots Story
I am hopeful that this is one of the last commentaries I pen where I show updated data on the number of new daily cases of COVID-19 being reported in the U.S. As of this writing, at the end of March, new cases in the U.S. averaged 61,000 a day compared to 315,119 last January,3 which is a significant improvement. However, the current numbers compare to last summer’s peak. That said, I’m cautiously optimistic about where we are given the additional data that shows the percentage of Americans who will likely have been vaccinated by June 2021. This could mean an expansion of reopening the U.S. economy by second half of 2021; only time will tell.
The mobility data that includes metrics, such as trends in airline traffic and open table reservations, supports the story that many seem to be getting back to more “normal” activity patterns in this country. I must note how impressive it is that the vaccine distribution rate shows that 80% of the U.S. population will be vaccinated by mid-year. Experts anticipate it won’t be until early 2023 when the rest of the world achieves these levels. In fact, at the time of this writing, France just announced their third lock down. Despite all the negative rhetoric, the U.S. has set a steady pace in inoculating the population. Perhaps we lagged foreign countries on social distancing and tracing in 2020, but we have advanced the development and launch of COVID-19 vaccines.
The above facts are critical components to the continued reopening story in the U.S. and rejuvenation of the important service sector. Approaching herd immunity should allow the travel, airline and hotel industries to accelerate and catch-up with the already recovered manufacturing sector. This is key in fostering that shift from government-sponsored stimulus and growth to true organic growth with the runway we anticipate. We appear to be well on our way at this juncture.
Update on Key Wall of Worry Items
So far, we have covered the honey-oriented items out there, or the positive factors. There’s some vinegar in the jar, too. The current wall of worry items include:
- The specter of rising inflation and rates; what if the Federal Reserve (Fed) must hike short-term rates as a result?
- The probability and potential impact of legislation to increase tax rates on the wealthy
We’ll address each of these sequentially:
Inflation, Rates and the Fed
We accept the Fed’s argument for now that we should expect some one-time bumps in prices in certain goods and industries as consumers begin to resume normal activities…restaurant prices should rise as capacity in the industry normalizes. The same should occur in such industries as lodging and airline travel. These should not be sustainable, however.
The Amazon factor in price transparency is alive and well. This serves to put a ceiling on inflation. Importantly, labor productivity has accelerated handsomely, and this serves to enable companies to increase wages they pay workers without having to raise product prices commensurately to maintain margins. The bottom line is that we believe inflation will accelerate a tad but in controlled fashion…we are still at low levels and do not see a nasty wage-price spiral on the horizon. For similar reasons…measured inflation expectations…we see bond yields rising, but in measured fashion. There are plenty of foreign buyers of our bonds at present. If anything, bonds look a little oversold at this moment, and the recent rise in yields is due for a pause.
Regardless, we built into our base case expectations (which called for an S&P 500 of up to 4,150 by year 2021), a range in the 10-year bond yield of 1-2.5%. We currently stand at 1.7% on the 10-year Treasury and that fits snugly in that range. It is only if rates rose sharply and swiftly above that range level that we would become significantly more cautious.
As for the risk of the Fed becoming less accommodative, they have said they won’t for a while, and we believe them for now. We know that, at some point, if the economy does continue to chug along nicely, they will react. In fact, in a growth environment, normal real Fed funds rates are 1-2%. The economy is used to that and should eventually accept that in stride. But, when the Fed begins to suggest they are leaning toward hike short-term rates, typically investors will react negatively and that could cause volatility and a short-term correction in stock prices. The good news is that, reasonable hikes don’t generally end a bull market amid a positive fundamental backdrop. We think the Fed is unlikely to begin unwinding accommodation when rates and inflation are still this low, unemployment still above pre-pandemic levels, and with the possibility of an increase in tax rates for the wealthy on the horizon. We need to see more inflationary pressure and lower unemployment levels to adjust our thinking.
Probability and Impact of Potential Tax Increases
We are not political analysts, but we do talk frequently with some very good ones. Based on the details associated with upcoming proposed infrastructure legislation, we do think investors need to brace themselves for discussion of tax hikes for those making above $400,000 and their eventual passage. But in our minds, the key is not to panic about worst-case outcomes…with leadership so split, worst-case outcomes very rarely are realized. If the wealthy do experience tax increases, these are the salient points that allow us to maintain a still positive view on the market over the next 12 months:
- If taxes for the wealthy do increase, this is likely a 2022 event and not retroactive.
- Worst-case tax rates bantered about are unlikely to occur with political leadership so closely divided…e.g. a maximum 28% capital gains tax rate is far more likely in our view than a 40% tax rate mentioned during the 2020 campaign.
- The potential tax hikes should reduce earnings growth a bit in 2022 but to only still-healthy levels from current robust levels…in other words, growth will still be solid.
One must remember that we experienced healthy tax increases in 1993 during the Clinton years. It was right in the face of one of the best seven-year runs in the S&P 500 on record. So, let’s not let the tax tail wag the dog yet, regarding our stock market outlook.
Conclusions and How to Position?
In assessing the still favorable fundamental, valuation and earnings growth metrics in the face of these upcoming wall of worry items, we still maintain our base-case call for 6-13% returns for the S&P 500 in 2021. We reaffirm our hold-your-ground, positive view on U.S. stocks. These headline concerns are manageable in our view and should not derail the ongoing bull market advance. They could spark a temporary correction, but not necessarily so given the rotational behavior we’ve seen at the sector level already this year.
Instead of a correction at the index level, perhaps we’ll just experience a brief stall in the overall market and instead absorb rolling corrections in various sectors before moving on to higher-highs later in the year. For example, the tech-laden NASDAQ Composite Index is off more than 10% in 2021, with a stalwart constituent such as Apple down almost 20% from its high.4 Maybe this is the choppy type of behavior we’ll see for a bit as the economy transitions to a broader reopening and organic growth clearly resumes.
In addition, we believe that these headline items, such as the fear of rising inflation, will impact positioning of a portfolio rather than how much to dedicate to stocks. For instance, rising rates and inflation have tended to benefit stocks in financial and commodity-related areas. We will pay attention to such opportunities. However, for us, staying invested and proper balance in portfolio construction is key in the midst of this transitional choppiness. One day the cyclicals seem to do well, while the following day, the market is back on a growth-stock theme. In this environment, we want exposure to both grow and value in a fairly balanced way. Stay tuned.
3“Here’s Where Cases are Rising and Falling,” Healthline
The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s and is comprised of 500 companies chosen for market size and industry group representation. The NASDAQ Composite Index is a market value-weighted, technology-oriented index composed of approximately 5,000 domestic and non-U.S.-based securities. It is not possible to invest directly in an index.
The 2-10 Treasury Yield Spread is the difference between the 10 year treasury rate and the 2 year treasury rate. A 2-10 treasury spread that approaches 0 signifies a flattening yield curve and anticipated slower growth. A steepening yield curve typically indicates stronger economic growth and rising inflation.
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