Market and Economic Outlook
Market Commentary - Q2 2021
Fueled by another massive dose of fiscal stimulus for the second consecutive quarter and the ongoing deployment of vaccines, the economic flame is likely to continue burning hot in 2021. President Biden’s $1.9 trillion American Rescue Plan effectively supersized the already enormous fiscal support initially pumped into the domestic economy in response to the impact of the pandemic.
Nonfarm payrolls rose by 916,000 in March—the most since October 2019—while new unemployment claims declined at the fastest rate since the pandemic began and unemployment edged down to 6 percent at quarter-end.
Equity markets continued to cheer progress towards putting the pandemic in the rearview mirror with the large cap S&P 500 index gaining 6.2 percent year-to-date and, at 3,973, within striking distance of the record 4,000 level. In a change of pace from the prior three quarters, and reflecting increasing confidence in a robust economic recovery, more cyclically sensitive domestic large cap value stocks significantly outperformed growth stocks during the first quarter by 9.1 percent. International stocks also posted a solid quarter, rising by 3.5 percent.
Cyclically sensitive equity sectors including energy, financials and industrials—the biggest underperformers of 2020—have outperformed strongly this year while leading technology companies have lagged. U.S. small cap stocks, which are typically more leveraged to the domestic economy relative to their larger peers, have been the best performing asset class over the past year, logging a staggering return of 95.2%.
As consumer and industrial demand surges, commodity prices responded by sending crude oil prices up some 22 percent during the first quarter. Another closely followed economic barometer in the commodity complex, the price of copper, also affirmed the strength of the global economic rebound. The industrial metal now costs nearly double what it was selling for just one year ago.
While equity markets embraced fiscal stimulus-induced economic progress, bond markets recoiled as inflation and growth expectations reset, sending interest rates higher. The bellwether 10-year Treasury yield reached 1.74 percent at quarter end nearly doubling its level at the start of the year.
Bond index returns fell in suit, with longer-term investment grade bonds faring the worst—falling by over 10% year-to-date. Only the most credit-sensitive sectors of the fixed income market were able to overcome the headwinds of rising interest rates to post positive returns for the quarter. Bank loans and high yield bonds benefited from tightening credit spreads and lower sensitivity to the Treasury yield curve. Tax-exempt municipal bonds, while not totally immune from rising rates, fared better due to a combination of stimulus measures intended to shore up state and local finances and increasing prospects for higher taxes on the wealthy.
Not all Roses
Flourishing economic optimism remains at least partially balanced by some notable areas that continue to concern financial markets. In the geopolitical realm, U.S. tensions with China may be bound for a return to the front burner following China’s recent $400 billion, 25-year strategic agreement with Iran that calls for joint weapons development and the sharing of intelligence. Such an agreement only raises the odds that the relationship between the world’s two largest economies becomes increasingly antagonistic.
And of course, the pandemic remains in play.
Many more shots need to make their way into arms before business-as-usual returns.
Here in the U.S., as some states lift mask requirements and restrictions on gatherings, there is concern over a “fourth wave” of infections and hospitalizations due to the existing and emerging variants of the virus. Internationally, the deployment of vaccines has not gone as well as it has domestically. In fact, many countries are already dealing with a resurgence in infections. In this regard, optimism is at risk of being derailed if the progress of global vaccine deployment does not step up to meet expectations.
After twelve months of increasing equity market valuations, the follow-through for corporate earnings is a critical underpinning of future returns. Known and unknown risks notwithstanding, it would not be shocking to see company earnings surprise to the upside again in the second quarter, similar to when the U.S. emerged from the 2008 financial crisis. We believe economically-sensitive areas of the market are poised to show strong earnings growth due to low expectations and an uplift in stimulus-driven demand.
With the recession behind us and a robust early-stage recovery in force, we believe companies should perform well this year. We believe risk asset returns in 2021 and beyond will be driven by the interplay of improving fundamentals, counterbalanced by valuation compression, as the market cycle matures. Meanwhile, fixed income asset classes, particularly those with longer durations, will continue to battle the headwinds of increasing public debt and a reflationary economic outlook. Such a challenging environment for fixed income must be balanced with the potential for an escalation of prevailing uncertainties that can quickly change market appetite for risk assets.
Inflation: Sheep in Wolves' Clothing?
Bond market observers have followed the recent rise of the 10-year U.S. Treasury with concern, with some viewing the risk of rising inflation as the culprit. Investors who solely focus on the risk of inflation may be missing a key piece of the puzzle. Increasing real yields, or interest rates after removing the effects of expected inflation, have been part of the current influence of rising rates and we believe will be the primary driver of higher intermediate and longer maturity U.S. Treasury yields over the next couple of years. However, short maturity rates, Treasuries maturing in less than three years, are likely to stay at low levels for several years.
When interest rates increase for the right reasons, it is not necessarily a negative phenomenon. Accelerating economic growth and improving economic prospects can translate, especially today, into rising real interest rates which is positive. However, there are also several less favorable factors that can also drive real interest rates higher. Further, when rising interest rates are a result of increasing inflation expectations beyond a nominal threshold, it could force the Federal Reserve (Fed) to tap the brakes on the economy through various monetary policy tools at its disposal.
Why Real Yields Matter
Negative real yields, or the difference between expected inflation and nominal Treasury yields, are an exception rather than the norm: over the last 20 years, protracted periods of negative real yields (using 10-year maturity U.S. government bonds) have only occurred twice, most recently since early 2000.
Several factors can combine to drive real rates into negative territory, including global quantitative easing (QE), strong “flight to quality” demand for government bonds such as U.S. Treasuries during periods of market turbulence, and low or even negative central bank policy rates. The end of the current period of negative 10-year real yields may now be in sight. Enormous pandemic stimulus bills and bloated fiscal deficits may result in record net U.S. Treasury bond issuance in 2021 thereby pressuring real yields higher.
Further, stronger economic growth prospects as we emerge from the pandemic as well as a reduced “flight to safety” demand for government bonds should further pressure real yields. In addition, as economic prospects improve and given that markets tend to be forward-looking, a slowing of QE, also called “tapering,” will be anticipated. Finally, stronger economic growth abroad and less aggressive central bank policy may also push non-U.S. government bond yields higher, thereby reducing some of the incentive for foreigners to buy the same quantity of U.S. government bonds.
What Goes Down Must Go Up?
After peaking at 15 percent in March of 1980, inflation has been declining and relatively contained for a few decades, averaging just over 2 percent since 1990. There are several possible explanations for 30 years of contained inflation, including technological innovations and improved efficiency driving prices down, the decline in workforce union representation, an aging demographic, and lower prices for consumer goods as globalization led to lower labor and materials costs in general.
Looking forward, some of the social, economic, and globalization trends may begin to diminish. Labor arbitrage, or seeking low-cost labor outside the U.S., could fade as workers abroad begin to demand higher wages. Changing political winds could cause an increase in unionization. A potential reversal of globalization or repatriation of manufacturing from abroad can reverse a product cost advantage and push prices higher.
Similar to a butterfly effect, exogenous shocks can also impact inflationary expectations. The recent grounding of the Ever Given container ship in the Suez Canal held up about 400 ships for nearly a week and raised concerns that commodity and consumer goods prices would rise as shipments were delayed, impacting “just-in-time” manufacturing. Global supply chain disruption from the pandemic can also pressure input prices higher, at least in the near term.
Other potential inflationary trends include:
The Fed appears unconcerned about the prospects for rising near-term inflation. From the Fed’s point of view, short-term “transitory” increases in inflation are acceptable and anticipated. Furthermore, the Fed’s new policy-making framework, introduced in August 2020, allows for higher levels of average inflation over an unspecified timeframe before they spark monetary policy action.
For now, bond markets agree that inflation increases will be “transitory.” However, if these rising near-term price pressures lead to higher labor costs which become embedded in the real economy, inflation would likely continue to trend higher and the Fed would have to get re-engaged sooner than expected. We do not, however, expect inflation to be more than transitory, yet we do expect intermediate and longer maturity U.S. government bond yields to continue to rise, fueled by an increase in real yields.
As the economy continues to improve, various stocks and other financial assets should benefit from improving growth prospects, but could also be hindered by rising interest rates. Ultimately, we believe the underlying cause or causes of rising rates will determine which factor will win out, thereby driving near term financial market performance.
Readers of the Congressional Budget Office’s (CBO) 2021 annual report, which forecasts debt, deficits, spending, and revenues over the next 30 years, might come away with the impression that our government’s fiscal house is anything but in order.
U.S. Debt to Gross Domestic Product (GDP) will surge from approximately 80% at the end of 2019 to over 100% in just two years and could reach over 200% by 2051. Because these forecasts do not include the recently enacted $1.9 trillion fiscal stimulus package, the CBO’s projected deficit could undershoot the long-term painful tally.
And there may be more debt-reliant stimulus in the not-too-distant future. Discussions are underway to fund a large-scale infrastructure spending program estimated at around $2 trillion and targeting investment in roads, bridges, ports, broadband, climate change and research and development. The package would require a combination of additional deficit spending and, potentially, tax hikes for corporations and high-income individuals.
Doubtless mindful of the deficit impact of the administration’s $2 trillion infrastructure proposal, on top of Biden’s and former President Trump’s $5.2 trillion stimulus bills, Biden’s team is floating proposals to return corporate taxes to 28 percent from 21 percent as enacted in the 2017 Tax Cuts and Jobs Act as well as hike taxes on high-earning households. In so doing, Biden hopes to honor his campaign pledge to enact an economic strategy that will not add to the ballooning national debt.
No Free Lunch
Can multi-trillion-dollar fiscal stimulus bills that rely on government debt issuance be implemented and remain deficit-neutral? Many observers are skeptical and, at some point, markets might begin to discount the negative impacts of current and future deficits.
While targeted stimulus is appropriate to heal a pandemic-sickened economy, it remains to be seen if massive fiscal initiatives will stimulate the overall economy long-term. Equity markets are on a stimulus “sugar high” and, while we could see a short-term economic boost, in the long-term we can expect to fall back to historic growth patterns but with dramatically higher debt and deficits. No good deed goes unpunished and we expect the bond market to reprice debt-associated risk higher, potentially causing volatility in risk assets.
Both the Trump and Biden administrations have provided unprecedented fiscal stimulus measures to help Americans weather the economic disruption from the coronavirus pandemic. The recent $1.9 trillion stimulus package has also clearly been aimed at addressing inequality by allocating billions in stimulus checks to lower- and middle-income households, expanding unemployment relief and directing tax credits to families with children.
This remarkable experiment in income distribution should make it particularly potent in hastening an economic recovery but might also lead to rising inflation, higher taxes and a worsening of our fiscal and trade deficits as it increases the purchasing power of consumer goods by lower- and middle-income households. And debt service and entitlement spending will also become increasingly challenging.
Financial history suggests that when the government debt to GDP ratio exceeds 90%, it reduces potential growth by one-third, i.e., U.S. GDP from 3% to 2% or less. This is problematic as lower levels of growth shrink the economic pie for everyone, limit upward mobility, and entrench widening income and wealth inequality. It is then possible for a domino effect to breed social unrest and result in harmful populist policies that further diminish growth and opportunity. According to the CBO, GDP growth under the current fiscal situation is expected to decline to levels well below those of the prior 70 years due, in part, to rising debt burdens.
We believe the government has one of three options to manage deficit spending and accumulating debt: raise taxes, reduce spending, or ignite inflation to essentially “inflate” the burden away. All these actions invariably have negative consequences for future economic growth potential.
Should investors with investment horizons of decades, rather than years, incorporate rising deficits into their portfolio allocations? While individual portfolio strategies will take into account risk tolerances, income requirements, and legacy considerations, here are a few thoughts on portfolio structure given the potential for rising inflation, reduced entitlement spending and increased taxation.
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