As we enter the second quarter of the year, U.S. stock markets are at all-time highs, interest rates are historically low, and the economy is growing faster than it has in decades. We’re now vaccinating over 3 million people per day, with over 165 million doses administered so far. Life is returning to normal and economic activity is akin to a post-war reconstruction period.
The implications of COVID vaccines for the economy and markets are enormous. So is the scale of fiscal and monetary stimulus. In the U.S. alone, combined monetary and fiscal policy as a percent of GDP (the total size of government intervention relative to the size of the economy) hit 35%. That’s twice as large as the Financial Crisis and even larger than what was provided throughout World War II. Historically, big deficits lead to modest recoveries, but huge deficits lead to robust recoveries. Many investors are still scarred from the financial and economic pain of 2008, but it’s been thirteen years; we’ve gone from a deflationary bust to an inflationary boom. We need a new playbook.
At this moment, we’re experiencing the fastest economic growth in 35 years, with Goldman Sachs, Morgan Stanley and others predicting GDP growth above 8% for the full year. If we get much above that (and we could) we’d have to go back to the 1950’s and 60’s to see comparable growth.
Government intervention has shown its strength here. But it’s worth noting that when stimulus is introduced, or when policies are eased, it takes about a year for the effect on the economy to show up in the data. We talk about the stock market leading the economy, and this is proof positive of that. But I wonder if future growth might surprise to the upside even further. Maybe the lag time of all this stimulus hasn’t been fully priced in?
By the way, all the emergency liquidity measures from last year are still in place. I said last spring that the Fed’s liquidity programs would be hard to end, and well, here we are. Spreads on corporate bonds and junk bonds are back to post-GFC lows and the search for yield is as voracious as ever. The opportunity in credit was a “blink and you’ve missed it” event. For now, we’ll stick with our lower-duration exposure and wait for the right opportunities.
Treasury rates have moved higher, but that doesn’t mean stocks are on the edge. The backup in yields coincided with massive increases in growth expectations. Said another way, the economy is doing much better than expected, which is very good for earnings. In fact, most strategists believe S&P 500 earnings will hit a new record this summer. (And ultimately, stock prices are all about earnings.)
In a typical recession, there are big drops in earnings because companies are slow to adjust. The peak-to-trough-to-peak cycle lasts 3-5 years on average. But last year as companies tried to survive a pandemic, they cut costs to run as lean as possible. So lean, in fact, that even though we had the largest ever drop in GDP, the decline in corporate earnings was the smallest since 1980. So we have entire industries running at maximum operating leverage (minimal cost) while demand is booming. It doesn’t take a big imagination to see profit margins exploding. I have low confidence that full-year earnings estimates are on the mark given how quickly economic growth assumptions are moving.
Valuations may look elevated, but that’s partially because earnings dropped last year. At the start of the last three bull markets (1990, 2002, 2009) valuations looked much the same—high Price-to-Earnings multiples caused by recessionary contractions in earnings. But then what happened? Earnings recovered and the market got cheaper as it went higher. Said another way, earnings grew faster than the prices paid for them. Who’s to say that can’t happen this time?
What about inflation? The Fed believes it will be transitory until we’re back at full capacity. Maybe so, but as I said earlier, we don’t have a playbook for the current environment and neither does the Fed. To their point, our economy is more open now than it was fifty years ago when we last had sustained, above-average inflation. Globalization reduces the likelihood of inflationary price shocks. Also, technology is the biggest sector of our economy and it’s massively deflationary. Demographics don’t support sustained inflation either, especially in Europe, China and Japan. But deficit spending on the scale we’ve been on will have consequences. We just don’t have the framework to know exactly what and when.
Looking to market sentiment, there certainly are pockets of froth. Some of that has been worked off as the SPAC / crypto / “meme stock” trends have cooled. But broad exuberance? I don’t see it. The Conference Board’s most recent survey found that main street is far less bullish on the stock market than usual and far more bullish on bonds! And according to J.P. Morgan, investors have only added a net $7 billion to U.S. equity funds so far this year after liquidating $222 billion last year. That’s not what exuberance looks like. Exuberance looks like GameStop stock in February. Bitcoin in November and December of 2017. Electric Vehicle startups selling for billions of dollars before they’ve earned any revenue. That’s exuberance. The S&P trading at 21x expected earnings is not 1999 dot-com era redux.
As for our approach, we’re still leaning into the reflation trade, with an emphasis on cyclical, value-oriented equity holdings. Earnings growth in these areas should continue to improve as the real economy improves. Plenty of investors worry about rates and inflation, but real economic growth is the more dominant factor. If we’ve got a war-time boom in real activity at a time when inflation and interest rates are going from very low levels back to where they were pre-pandemic, I don’t know if that’s such a challenge—at least not right away. If we get much above the levels of the last few decades, I’ll amend that statement. But in the meantime, I would think investors would accept the normalization of inflation and interest rates in exchange for above-average economic growth.
Household balance sheets are in great shape, corporate earnings are a coiled spring, there are trillions of dollars in excess savings (“demand in waiting”), the Fed is still on hold, interest rates are relatively low, employment is rapidly improving, manufacturing and service sectors are in record expansion territory, we’re about to get a $2 trillion infrastructure bill while productivity growth is double its pre-pandemic pace. The prospect of higher taxes will have to take a back seat for now.
We will get a market correction eventually. Maybe the great vaccine-driven reopening will be a “buy the rumor, sell the news” event. But we’re still in the first year of a globally synchronized recovery fueled by the largest policy stimulus in history with support still in place. It will be hard to keep the market down when global economic growth is in the 4th or 5th quintile. Investors would do well to not overthink it.
Ashley Vice, CFA, CFP®– Portfolio Manager
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