2021 So Far. What you need to know.
Markets have voted in favor of “risky” assets so far in 2021. Through the end of the first quarter, inflationary and growth-oriented asset categories such as commodities and stocks outperformed the deflationary and safety assets of US Treasury bonds and gold.
Vaccination rates and reopening are happening at a faster pace in the US vs. other major world economic regions. This has undoubtedly contributed to the outperformance of US stocks vs. the rest of the world.
Recent reports show the US economy is on a solid recovery path. GDP is now widely expected to continue above trend (>3%, Via IMF) for the next two years. Coming out of the ’07-’08 recession, it took forty months for retail sales to recover, it took just five months during Covid. March’s employment report showed 916,000 jobs added, the most in seven months, and the Institute for Supply Management reported factory activity expanded at the fastest pace since 1983. We’re seeing across the board growth in economic data and leading economic indicators continue to show strength.
Underpinning the already vibrant recovery is extremely accommodative fiscal and monetary support--$12.3T between February 2020 and March 2021. The Biden administration’s economic objectives go beyond “restarting” the economy with its fiscal initiatives. New policies also seek to address social inequality and minority unemployment. The President’s latest fiscal initiative unveiled early this month targets $2T in infrastructure spending over and above $5.5T of Covid-related legislation enacted thus far. As policy makers push the boundaries of borrowing limits, deficits continue to grow. The CBO currently estimates US budget shortfalls in the range of $1T/year through 2025. So far, markets don’t seem to mind.
Add to this a monetary policy pivot from objective to outcome-based policy (the Fed now wants to see actual sustained inflation before acting), and you have a recipe for an epic overheat in the economy and markets. Compared to the response during the Global Financial Crisis (GFC), when ten years of expansive monetary expansion and Quantitative Easing (QE) failed to stoke inflation, officials today believe more can be done to accomplish economic objectives before inflation experiences a pronounced upturn. Some market participants disagree, noting a key difference being post-GFC monetary policy remained trapped in the financial system, elevating the prices of stocks and bonds. Today’s added fiscal response provides “money to the people” in the form of enhanced unemployment benefits, fiscal checks and perhaps infrastructure spending. These payments put money directly into the real economy, which could in turn stoke inflation much faster than the QE of the last cycle. If a sustained upturn in inflation were to occur, you would expect to see real assets—real estate and inputs to production such as basic materials and commodities—outperform financial assets—stocks and bonds.
Portfolio Implications
Stocks- Make no mistake about it, risky assets are in a speculative bubble—some parts more so than others. As Howard Marks has stated, “returns are most generous when capital is scarce and lowest when capital is plentiful.” There is ample evidence of excessive risk taking. We are observing record high US equity and equity-linked issuance, record low borrowing costs for the most financially-fragile companies, historic growth in margin debt, stock allocations at near-record highs, fraudulent and meme driven storylines and NFTs, SPACs and cryptocurrencies accounting for an increased share of investors’ portfolio allocations. While the valuation holdout in recent years has been, “well, we’re not as expensive as 1999,” certain metrics now meet or exceed 1999’s all-time high in valuation.
In a world awash in liquidity, fundamentals and prudent risk taking have taken a back seat. As long as investors maintain a strong risk appetite, we should expect that stocks trend higher as reopening continues. However, portfolios should reflect one underlying reality—investors are not concerned with the increasing presence of downside risks, and they should be. Overall, lower risk allocations make sense given this environment.
Problems for stocks down the road: 1) looming fiscal cliff, 2) rising corporate and personal taxes, 3) rising interest rates 3) valuations need a reset 4) the post-Covid recovery may be shorter than average.
Within today’s equity markets, there are more appealing risk/return profiles than the broad market S&P 500 has to offer. For example, an internal rotation from growth toward value stocks may be underway. The Covid world accelerated many trends in technology, e-commerce and remote work. Many growth companies profited not only from the stay-at-home and low interest rate environment, but from the pre-Covid low growth economic cycle of the 2010s. With the economy re-opening and interest rates rising, value stocks have the opportunity to play “catch up” from a decade of underperforming their high-growth counterparts.
Additionally, non-US Equities continue to offer attractive long-term return potential, as much as 5% or more annualized, vs. an expected 2% in the S&P 500, as estimated by asset management firm Research Affiliates. Investors have been patiently waiting for non-US stocks to have their day in the sun. With the rest of the world a few months behind in re-opening and the US Dollar losing purchasing power relative to its major trading partners, non-US stocks may get the extra boost needed for a sustained move higher.
Bonds- Even without inflation, the prospects for safe bond returns in the near term are quite dire. The current 10-year yield on a US Treasury bond is 1.57%. Any level of inflation above 1.57%--an outcome that seems all but assured in light of recent FOMC policy objectives—means negative real (after inflation) returns. Despite a horrible return profile, safe bonds do still play a role in a balanced portfolio or a portfolio with a risk-management objective. You need bonds for the times return seeking investments fail.
Gold- Gold finished March 50% above its late 2016 low. However, year-to-date, gold is down over 10%. The biggest positive driver for gold historically is falling real interest rates. Real rates had been in an almost uninterrupted slide from early 2019 until late 2020, when real rates stabilized and turned higher into 2021. If the US continues deficit spending, government borrowing will continue to put upward pressure interest rates. Higher rates will have adverse consequences on the economy and Federal debt service payments. In this scenario, the most likely path would be for the Federal Reserve to limit the extent longer-dated yields can rise, through a process known as Yield-Curve-Control (YCC). YCC caps nominal rates, pushing real rates deeper into negative territory as inflation expectations rise. A turn lower in real yields (breaking green line below) may push gold into another move higher.
