From, Peter Mueller & the HoyleCohen Investment Committee
With the first quarter of 2021 now behind us, normalcy has resurfaced in much of our daily lives and in the economy as a whole. The pandemic and economic crisis of 2020 began with a health crisis and it is rightfully ending with a solution to that crisis – the prevalence of science and mass vaccination programs. Much like fiscal and monetary policy, vaccination programs are having a positive impact on economic activity – working as an accelerant to the economic rebound.
In the US, we have ample vaccine supply to go around, and one by one, states are lifting covid restrictions. In California, the Governor has announced that the state will fully reopen on June 15th. Economically, activity continues to rebound and accelerate based on pent-up demand, excess liquidity (cash reserves), continuation of expansionary monetary policy (via Federal Reserve), fiscal stimulus (via government spending), a rebound in jobs, and a simultaneous global recovery. Economic activity in the US (as measured by gross domestic product) should grow north of 6.5% this year – reaching its strongest growth level in almost 40 years. Much of the growth will be frontloaded as the recent $1.9 trillion stimulus puts money directly in the hands of consumers and businesses where it is needed most. Growth rates should then taper a bit throughout the year as the effect of the stimulus wanes.
In order to elongate the economic cycle, government is debating a $2.25 trillion infrastructure spending bill that will make long-term investments in our country’s infrastructure and alternative energy (both areas are sorely needed). This spending program is proposed to be spread out over 8 years and will serve to provide a longer-term stimulus to economic activity – via investment and job creation. If the money is allocated wisely, these investments will generate a positive return both socially and economically – far offsetting the cost that can be financed with today’s low interest rates.
While economic growth should shoot the lights out this year, market returns will most likely be choppy and lower than the stellar returns of 2020. Markets are always looking forward and much of the run last year was in anticipation of the recovery that we are now experiencing. Consequently, corporate earnings will need to grow into current valuations. However, we are seeing this take place at a faster rate than previously thought as 4th quarter 2020 earnings exceeded market expectations. We anticipate good earnings results for the 1st quarter 2021 as earnings reporting seasons gets underway this month.
Another issue impacting asset returns this year will be the increase in the market derived risk free interest rate over time (currently the 10 Year US Treasury Note, or risk free rate, is at 1.68%) coupled with the rise in inflation expectations due to the government spending and the economic rebound.
As the economy expands and there is more demand for goods, services, and money – interest rates will naturally rise, or normalize, to levels seen prior to the pandemic and reflecting the stronger economy (these are intermediate to long-term interest rates set by the market). While this normalization of interest rates is a positive as it’s reflective of a post-pandemic world and a vibrant economy, the higher interest rates can adversely affect stock price values. Simply, as interest rates rise, the cost of borrowing increases for businesses and consumers which slows economic activity. Also, the earnings stream that companies generate in the future is valued in today’s dollars using a derivative of the risk free rate (10 Yr US Treasury) to determine value. As interest rates rise, the current value of those long-dated future earnings decline, thus affecting the stock price today. Of course, there are other factors that affect price, but the relationship between interest rates and valuation is one of the most important components to price realization.
Finally, inflation expectations are also increasing due to government spending and the economic rebound. Benign inflation is symbolic of a healthy economy and we have seen low levels of inflation prior to the pandemic that persisted globally since the great financial crisis of 2008. Technology remains a deflationary force which is prevalent in today’s digital economy and will continue to play an important role in anchoring inflation expectations. However, high inflation worries persist in the marketplace today due to the economic rebound and government spending which can cause periods of asset price volatility. Both the Federal Reserve Chairman, Powell and Treasury Secretary, Yellen believe that while current inflationary forces will be transitory (a temporary surge as a result of the stimulus, but wane over time), they are both willing to overshoot inflation targets in the short-term to make up for the deflationary pressures that have persisted in recent years. The question remains how long they will let short-term inflation trends run hot and if they fall “behind the curve” and inflation pressures remain which are corrosive to the economy, purchasing power, and corporate profits. This would cause the Fed to remove monetary and fiscal stimulus sooner rather than later which would likely result in a negative period of adjustment for the financial markets.
Market returns during the quarter have been a bit choppy as a result of the changes in interest rates and inflation expectations. While returns for the quarter were strong, beneath the market we are seeing a rotation into smaller capitalization and value oriented companies at the expense of the market leading growth companies (specifically technology). The broadening out of market leadership and participation to include sectors other than solely technology is a very positive development for the sustainability of the bull market. We have maintained exposure to sectors benefiting from this rotation including financial services, industrial, and traditional energy. However, while technology may take a short-term rest in performance, it is so central to our digital economy that it will remain a cornerstone of your portfolio and future expected return.
We leave you with some perspective from JP Morgan Chase CEO, Jamie Dimon as written in his annual shareholder letter released 4/7/2021:
“I have little doubt that with excess savings, new stimulus savings, huge deficit spending, more QE, a new potential infrastructure bill, a successful vaccine and euphoria around the end of the pandemic, the U.S. economy will likely boom. This boom could easily run into 2023 because all the spending could extend well into 2023. The permanent effect of this boom will be fully known only when we see the quality, effectiveness and sustainability of the infrastructure and other government investments. I hope there is extraordinary discipline on how all of this money is spent. Spent wisely, it will create more economic opportunity for everyone.
While equity valuations are quite high (by almost all measures, except against interest rates), historically, a multi-year booming economy could justify their current price. Equity markets look ahead, and they may very well be pricing in not only a booming economy but also the technical factor that lots of the excess liquidity will find its way into stocks. Clearly, there is some froth and speculation in parts of the market, which no one should find surprising.”
All the best,
Peter Mueller & Your HoyleCohen Team