“So be sure when you step, step with care and great tact. And remember that life’s a great balancing act. And will you succeed? Yes! You will, indeed!”
— Dr. Seuss, from Oh, the Places You’ll Go
As we arrive at the end of the first quarter of 2021, it is stunning to look back over the past 12 months and ponder all that has occurred. We will focus on the economy and markets, but the scale of the medical, social, and political events we have witnessed this past year is almost overwhelming. We hope you and your family have navigated the last year successfully and see much to be excited about as we all move beyond COVID-19 and return to an approximation of life prior to the pandemic.
When writing this letter last year, we were trying to digest the reality that an unknown virus was rampaging across the globe and had forced the almost unthinkable; a near total closure of the US economy. In that letter, we laid out our approach to the unprecedented circumstances: 1) do not sell equity exposure during the panic and use cash reserves to support spending needs, 2) rebalance back into stocks to keep appropriate exposure to a likely recovery, and 3) look for places to go on the offensive. Those three tenets have served us well and allowed us to maintain a balance through the crisis as we head into the start of a recovery. As we continue to scan the horizon for new risks and opportunities, we must be mindful that we continue to live in a volatile environment.
The broad US equity market continued to march higher in the quarter, but under the surface, a significant rotation is occurring in the type of stocks leading the market. In the fourth quarter of last year, value beat growth by 4.8%, a significant departure from the trend over the past decade. The strong showing from value firms accelerated in the first three months of 2021 with the value index beating the growth benchmark by 10.3%. The energy, financial, and industrial sectors, all significant components of the value index, were the three best performing sectors in the quarter, while the influential tech sector was barely positive. This rotation is a healthy development for a market that had become overly reliant on mega-cap technology firms to deliver positive returns. We have written in the past about the concentration of the largest five stocks in the S&P 500 and the need for the other 495 equities in the index to catch up if the market was going to continue to grind higher. The trend towards value over growth is one indicator that this transition is underway.
This rotation is critical to the future path of returns because the market remains expensive on a price to earnings (P/E) basis. Improved performance from the cheaper parts of the index will help the market “grow into” these elevated earnings expectations. With the S&P 500 up +31.5% in 2019 and +18.4% in 2020, we have essentially pulled forward several years’ worth of returns into a 24-month period. A reasonable path forward would see the equity market post positive returns as earnings meet elevated expectations, cheaper sectors continue to perform, and interest rates remain contained. We must remind ourselves that the equity market will not rise 18%+ every year and that more moderate returns over the next few quarters is not a reason for panic.
The S&P 500 forward P/E ratio is currently 22.95, well above the long-term average of 17.28, but slightly lower than it was a year ago. As noted in previous letters, the elevated P/E is more reasonable when viewed relative to interest rates. However, that justification becomes perilous if the yield on the 10-year Treasury spikes higher. Interest rates are low on an absolute basis, but the 10-year yield has gone from 0.91% at the end of December 2020 to 1.74% at the end of March 2021. This rapid rise in rates has quickly adjusted market expectations for the path of yields over the next few quarters. This sharp rate of change is more important than the actual level in the short run. While a 1.7% yield on the 10-year is historically quite low, it is almost double the rate just three months ago. This sudden surge has forced investors to reconsider their valuation frameworks and will likely cause additional volatility as equity markets react to changes in expectations for fixed income yields.
The move in interest rates is a direct result of several factors that have coalesced over the past few months: 1) a brisk start to the vaccination program in the US, 2) the passage of an additional $1.9 trillion stimulus package by the US Congress, and 3) the announcement of additional US government spending initiatives with a focus on infrastructure. Bond investors have reacted to the prospect for stronger GDP growth, higher government spending, and larger government deficits than previously anticipated.
Higher interest rates should ultimately be seen as a positive development. Enhanced GDP growth is a clear benefit, and some excess inflation after a decade of below target readings is not cause for alarm. However, we must remember that markets have a tendency to overreact to the immediate data. We are likely to see several months of shocking headline numbers on inflation and GDP growth as current figures are compared to the numbers posted during the COVID-19 shutdown period last year. These year-over-year comparisons will surprise some market participants and will likely cause volatility in the next few months. We remain focused on longer term trends and view these episodes as noise that we must understand and acknowledge, but largely ignore in reality.
The State of the U.S. Economy
We are beginning to see the outlines of the post-COVID economy, and initial indicators are impressive. The International Monetary Fund (IMF) recently published its updated global forecast and expects US GDP to grow by 6.5% in 2021. To place that number in context, the IMF expects average economic growth in emerging markets for the year to be 6.7%, meaning the US is expected to grow like an emerging economy this year. Given the amount of government support, accommodative financial conditions, and sense of optimism coming out of a year of challenges, that forecast may under estimate what our economy may produce this year. Recent returns from the US equity market indicate investors have already assumed economic growth at or above these levels.
The labor market continues to improve, and by the end of 2021, we will likely see unemployment below 5%. An impressive result considering where we were one year ago. The reason for the rapid recovery on the jobs front is that most of the positions lost during the pandemic were service related jobs in industries directly impacted by the shutdowns. As normal operations commence across the country, those roles will be quickly filled as the need for hospitality, retail, and event workers snaps back almost immediately.
Much has been made of the potential impact of the massive fiscal support packages that have been passed by the US Congress over the past year. Depending on how one classifies certain programs, the total is upwards of $5.7 trillion (yes, trillion with a T). That represents more than 30% of our pre-COVID national GDP, and is truly an unprecedented amount of spending to be allocated and dispersed so quickly. While impressive, it can be difficult to understand exactly where these dollars may be flowing, and what direct impact they may have.
One place to look is at the personal savings rate in the US. The stimulus bills contained very generous provisions that put cash directly in the accounts of most consumers. There were noticeable spikes in savings in the spring and winter when the payments were dispatched by the Treasury Department, and many households are exiting the pandemic with significantly more savings than they entered it with. Other factors including lower credit card balances and the benefit many received by refinancing their home mortgages at historically low rates provide additional confidence that the economy is poised for a large bounce. The consumer drives 60%+ of our growth, and most have significant savings to spend in a moment when they could be eager to make up for lost time.
Bumps in the road? – Tax Rates, Inflation & Something Worse
While the immediate economic outlook is exciting, all is not necessarily clear on the road ahead. With faster than trend economic growth and significant future deficits caused by substantial government spending programs, inflation and taxes are the risks most commonly cited for investors.
Taxes are the most immediate concern. In short, taxes will increase for corporations in the US. The infrastructure proposal that President Biden has put forth includes an increase in the corporate rate from 21% to 28%. Perhaps, even more important for US multi-nationals, the administration has also engaged with countries in the OECD to put forward a plan to develop a global minimum tax focused on digital revenues that can be difficult to assign to specific countries. While it is uncertain as to when these new formulas will be implemented, the bottom line is clear: higher taxes for firms in the US. Goldman Sachs analyst David Kostin estimates the impact on future S&P 500 earnings per share to be a 6.5% annual decrease in 2022 and beyond when compared to current tax regulations. This is not a positive development for corporate earnings growth and could have a significant negative impact on future equity returns in a market that is already expensive on a price to earnings basis.
Inflation is the other issue frequently in current headlines. We have already discussed the jump in consumer savings due to federal spending, but that is only one piece of the support Washington has provided. The Federal Reserve has been expanding its balance sheet by purchasing government, mortgage, and corporate bonds since the crisis began, and this injects cash into the banking system. When the Fed buys bonds from banks it pays out cash in return. Since they have a very deep wallet, they can deploy a significant amount of capital. One way to measure this is to look at the official monetary aggregates, or amount of money in the economy. This measure of all cash in circulation, bank accounts, and money market funds in the US is known as M2 and has seen a staggering increase in the last 12 months.
The rise in the money supply would traditionally cause market expectations of future inflation to also spike. The old adage that inflation is a result of “too much money chasing too few goods” would seem to be a real threat. However, market based indicators of inflation expectations, such as the five year forward breakeven rate, seem contained. While the rate has moved above 2%, it is still below longer term averages. This is likely due to confidence that the Fed will be able to withdraw its extraordinary balance sheet support before an inflationary spiral takes hold.
Investors anticipated higher inflation as an outcome of government spending after the 2008 financial crisis. In 2012, inflation expectations were above 3%, but it never materialized. In fact, inflation has failed to reach 2% on a consistent basis over the past decade, and has averaged only 1.8% since the start of 2009. Markets are signaling that investors expect higher inflation as the economy reopens and supply chains adjust, but by 2022 it will return to its pre-pandemic trend of below 2%. That path would allow the Federal Reserve to raise interest rates at a measured pace, enabling the economy to get back to full employment before tightening policy.
That scenario would be very supportive for financial markets and would be an excellent outcome for investors. This would prevent a sudden revaluation of equity markets that an increase in interest rates would force upon market participants. Elevated equity multiples only makes sense relative to very low interest rates. If that paradigm shifts quickly, it will force investors to adjust their perspective at a time where almost all assets are expensive and markets seem priced for perfection. At this point, such an outcome seems remote, but remote risks can cause serious damage.
As frightening as the prospect for runaway inflation and surging interest rates may be, the opposite may make for an even worse surprise. If at some point we do not see higher inflation and interest rates, that means markets are anticipating slow growth or even deflationary periods in the future. If mediocre long-term growth and inflation expectations become imbedded in the minds of investors, even in the face of massive stimulus efforts, it could indicate a truly stagnant future economy. That is a fate worse than a short bout of above average inflation and something Japan has been unsuccessfully wrestling with for over 30 years. From the actions of the Fed, it seems clear they agree.
A Constant Balancing Act
It is an old adage that markets are driven by fear and greed. In reality, the market just reflects human nature. A year ago, fear had the upper hand. Today, greed seems firmly in control. Balancing these two emotions when positioning a portfolio is a critical, ongoing task that is never completely accomplished. Markets continue to evolve, and we must evolve with it.
We remain focused on the three tactical themes we emphasized at the beginning of the year: 1) maintain a cash reserve to cushion market volatility, 2) balance exposure to growth and value strategies in equity holdings, and 3) seek yield in private credit markets. In addition to the three main areas, we continue to monitor emerging market equities, additional alternative exposure in private growth equity, and potential opportunities in commodities and infrastructure.
The past year has been challenging, but we must be humble enough to remember that all generations have passed through difficult periods. We have always doggedly moved forward, and today is no different. We will continue to invest the assets we have been entrusted with to grow in an appropriate manner while also safeguarding them for the future. The macro conditions may change during the journey, but the goal and the course to get there, remain constant.
We hope your 2021 is off to a great start and look forward to visiting, hopefully in person, very soon.