The U.S. economy is currently experiencing a significant rebound, fueled by major progress in the pace of Covid vaccinations and a massive amount of fiscal stimulus. Barring a setback in the fight against the Virus or some other ugly surprise from left field, this double dose of medicine and money coursing through society and the economy should drive economic growth and lead to higher prices for stocks and other risk assets through the rest of the year.
As Chart 1 shows, the acceleration in vaccination in the U.S., has been remarkable. At the beginning of the year, the U.S. was vaccinating about 325,000 people a day relative to an average daily infection rate of about 250,000. Today, the U.S. is providing over 3 million daily vaccinations relative to an average daily infection rate of 75,000. At the current rate, the CDC estimates that close to 80% of the total U.S. population could be vaccinated by the end of June, allowing the population to achieve herd immunity.
The rest of the world, excluding the U.K. and a few other exceptions, currently lags the U.S. on the vaccination front by a wide margin. We think that Europe and the rest of the world will start to catch up in the coming months as vaccine supplies become more readily available.
As Chart 2 shows, the U.S. also leads the pack in terms of fiscal stimulus, but the amount of extraordinary stimulus throughout the rest of the world is still formidable. This should support a robust economic recovery outside the U.S., providing that vaccination efforts are successful in finally smothering the growth of the virus.
A tsunami of money…
In the U.S., the amount of extraordinary fiscal and monetary stimulus has been unprecedented. In March of 2020, the Federal Reserve lowered the Federal Funds rate to 0% and embarked on a massive new program of buying bonds and other assets to stabilize markets. Meanwhile, Congress passed the $2.2 trillion-dollar C.A.R.E.S. Act, followed by a $900 billion Covid relief bill in December, followed by the recently passed $1.9 trillion American Rescue Plan. Now the Biden Administration is working on an additional $2 trillion infrastructure bill. Together, these bills amount to over $7 trillion dollars in extraordinary spending or almost 30% of GDP. By comparison, the fiscal response to the Credit Crisis amounted to less than 5% of GDP.
There is literally a tsunami of money flowing into and through the U.S. economy. Much of this money will flow into increased spending and economic activity in the U.S. and around the world. It will also likely flow into financial markets driving the prices of stocks, real estate and commodities even higher.
Outside the U.S., the amount of monetary and fiscal stimulus has also been significant and will boost the respective recoveries, especially in Europe. China is much further ahead in its recovery but will still benefit from increased demand for goods and services from the U.S., Europe and the rest of the World.
Inflation and Interest rates.
One logical concern is that all of this money will lead to runaway inflation and significantly higher interest rates. Already this year we have seen the yield on the 10-year U.S. Treasury bond rise from 0.9% to 1.6%, a 67% increase. While the percentage increase is significant, the absolute yield is still low by historical standards and not enough to hinder economic growth.
In the near-term, we would expect inflationary pressures to build in some parts of the economy, especially in areas where supplies are constrained and capacity is limited.
The Federal Reserve believes that these pressures will be temporary and will subside as the supply of goods and services rises to meet demand and as the stimulus tapers off. For the time being, we are inclined to agree with this viewpoint but think it is wise to have some inflation protection in portfolios.
Although the markets have been concerned about both inflation and rising interest rates, Charts 3 and 4 show that markets can actually rise as long as the rise in both inflation and interest rates remain within normal ranges. Large selloffs in markets typically occur only after the Federal Reserve starts to tighten monetary policy and rising interest rates precipitate a recession. We don’t expect that to happen in the next 12 to 24 months.
Over the longer term, we think that unsustainably high levels of government debt will lead to higher inflation and interest rates and slower economic growth. This will be a more persistent challenge for the economy and markets in years to come. Despite the potential hangover and a potentially more challenging environment for risk assets, rising inflation and interest rates are even more challenging for cash and bonds which are almost guaranteed to lose intrinsic, if not nominal value. It still makes sense to own assets that can maintain and increase their intrinsic value over time.
Taxes:
Taxes will very likely increase in the United States to help pay for some of this spending. As with the concerns with inflation and rising interest rates, we think that a lot of the near-term fears about tax increases are overstated. Congress is sharply and equally divided and so Democrats need every vote to pass any legislation. They will likely focus on low-hanging fruit such as an increase in the Corporate tax rate from 20% to somewhere between 25% and 28%. This is still below where it was during the Obama administration and the economy performed well.
Another easy increase is to allow the current and temporary $11 million per person estate tax exemption to expire. This will happen automatically and the exemption will revert back to $5 million per person. Congress may try to increase the top marginal tax rate for high income earners and may increase the long-term capital gains rate, moving it in line with the rate on earned income, but this may only apply on realized gains in excess of a high threshold like $1 million.
Other measures, like an elimination in the step-up of the cost basis on holdings upon death or an outright “wealth tax” on people’s assets are more controversial, less practical and less likely to pass. As with most legislation, lots of ideas get thrown around but most don’t make it into law. The bottom line is that we do expect some tax increases, mostly on corporations and higher income individuals, but these will be offset by increased economic growth and investment which should benefit the overall economy.
Where to Invest?
Our base case outlook is for strong economic growth in the U.S. and improving growth in the rest of the developed world in the second half of the year.
This outlook should support rising stock prices but not uniformly, and less in the U.S. than in the rest of the world where valuation levels are lower and there is more room for improvement.
As Chart 5 shows, the forward Price to Earnings ratio of the S&P 500 Index is significantly above its historical range. The U.S. stock market is already reflecting a lot of good news and high expectations for the future. While market valuations can remain elevated for a long period of time and move from overpriced to more overpriced, expected returns from here on for the broad U.S. stock market are not very attractive.
This is not a uniform truth. Underneath the hood of the U.S. stock market there are significant divergences in valuation between more growth-oriented sectors such as technology, and more value-oriented and economically sensitive sectors such as industrial or financial companies. These sectors were hit especially hard by Covid but also stand to rebound sharply as the economy recovers. Chart 6 shows the current valuation of “value” oriented companies relative to growth-oriented companies in the U.S. stock market.
We do not want to abandon our long-term investment focus on technology and innovation and rapid growth, but think these sectors are currently overvalued, over-loved and over-owned. We have therefore been trimming our exposure to them and redeploying capital into more value-oriented areas that are less expensive and more directly tied to the economic recovery.
The valuation and performance divergences are even more pronounced between the U.S. stock market and the rest of the developed world. As noted earlier, Europe is lagging the U.S. in battling covid and recovering economically. They are behind the U.S. by several months on the vaccination front and infection rates are currently rising sharply, forcing parts of Europe to go back into lockdowns. We think these challenges are temporary. Meanwhile, as Chart 7 shows, international stocks are historically and extraordinarily cheap relative to the U.S. We therefore think that international stocks offer a compelling combination of valuation and opportunity and have been increasing our exposure to them. We are also maintaining a significant weighting to Emerging Markets and the developing world.
We also think that real estate is an attractive asset class, providing income, diversification and inflation protection to client portfolios. We have been particularly focused on areas of secular growth including multi-family housing and industrial infrastructure holdings. We have been avoiding exposure to commercial office space.
With the prospects for rising inflation, both in the near and longer term, we continue to think that gold is an attractive and diversifying holding in client portfolios. We also think that other commodities should benefit from the recovery and can also offer portfolios an added measure of protection against inflation.
Finally, our outlook for bonds remains guarded. It has already been a difficult year for the U.S. bond market as yields have climbed and the aggregate U.S. bond index is down 3%. Bonds still offer a good safe harbor from the storm but we think that it makes sense to keep most of the bond portfolio focused on higher quality and shorter maturity holdings, even if the potential returns are lackluster. We would rather take our risk owning stocks and maintain bonds and cash as a foundational base for the portfolio, providing diversification, stability and capital to redeploy into stocks and other risk assets as opportunities present themselves.
As always, we continue to invest with a global focus; balancing investments targeted at areas of long-term growth and innovation with more defensive equity, alternative and fixed income strategies aimed at mitigating volatility and risk.
Please let us know if you have any questions and/or if there is anything we can help you with relating to your financial life. And, if we can ever be of any help to a family member or friend, we always welcome referrals from our clients.
Jurika, Mills & Keifer
April, 2021