“To everything (turn, turn, turn). There is a season (turn, turn, turn). And a time to every purpose, under heaven.” ~ The Byrds
It seems appropriate to quote The Byrds given we find ourselves in the midst of so much societal and economic change worthy of discussion. How about economic growth for starters? Ronald Reagan was in the White House and Return of the Jedi was in theaters when economic growth hit levels that we expect to see this year if economists are correct. Those surveyed by The Wall Street Journal boosted their average forecast for 2021 economic growth to 6.4%, measured as the change in inflation-adjusted gross domestic product in the fourth quarter from a year earlier. If realized, that would be one of the few times in 70 years that the economy has grown so quickly. Adding fuel to this projection, Congress just approved another $1.9 trillion in fiscal support as President Biden unveiled an infrastructure investment plan to be partly financed by higher corporate taxes.
How about efforts to resurrect normal life after COVID lockdowns? While a purely digital existence has been interesting and miraculous in many ways, it’s not sustainable. Humans are social animals, and we need real interaction with each other to thrive. About a third of Americans have now received at least one COVID vaccine and recent data shows 19.4% of the U.S. population is fully inoculated against COVID-19 according to the Centers for Disease Control and Prevention.1 We’re not out of the woods yet. But parts of pre-pandemic life are returning, from Hollywood movie openings (Godzilla vs. Kong raked in $48.5 million despite capacity limitations at most theaters) and baseball fans are returning to stadiums as MLB kicked off the season on April 1, (roughly 13,000 fans were allowed to watch the Los Angeles Angels play the Chicago White Sox on Opening Day, as Angel Stadium opened at 33% capacity).2
And for investors, what about all-time highs in the stock market coinciding with a historically significant rise in bond rates? The good news is your portfolio has got you feeling pretty good. The bad news is that financial assets have never been so expensive at the start of an economic recovery, and the market euphoria is increasingly turning into concern about the outlook for inflation. Stock markets are discounting machines and it’s important to ask “will people buy 4 Peloton bikes?” or said another way, at what point is all that future growth already priced in? Having been quiet for much of last year, bond markets are getting more worried about inflation, and both central expectations and the inflation risk premium have started to rise. US 10-year Treasury yields are currently around 1.7% and forwards indicate they are likely to move higher. That amounts to a ~80 basis point rise in yields in three months, the sharpest move in over four years (Table A). Much of the bond market concern is centered in the US, where some fear the $1.9 trillion fiscal stimulus is too large, especially on the back of $3.1 trillion in stimulus to date, the full effects of which are yet to be felt. In addition to those factors, markets also sense that potentially very large pent-up private demand may meet significant supply constraints across economies once they fully re-open. If that wasn’t enough, underneath those estimates lurk some concerning details – China’s producer prices climbed in March by the most since July 2018 on surging commodity costs and the producer price index rose 4.4% from a year earlier after gaining 1.7% in February.
Table A: Upward Cycles for the US 10-year Treasury Yield and S&P 500 Returns
Source: BofA Global Research, Bloomberg Global Financial Data (GFD).
So what does that mean going forward? In our mind stocks continue to be good assets to own. We do expect further gains this year but with much more volatility. Second quarter earnings between now and the end of May are important because the S&P 500 is trading at 22.6 times its projected earnings over the next 12 months, above the five-year average of 18.143. Higher valuation measures don’t lead to bear markets alone and too many other positive market metrics (technical, macro-economic and business sentiment in particular) still make the market attractive. But I would expect at least one pretty good scare during the summer. Volumes are lower at that time, which can exacerbate some corrections. My guess is inflation concerns will probably be the culprit as it becomes more difficult for the biggest and most expensive stocks to withstand the pressure of long duration valuation measures. But corrections are inevitable and shouldn’t matter to investors with at least a three-year outlook. By the time people start reacting to it, it will probably be over.
The climate on inflation and rates warrants some additional detail, and I asked Julia Zhu, who manages our tactical income portfolio, to share her thoughts on the bond market in this newsletter. For those of you who own large bond allocations (especially with longer dated maturities) this is an important topic to monitor, and a quick 30-minute check-in with your advisor to plan ahead will be time well spent. We have a number of good ideas to help you generate income from your portfolio with a mix of conventional and non-conventional approaches using options.
On a personal note, as we turn into this next season and with my first COVID vaccine appointment behind me, I look forward to reconnecting with friends and family, and even planning a summer getaway. My hope is that you and your family are also looking forward with hope and promise of greater things to come, this summer and beyond.
Notes:
1 Source: Centers for Disease Control COVID-19 statistics.
2 Source: ESPN.
3 Source: FactSet.
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