Economic growth rebounded sharply in the 2nd half of 2020 and has continued to gain momentum through the first quarter of 2021. In 4Q20, GDP grew 4.3% from the previous quarter, and was only down an astonishing -2.4% year over year, despite the massive disruption caused by COVID-19 pandemic.I After a year of social and economic hibernation, the light at the end of the tunnel that we’ve been waiting for appears well within sight.
With the availability and distribution of multiple vaccines, the U.S. has seen 7-day moving averages for infections and fatalities decline substantially since peaking in January. As of March 31st, daily infections were down from their highs of 250,000+ /day to roughly 65,000. Fatalities were down from highs of 3,500/day to under 1,000. I As of April 2021, approximately 66 million Americans are fully vaccinated (~20%), while another 112 million are at least partially vaccinated (~34%). II When combined with those previously infected, the domestic inoculation rate is estimated to be around 55%, moving us closer to the 70%-80% range that could represent herd immunity.
While all roadblocks to economic normalcy have not been abated, what we view as favorable spending fundamentals coupled with a faster than anticipated vaccine rollout are converging to create a perfect runway for short-term growth. The Fed has formally acknowledged this as well, despite remaining cautious about recovery timetables, as evidenced by its upward revision of GDP growth estimates for the next couple of years. On March 17th, the Fed sharply upgraded its projection for 2021 GDP growth from 4.2% to 6.5% (highest since 1984), while also moving up its 2022 projection from a range of 2.5-3.5% to 4.0%. IV While long-term annual growth prospects remain largely unchanged (2.0-2.5% range), pent-up demand coupled with historically high personal savings rates are expected to propel GDP growth substantially over the next couple years. Though COVID still remains the primary headwind towards a full economic recovery, there are many optimistic indicators we believe are beginning to emerge from the worst of the global crisis.
Despite heightened optimism regarding economic recovery prospects, the Fed maintained its position that “full recovery” will take some time to materialize. To recap, the Fed reacted to market volatility in February 2020, with a fast and aggressive policy response that started with the Global Financial Crisis playbook and then went significantly further. These actions included cutting interest rates back to zero and initiating fresh rounds of quantitative easing. This level of response was initially critical to stabilize markets and address corporate liquidity demand related to COVID shutdowns. Furthermore, these actions signaled to the economy that the Fed stood ready to use its full arsenal of tools to help businesses survive the pandemic.
A little over a year later, the Fed has continued its robust economic support by expanding its balance sheet to more than $7 trillion since the pandemic started, through the purchase and issuance of fixed income securities, mortgages, and general business purpose credit facilities. IV While there is an expectation that reducing these expenditures will likely be the first stage of “normalizing” monetary policy, there is no indication that the Fed will begin curtailing its current stimulus injection rate of $120 billion/month anytime this year. As such, it would not be unreasonable to assume the Federal Reserve’s total debt could exceed $8 trillion by December 2021.
Furthermore, despite the recent ~85% interest rate spike on the 10-year treasury (from 0.93% to 1.73%), Chairman Powell remained steadfast, in his March 17th FOMC address, that he does not anticipate raising rates for at least another two years. The Fed intends to tie future interest rate policy more heavily to the unemployment rate and other variables that they believe more closely reflect economic progress on the ground. V After slashing the federal funds rate down to the 0-0.25% range in March of 2020, the Fed announced in August that it would pursue a policy of “Average Inflation Targeting.” Essentially, rather than raising interest rates once inflation hits the 2% target rate, they will look to maintain the current interest rate posture for a while after the target has been met, until it appears inflation is on track to moderately exceed 2% going forward. While the recent runup in the 10-year rate is concerning to inflation hawks, the Fed views this current trend as somewhat transitory, and expects to maintain its accommodative stance for the near future at least. I
Short-term inflation, however, is starting to become a larger part of the narrative for this year, something which the Fed acknowledged on March 17th. V Specifically, the slump in inflation that occurred at the height of the lockdowns is expected to work its way out of the data by the end of May, likely resulting in a bump in inflation. Additionally, businesses are reporting that input costs are rising due to COVID-related supply-side disruptions and high commodity costs. Although it appears that these increases are most likely temporary, some analysts believe the CPI could rise above 3% this year, which would be its highest level in a decade. IV
For a number of years now, divisions between political parties had escalated significantly, resulting in intense political gridlock, making it difficult for meaningful bi-partisan legislation to come out of Congress. However, after the November elections saw one party gain control of both the Legislative and Executive branches of government, Congress passed two more rounds of fiscal stimulus (in 4Q20 and 1Q21) with the potential for another installment, tied to infrastructure, currently in the works. While the passage of these policies has been a relief for some, their large size and scope has further stoked fears about our national debt. Specifically, combined fiscal stimulus has contributed $5 trillion to the economy since the pandemic began, representing 25% of total GDP. IV This influx of support has driven Federal net debt to record levels of 107.6% of GDP (as of 3/31/21). Furthermore, the Congressional Budget Office projects the federal budget to hit $6.9 trillion by year-end, of which approx. 50% will need to be funded by more borrowing.
Due to the substantial revenue gap caused by ever-increasing levels of government spending, coupled with the 2018 tax cuts, future tax increases have been on our radar for quite some time now, only to be exacerbated by the unprecedented events of 2020. While the pandemic has certainly accelerated this trend, gradual tax increases over many years can be more easily absorbed by a growing economy and are less likely to cause material disruptions. The underlying economic stress caused by the pandemic was expected to table new tax policies for at least a year. However, stronger than anticipated economic performance and heightened optimism about recovery prospects, have opened the door for these discussions to commence much sooner. Last week gave us our first glimpse into what that debate might look like as President Biden announced his “Made in America Tax Plan.” The main focus of this proposal is on corporations, calling for an increase in the corporate tax rate to 28% (currently 21%), the development of a 15% minimum tax on book income for large corporations, strengthening the global minimum tax on multi-national corporations, and enhanced funding for enforcing corporate tax avoidance. VI While there have also been discussions about raising taxes on high-income earners and even possibly increasing capital gains tax rates, these policies could face opposition from both parties on Capitol Hill while so many Americans look to get back on their feet. It remains to be seen how much of Biden’s plan actually gets passed; we would expect a more watered-down version is likely to emerge after Congress weighs in on the matter.
Lastly, there is another large spending bill on the table that is bound to further complicate the debate over debt and taxes. In conjunction with his proposed tax plan, President Biden has also outlined a roughly $3 trillion infrastructure plan aimed at retrofitting our nation’s outdated and dilapidated structures, as well as laying the foundation for a new “greener” economy. VII While both sides of the political aisle agree that infrastructure spending is needed, the scale and scope of this proposal is likely to encounter significant opposition in its current form. Particularly because of our bloated federal balance sheet, it seems unlikely that such a massive spending package will get passed without some substantial trimming.
At the macro level, corporate earnings are poised to set new all-time highs in 2021. In particular, companies with fast and efficient online business models are expected to continue soaring past those that require in-person transactions. E-commerce grew more in 2020 than it had the previous ten years combined, accounting for 16% of total U.S. retail sales by year-end. VIII Similarly, companies who were able to adapt their internal processes to a “work-from-home” model, without disrupting operational efficiency, significantly outperformed their brick-and-mortar peers. Among the biggest winners, the technology, communications, health care and consumer staples sectors have mostly seen their earnings either recapture or exceed their pre-COVID levels.
Of course, the strong recovery has not been felt evenly across all industries. In many ways, the pandemic created a bifurcation within our economy between companies that were able to adapt their business practices and operate remotely and those forced to shut down operations entirely. Specifically, the airline, restaurant, and hospitality industries were decimated by the mandated lockdowns, and have still yet to experience meaningful rebound since economies have begun to reopen. For all intents and purposes, these industries remain relatively “closed” due to their dependency on in-person business operations, which have been substantially limited by public health restrictions. On the brighter side, the timetable within which these industries were expected to reopen has moved up from the 2nd half of 2021 to 2Q21 due to the rapid deployment of vaccines. It is anticipated that these restricted sectors will more meaningfully contribute to total GDP and corporate profits for the remainder of the year.
A variety of factors have contributed to a “perfect storm” scenario for personal consumption growth in 2021. To begin with, the average personal savings rate is expected to surge above the 30% level as early as this month, thanks to a combination of stimulus checks and prolonged spending constraints. Homeowners received another nice boost to their net worth and cash flow as soaring home prices and the low interest rate environment persists. As a result, total household net worth climbed $12 trillion in 2020 to over 750% of disposable income. IV Not surprisingly, average household debt is at its lowest level since 1980. It’s no wonder that consumption expectations are high due to pent-up demand. Given that 70% of domestic GDP is derived from this source, consumers continue to play the most critical role in determining the pace and breadth of the recovery. This will be particularly important in the hospitality and travel industries (restaurants, airlines, hotels, etc.), which will likely be the last to reopen fully.
At the end of 1Q21, the unemployment rate stood at 6.2%, right around its long-term average and much lower than initial estimates. While still well above pre-COVID levels, the Fed estimates that number will drop to as low as 4.5% by year-end. I Although this data certainly validates a bullish outlook, meeting these expectations will largely depend on how fast the service sector recovers, as many of the remaining jobs left to recoup are from these industries. Given the “in-person” nature of these businesses (restaurants, travel and hospitality, etc.) a full recovery will largely depend on our ability to control and prevent COVID relapses and a lifting of the stringent health restrictions and localized shutdowns. As more and more people feel comfortable traveling, socializing, and recreating, we would expect unemployment to continue ticking down at a steady clip throughout the year.
As mentioned previously, the Fed will be focusing heavily on unemployment when determining interest rate policy moving forward. That being said, it’s a little difficult to reconcile the Fed’s commitment to maintaining current low rates for the next few years, while at the same time also projecting strong employment gains over that same period. If interest rate policy is going to be largely based on unemployment, and unemployment is expected to substantially improve, wouldn’t this imply the Fed would need to begin raising rates sooner than expected? While theoretically true, the reality is that current unemployment estimates may be masking the full picture. Since the pandemic began, approximately 4.4 million people have dropped out of the labor force altogether and are therefore not included in unemployment calculations. As a result, the workforce participation rate declined from 63.4% at the beginning of 2020, to as low as 60.2% during the economic shutdown, before rebounding to its current level of 61.4%. IV While these numbers should also improve as the economy reopens, businesses tend to be more cautious about expanding payroll coming out of a recession, subsequently causing a gradual or delayed workforce reintegration for many. With these variables in mind, we can now better understand how the Fed is able to assert a bullish posture regarding its labor projections while simultaneously maintaining dovish interest rate policies.
Despite a somewhat choppy ride, stocks posted a fourth consecutive quarter of strong gains following the initial COVID-induced sell off in the first quarter of 2020. In 1Q21, the S&P 500 grew by 6.2%, up 56.4% from a year ago. Small cap stocks, measured by the Russell 2000 Index, outperformed large caps, and finished the quarter with a total return of 12.7%, up 94.8% year over year. Despite the likelihood of interest rate-induced volatility throughout the remainder of the year, we believe favorable recovery trends are expected to continue driving markets higher in 2021.
Though performance of all primary economic sectors was positive during the quarter, all gains were not created equal, with the more cyclical sectors posting higher returns as the economy continued to accelerate. Whereas a concentration of growth stocks carried markets higher last year, in 2021 rising rates and the steepening yield curve have become catalysts for rotations away from growth towards value companies, which are likely to continue driving equity returns throughout the current year. Growth stocks were up only 1.2% in 1Q21 vs. Value stocks with quarterly returns of 11.9%. This trend has been most apparent in the FAANG+ stocks, which have exhibited a strong negative correlation with interest rates, barely moving off their late-August price levels. IV Consumer Staples, Information Technology, and Utilities posted modest gains of 1.2%, 2.0%, and 2.8%, respectively in 1Q21. In contrast, industries hit hard by the pandemic last year, such as Energy, Financials, and Industrials, have significantly outperformed in 2021, with returns of 30.8%, 15.9%, and 11.4%, respectively. IX
While domestic stocks generally exhibit favorable fundamentals, their international counterparts are having a bit more difficulty coming out of the dark. International equities also posted gains for the quarter, with the MSCI All Country Would Index (ex-USA) up 3.5% in Q1. However, their performance has lagged US equities, due largely to a resurgence in COVID outbreaks. The MSCI Emerging Market Index grew a modest 2.3% in Q1. While international equities remain relatively cheaper than domestic stocks, it may take a little longer for their true value propositions to fully materialize.
Traditional fixed income securities struggled in Q1 with rising yields putting downward pressure on prices, as the global economy continued to heat up and inflation expectations rose. Even though the Fed and other central banks maintained an aggressive monetary policy stance, trillions of dollars of fiscal stimulus have heightened the threat of inflation. Yields have also reacted to the increasing availability of vaccines and their impact on accelerating economic growth.
The Barclays Aggregate Bond Index finished the quarter down -3.4%, eroding nearly two years’ worth of yield in the last few weeks. IV Intermediate term Treasuries, measured by the Bloomberg Barclays Treasury 5-7 Yr. Index, declined by -3.6% for the quarter. Municipals posted moderate losses, dropping -0.4% during the quarter. Prices of non-US fixed income securities posted even sharper losses, as the Bloomberg Barclays Global Aggregate ex-US Index gave up -5.3% in Q1 and emerging markets bonds fell -4.7%. IX
High yield bonds and leveraged loans, which often follow the performance of equities, were the only fixed income sectors with positive returns in Q1, up 0.9% and 1.8%, respectively. In the seventeen periods during which 5-year Treasury rates increased more than 70 basis points, 3-month forward returns for high-yield bonds have been negative only twice. The take-away being that higher yielding fixed income may be slightly more attractive for those looking to negative only twice. The take-away being that higher yielding fixed income may be slightly more attractive than the higher duration risk associated with long-term treasuries and investment grade bonds. IV Investors seeking income, may want to consider alternative sources such as direct lending or private real estate investments which can also serve as a future hedge against higher inflation.
Although COVID-19 and the effects of the pandemic still loom large over the economic landscape, a successful vaccine rollout, heightened optimism, and favorable recovery data support a bullish outlook for financial markets and we believe support a risk-on approach toward investing in 2021. Concerns over interest rates and inflation will be key talking points in the short-term, as a rapid recovery could lead to temporary spikes in both along with elevated levels of market volatility. At this point, the Fed remains steadfast in its commitment to keep short term rates low for the next 2-3 years and views any such volatility related to these metrics as transitory.
While fixed income investors need not avoid core bond holdings that are aligned with their more conservative risk tolerance, we believe there should be an expectation that historically low rates and tight spreads leaves traditional bonds considerably exposed to price fluctuations, which in our view could be persistent in 2021. With this in mind, we encourage short-term and conservative investors to consider working with their advisors to identify alternative strategies to help with providing additional downside protection. For income seeking investors, Private Credit funds or Direct Real Estate Funds may potentially provide meaningful income and inflation protection in the near to medium-term. As always, we strongly encourage you to connect with your fiduciary advisor to ensure your current investment strategy is in line with your risk tolerance, need for liquidity, and short-term/long-term goals.
|Andrew Mescon, MBA
VP of Strategy
Chief Investment Officer
I. P. Morgan – Economic & Market Update 1q21
III. First Trust / CNBC.com (March 29, 2021)
IV. FS Investments – Q2 2021 Economic Outlook
VIII. Goldman Sachs – Market Pulse Special Edition: 10 for 21 (12/2020)
IX. Envestnet / PMC Economic and Market Overview – First Quarter 2021
Disclosure: Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees, and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation, or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.