When the Crowds Return
BY: JIM McELROY
It’s been a little over a year since we first heard of COVID-19, lockdowns, mandatory masks, social distancing, asymptomatic carriers, Zoom meetings, etc. We may be premature, but it appears that the U.S. may be returning to some semblance of normality by summer of this year. The “warp speed” roll-out of the Pfizer, Moderna and Johnson and Johnson vaccines has emboldened even the most pessimistic epidemiologists to predict something approaching herd immunity by the end of summer. The stock market — not always the most accurate nor the most timely predictor of the economy — has been trading on the end of the pandemic since March of last year: after plunging about 34% from its previous high in February to its low on March 23rd, 2020, the S&P 500 has been on an almost continuous bull market tear, hitting record highs and, in the year since, has posted a 77.6% gain. The U.S. economy followed a similar path in 2020 — a jaw-dropping first-half GDP collapse of 18.2% and an encouraging second-half bounce of 18.9% — but unlike the stock market, which gained 16.3% for the full year 2020, U.S. GDP posted a decline of 2.7%. And indeed, despite the promising recoveries in most economic statistics — unemployment, capacity utilization, average hourly earnings, continuing jobless claims — the gap between the pre-pandemic and current levels, though shrinking, still remains.
There’s an old rule-of-thumb among stock market traders and other market participants that succinctly explains seemingly contradictory responses to good news: it advises traders to buy on rumor and sell on news. In the spring of last year, the rumors of effective vaccines and extraordinary government stimulus launched stock markets from the bottom of one of the shortest bear markets on record to propel the S&P 500 to new highs in anticipation of a recovery in consumer spending and corporate profits. Following this same “buy on rumor, sell on news” logic, we probably should be wary of the end of COVID-19 related privations and a return to pre-pandemic economic conditions. And we would be wary if the economy were just returning to the conditions that prevailed at the beginning of last year. Instead, thanks to the unprecedented fiscal and monetary stimulus that the government and the Fed have provided to consumers and businesses, the immediate prospects for the U.S. economy are rumored to have significantly improved.
Since the beginning of the pandemic, Congress has passed bills totaling $5.3 trillion in relief and support for the economy, including some $856 billion of direct payments to individuals earning up to $75,000 (couples up to $150,000). Almost half ($411 billion) of these direct payments to individuals will come from the stimulus package that Congress and the president enacted on March 11th of this year; this is on top of an additional $203 billion of extended unemployment benefits. Considering that these individuals/consumers represent about two thirds of the U.S. economy and that the consumer has been living a sequestered and Spartan existence for most of the last year, it’s no surprise that the market expects a booming economy for at least the remainder of 2021.
In addition to the fiscal stimulus from Congress, the Federal Reserve has played its part by making it clear that it intends to keep overnight interest rates near zero for the foreseeable future. The Fed has only limited influence over longer term rates and these rates have been increasing: the ten-year Treasury Note — a benchmark by which many commercial and retail rates are set — has moved up to 1.7% from a pandemic low of .52%. However, this rate, as well as most others, are equal to or below pre-pandemic levels, which were themselves on the lower end of historical norms. Not only does the consumer have more money to spend, he also has the ability to leverage it by borrowing at historically very low rates.
We should note that in addition to the positive rumors of ever improving future economic news, we need to be aware that there are also negative rumors swirling around in the market’s consciousness. As noted above, market interest rates have recently increased. There’s at least one happy reason and two unhappy reasons behind any increase in rates: an expanding economy is a happy thing and normally results in an elevated demand for borrowed capital and gradually increasing interest rates; if however, the economy is slowing and the risk of borrower defaults forces lenders to demand higher rates, or if the economy is growing too fast and higher rates are the market’s adjustment for accelerating inflation expectations, then there is little in the way of happiness. For now, the recent increases in market rates appear to have a happy source: rate increases have been more pronounced in higher quality bonds (U.S. Treasuries, investment grade corporates) than in lower quality bonds (so-called junk bonds), suggesting that the market is more focused on increases in demand for borrowed capital during an economic expansion than in the riskiness of issuer defaults. And at this point in a rumored economic expansion (remember, the National Bureau of Economic Research has yet to call an end to the pandemic induced recession), it would be unlikely that heightened inflation expectations would be a cause for higher interest rates. After all, the latest annualized inflation number is only 1.7% (1.3%, excluding food and energy) and the Fed has for some time expressed its frustration at getting the annual rate above 2%.
But higher inflation expectations are a risk. Few have doubted the need for deficit spending to combat the COVID-19 threat to the economy. However, some have argued that the $5.3 trillion level of the stimulus has been excessive; in particular, critics argue that the recent installment of $1.9 trillion is unnecessary, given the progress of vaccinations and the already strong economic rebound over the last several months. We shall see. In the meantime, we expect to see volatile inflation numbers as suppliers, still struggling with shortages, both from the pandemic and from other causes, continue to adjust to increased consumer demand. This is likely to create some hand wringing and somewhat higher rates in the bond market as traders recall what their parents told them about the hyper-inflationary 1970s. But this is not the 1970s, with its combination of a “guns and butter” hangover (spending on the Viet-Nam war and Johnson’s “Great Society”) and the continuing assimilation of the postwar baby boom generation into the workplace. And at current levels, there’s a lot of room for interest rates to increase before they represent a threat to the economy. If there is a risk of stubbornly high inflation and escalating interest rates, it would more likely appear in the 2023-2024 time frame than in the next twelve months.
As the U.S. economy opens further and life in the “new normal” begins to more closely resemble the old normal, we expect to see a burst of economic activity that will be driven as much by relief as by the accelerants that Congress and the Fed have provided. Some estimates of GDP for 2020 place the number at close to 7%, three percentage points higher than the fourth quarter of last year. We think that’s altogether possible, but wouldn’t be surprised to see an even higher number. The estimates for S&P 500 earnings in 2021 are in the $150-$160 range (about a 24% increase over 2020) and for 2022 in the $215-$225 range (about a 42% increase over 2021’s estimates). Interest rates are expected to rise slowly as the yield curve steepens, but long and short rates should remain accommodative to economic expansion. Inflation fears will likely trouble the markets somewhat, but at least for the next twelve months, these fears should remain muted. For now, equities remain the investment of choice over bonds and cash: with interest rates at historically low levels — in many cases, lower than stock market dividend yields — the choice seems very clear.
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
