Many economic and market drivers rotated during the first quarter including COVID-19, stimulus, economic activity, political power and financial market leadership. Here, we break down the impact of each and what it means for investors.
The impact of COVID-19
In the quarter, the COVID narrative has rotated from cases and deaths to positive news of vaccinations. The daily change in COVID-19 cases has come down from the first of the year and the average number of daily vaccines administered continues to climb. According to the Centers for Disease Control and Prevention (CDC), 106 million Americans have received at least one dose of a vaccine and 62 million are fully vaccinated. With the vaccine rollout, more people are starting to feel comfortable getting back to their normal routine and consuming. The hard-hit hospitality and leisure industry is rapidly healing and is part of the overall economy recovering.
There are some still some risks and concerns. For example, Brazil just saw a new record of daily cases with over 100,000 positive tests in one day. In France, lockdown measures are in place for the next four weeks as infections threaten to overwhelm hospital capacity and Italy remains in lockdown until the end of April. The United Kingdom was on lockdown most of the first quarter and there are still some restrictions in place. Clearly, There is light at the end of the tunnel, however we are still in the tunnel.
Reopening of economies
High frequency data allows us to get a good sense of economic activity in real time and some of the mobility indices paint a promising picture. Retail traffic year-over-year is trending up, as well as open table seated diners and Transportation Security Administration (TSA) passenger throughput. This indicates that people are ready to go out and consume once again, which suggests robust economic activity. The activity and thus consumption, is great for job growth, especially in the most hard-hit sectors.
It does, however, present the risk of inflation. For example, when the pandemic first hit, some airline pilots were laid off or offered early retirement packages due to lack of demand. Now, as travel picks up, some flights are being canceled due to a pilot shortage, so that industry could experience wage inflation as pilots are enticed back to the labor force.
As the economy rotates back to full strength, more and more jobs are being created. The unemployment rate spiked to 14.7% in April of 2020 and has now come down to 6% in March of 2021. Initial unemployment claims have also come down dramatically. We are not all the way back to pre-pandemic levels, but we are well on our way and this supports income and consumption. Our forecast is for unemployment to end the calendar year close to 5%.
Consumer confidence is now up to the highest level that we’ve seen since the pandemic started and much of this is driven by stimulus and jobs. Small business optimism is still low and hasn’t recovered yet, but we are seeing it improve each month. One reason the data remains muted is that businesses are having difficulty finding workers. CEO confidence has fared well throughout the entire pandemic, recovering from a slump after 2018 when former President Trump passed the America First Act which implemented confusing tariffs and custom regulations. It is now above the 2018 level. All this data supports robust economic activity for 2021.
The role of manufacturing
The data on manufacturing is quite positive right now. If the manufacturing purchasing mangers’ index (PMI) is above 50, that indicates expansionary status and both China and the U.S. have PMIs above that mark. The U.S. PMI is above 60, which supports a strong gross domestic product (GDP) forecast for this year and is the highest we’ve seen since 1983. While at first glance, these positive figures may inspire confidence, bear in mind that if these trends continue, we are increasingly at risk of finding ourselves facing an environment of inflation. Recall that a year ago, when factories were shut down, there were significant supply shortages. Shortages and disruptions in the supply chain are now being resolved. Nevertheless, in the short-term these disruptions, along with surging demand, will create some transitory inflation. If these supply shortages continue while demand grows, this may create longer-term problematic inflationary pressure.
Personal income and money supply
U.S. personal income spiked when the recession began from the government stimulus checks and stayed above pre-crisis levels throughout 2020, spiking again in early 2021 from additional stimulus. The stimulus checks have also created a significant amount of personal savings as people both unemployed and employed received benefits from the government. This sets the stage for robust consumption and growth as the economy reopens.
Expectations of a new administration
The political power in Washington has rotated but we don’t expect a change in administration to have a meaningful impact on the economy. However, we could see more stimulus, which in the short term will support economic activity. The $1.9 trillion American Rescue Plan was recently passed, and a $2-2.5 trillion American Jobs Plan is currently being negotiated. President Biden has also suggested that there is more to come with the American Family Plan which will support healthcare and childcare.
President Biden has offered solutions to pay for this stimulus by raising tax rates for both individuals and corporations. Many people are concerned about whether a change in tax policy would ruin economic growth and the short answer is no. We saw increased taxes in 2013 and not only did it not disrupt economic activity, the markets actually had a great year. While higher taxes do negatively impact earnings at the corporate and individual level, the massive spending amount on the stimulus package will offset the potential negative risk of higher taxes. Overall, the additional stimulus will provide another economic boost to the gains we have already seen.
The threat of inflation
Inflation is a prominent topic right now and for a good reason. We’ve had a massive increase in demand for both goods and services, and we are seeing limited supply, which is causing prices to increase. We also have massive amounts of cash on the sidelines from stimulus, incomes are solid, the jobs market is healing, vaccines are working and there is pent-up demand. Household net worth is at an all-time high. This combination of factors creates a serious inflation concern.
There are several ways to measure inflation expectations. To begin, the five-year breakeven rate has moved from 0.5% in April 2020 to 2.6% in March 2021. A breakeven rate above 2% is what triggers the Fed to pay close attention to additional inflation indicators and we would expect them to act if this breakeven rate continues to grow over the next two years. While inflation and subsequent action by the Fed is not an immediate concern, we anticipate that inflation will rise late next year into the following year and will continue to be something we watch closely.
There were three recent rotations in equity markets during the first quarter of the year. Looking first at the S&P 500, we saw the index rise after the special Senate election in January as that removed uncertainty, then decline as interest rates rose, and then increase again with vaccinations becoming available, giving us a 6.2% gain for the quarter.
The second is the rotation from growth stocks to value stocks. We do think value stocks have legs and can continue to outperform in the short term. However, over the past 10 years, the rotations into value have been very short-lived, meaning growth has done extremely well compared to value over the last 10 years. So, while we like the move into value and reopening stocks for the short term, in the long term, their return is less certain.
The last rotation is from large cap stocks to small cap stocks. There was a significant jump in small cap performance for the quarter with a 6.7% return. Historically, small caps outperform large caps as an economy emerges from a recession, primarily because businesses are depressed and small company earnings growth can be significantly higher than large caps as an economy recovers.
Fixed income and interest rates
The 10-year treasury yield has moved from around 0.6% in the summer of 2020 to 1.73% in March of 2021, largely due to inflation expectations. However, when considering the 10-year treasury yield throughout history, the spike in rates is coming off all-time lows and interest rates are still incredibly low. Even if interest rates rise slowly, they will still be comparatively low, and we anticipate stimulative financial measures to continue.
2021 forecast: Positive, but below average
We do expect positive returns in 2021 and are forecasting between 7-11% total return (notably, the S&P 500 is already up 6.2%). This could be conservative, but on average we see a 14% correction in the S&P 500, and we have not seen one this year yet. Our GDP forecast is close to 6% for the year – and as we rotate to more vaccinations and global economies reopen, we could see growth north of 6%. That would be positive for the labor market pushing unemployment down as more people are put to work.
Currently, we have very accommodative conditions and the Fed has promised low interest rates for the foreseeable future, which is good for economic activity, even though the 1-year Treasury has increased due to inflation expectations. When interest rates are low, the S&P 500 trends higher, which supports our bigger picture, long -term forecast for the year.
Fundamentals of the U.S. Economy:
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