2021 economic growth may likely be the highest you’ve ever seen.
Consumers, flush with saved cash, are spending freely. We expect GDP growth upwards of 8%; before returning to the anemic 2% we’ve seen over the past decade. The S&P 500® index built on 2020 recovery gains and finished up 14.4% for the first half, adding 8% over the Spring quarter. Foreign markets (ACWI ex-US)1 rose 5.5% since March and are up over 10% this year, comparatively subdued by a prolonged COVID crisis in Europe, India, and South America.
Pundits expected the Grand Reopening to generate sequentially improving economic conditions, fostering higher commodity prices, interest rates, and inflation. Recovering employment has accelerated household formation, so home prices and stock markets had nowhere to go but up. Let’s look to the bond market as another barometer. Interest rates did not rise near the degree expected. 10-year Treasuries were predicted to sell off and push yields above 2.5% as inflation soared. Monthly inflation readings are year-over-year, recently causing market jitters. We feel these jumps are transitory, but wage increases are not. So, don’t be unduly concerned that outsized inflation will translate to market declines.
We are at the high point of global economic recovery.
We monitor many leading economic indicators as part of our tactical market analysis. The burst of activity as supply chains started healing, manufacturing caught up to demand and goods got delivered all contribute to higher GDP. Global PMI’s2 are moderating from their highs and the value outperforming growth trend that began in earnest last November is now reversing. Commodity prices have moderated, input costs are declining, and the inflation scare is easing. Today, the 10-Yr Treasury Bond is yielding 1.35%, far from reflecting runaway inflation.
Don’t read into this that the economy is weakening or stalling. Far from it. This will be the strongest year of GDP growth probably since WWII. We said earlier that 2021 would be very strong and carry over into early 2022. Things will revert to the slow growth, relatively low inflation environment that has persisted for many years. For now, markets are likely to continue grinding higher as corporate profits continue to impress. The focus now is on the Federal Reserve.
The Federal Reserve will likely begin winding down its Quantitative Easing program this year.
They currently buy $80 billion of US Government and agency bonds and $40 billion of mortgage-backed securities every month. To soften market reaction, they are previewing “tapering” this program, likely ending it over the next 18 months. How markets react is a primary concern going forward. This systemic liquidity pushed investors into riskier market segments seeking attractive returns, forcing up valuations across all asset classes. A scary example is the high-yield (junk bond) market, where yields are now less than CPI for the first time in history! As excess liquidity leaves the system, we’re concerned that stock and bond prices will fall unless corporate profits continue increasing to justify them. We expect that justification as profits could increase 30% this year. 2022 may be a different story when the extra liquidity dries up. While we always have some concerns going forward, recognize that within the major asset classes, stocks are the primary sector for achieving meaningful returns and keeping financial plans on track. This too will change, but for now, we’re participating as markets go up.
Investor Success may rely on tactical efforts to seek opportunities and returns going forward.
The US has been greatly outperforming the rest of the world (ACWI ex-US). With a dramatic gap over the past year, it’s now roughly 3:1 over the past 10+ years. This largely comes from big tech stocks representing an ever-larger part of US market values, and the disparity of higher U.S. interest rates vs. developed foreign countries. Trees do not grow to the sky and trends do not last forever. This rate differential and our Dollar strength that greatly benefitted US stocks will narrow, pushing the dollar down over the next few years. Growing federal deficits and equalizing interest rates are both driving factors. So, foreign stocks will be in favor going forward. We have been rotating portfolios in this direction, as we expected it already started, pre-COVID. Now, foreign markets are cheaper, sport both higher growth rates and dividends which we believe are relatively immune from our liquidity decreases.
Secondly, we expect growth and value to take turns outperforming, much as they have the past several months. This internal market churn will benefit some industry sectors early in the market cycle and others later. We expect interest rates to gradually move higher, supporting value before economic growth moderates its torrid pace, supporting growth stocks. Both will follow different paths in a generally upward trend, so it is important to maintain some balance in longer-term strategies. This is still an active manager’s market, as not all value and not all growth will participate.
While it may be a bit early, as liquidity is removed from the system credit will be harder to come by. This will greatly impact so-called Zombie companies who have stayed alive with cheap and/or government financing. Think of AMC Theaters, Carnival Cruise Lines, Six Flags, airlines, regional banks, and restaurants, etc. As liquidity dries, some companies in these industries will not cheaply refinance debt and their stock prices will suffer. Passive indexes are full of these stocks, especially in small caps. Roughly 40% of Russell 2000 Index® companies are not profitable now, even with cheap and available credit. Once the spigot turns, some of these companies will plummet, and the indexes must reflect it. Our style of being tactical within strategies is important. This is especially true in the small, mid-cap, and foreign asset classes where we utilize active fund managers.
Look to stocks of companies paying and growing solid dividends that exceed US Treasury rates. While many of these companies are household names with strong balance sheets and defensive characteristics, some are not, yet thrive during market upheavals. Expect the current speculative investment environment to ultimately result in the same fate as all previous ones. When speculative greed ends in regret, investor attention returns to the merits of solid companies. Our Dividend Growth Strategy is built upon this discipline, plus we hold two active funds in our longest-timeframe Growth Strategies devoted to “wide moat” quality companies for this reason.
While we expect markets to continue grinding higher this year, remember that volatility usually reveals itself when fear is low. Markets have performed impressively since the COVID bottom and investor complacency is high. It is normal for markets to experience healthy drawdowns that test the mettle of investor convictions. On average, the S&P 500® experiences a drawdown of 14% at some point every year. Some years are much worse and rarely is -14% the stopping point. We can’t predict a meaningful correction but be mindful that the technical conditions for it are ripe: i.e., speculative investment concentrations, less traditional market liquidity, robotic trading algorithms, and wide bid/ask spreads. Markets rise like an escalator and fall like an elevator when volatility spikes.
With the abundance of cash in investor pockets, a correction is likely to once again be short-lived. Should we see a sharp sell-off, we intend to leverage the opportunity to design another structured note to take advantage of volatility and capture high yields.
Our best guess at this point is the S&P 500 will tack on another 5% – 8% by year-end. Next year, we hope to see 5% – 8% total, including dividends. In 2023 we may run into trouble. Higher interest rates, removal of stimulus, tax increases, and slower economic growth will all pressure stock values. Since markets are forward-looking, we are focused on how soon to reduce exposures to growth assets.
For now, pent-up demand will continue driving consumers and corporate revenues. The entire world is more than ready to get outside. Profits are strong and likely to get stronger. Corporate and individual balance sheets are healed and in aggregate, perhaps in the best shape ever. The economic environment is healthy and supporting global growth. At Integras Partners, we replenish retiree immediate spending accounts in up markets, and will likely do it several times this year.
We provide clients the emotional freedom to live life with less worry about finances and enjoy their favorite activities!
We’ve got our eyes on the markets, the economy, and politics, so let us worry about the right moves for you.