With vaccinations leading to herd immunity, the US economy continues to blast out of its record-setting 2020 contraction.
Economic data continues to confirm what financial markets anticipated months ago: Not since the early 1980s have we experienced an economic resurgence like the one ahead of us, but it likely will not be a long ride.
Gross Domestic Product (GDP) growth this year should be somewhere between 7%-8% with some carryover into 2022 falling in the 4%-5% range. Then we expect to settle back into the 2%-3% range going forward.
Driving this growth will be a record $19.5 Trillion in consumer savings. Unemployment bonuses, stimulus checks, and limited spending contributed to a $4 Trillion increase last year! (M2 measured by Federal Reserve) We expect a good chunk of this to be unleashed on travel, restaurants, concerts, sporting events, and everything else we are longing to do. It will lead to dramatic employment gains across the wage spectrum, further sustaining the recovery itself.
Financial markets are forward-looking and have priced in much of this over the past six months. Making this repricing so close to “full” is all this cash in the system (with the Fed holding rates close to 0% and sustaining corporate and municipal bond purchases) forcing money into stocks and elevating prices. The Fed has gone far out of its way to articulate this strategy and will continue until employment and inflation show more durable and sustained levels. Financial markets have responded, and not just stocks and bonds. Everything from housing to collectibles to cryptocurrencies has been bid up in price due to this incredible amount of money in personal bank accounts earning close to zero while losing value to inflation.
The S&P 500 Index® is currently valued at 23 times NEXT YEAR’S expected earnings. While earnings estimates may revise further upward, this is a rich valuation vs. the long-term average of 16 times. This combined with investor enthusiasm has historically been a reliable indicator that markets have gotten ahead of themselves and are vulnerable to a correction.
Over the next 12 months, we expect to see rates on 10-year Treasuries exceed 2.5%. Should that occur and the S&P 500 achieve their 2022 estimate $200/share earnings, stocks today are still slightly overvalued. Further market gains can only come from unexpected earnings growth or investors throwing caution to the wind and driving prices even further. It’s possible that both will occur given the sheer amount of cash seeking a positive return. But, at some point, both will stop. Given the expectation for increased corporate taxes, higher earnings may be harder to achieve, and consumers may feel less confident. Soon, higher corporate borrowing costs due to rising rates will also impair earnings growth.
The Fed wants to see more permanent inflation (i.e., higher wages), unemployment levels come down, and benefit a broader demographic (i.e., close the employment gap). The pandemic has disproportionately impacted minorities and working mothers, and once schools re-open and subsidies stop, they will re-enter. Until these and broader data points indicate durability, the Fed will allow the economy to run hotter than normal before putting the brakes on. This means both higher inflation and higher long-term interest rates.
A positive return will be almost impossible in bonds – absent a severe stock decline. 20-year Treasuries have declined over 20% since their August high due solely to rising interest rates. There will be more losses to come as the recovery continues and the Fed allows inflation. Therefore, generating safe income requires a different definition of what constitutes safe. Yes, you could accept the assurance of a 1.5% yield from a 20-year T-bond, but you must also accept the certainty that it will lose principal value in the face of rising interest rates. Generating income has become increasingly uncertain as to the only options for yield place principal at greater and greater risk. So, we designed custom Structured Notes for our strategies last year and are attempting to do so again now. These are not without risk, but we get to define the parameters. If you would like to learn more about our tactics, schedule a brief call.
Mark our words, the instant the Fed hints at reducing its accommodative policies, financial markets will react harshly. Asset values built upon the assumption of sustained easy money will fall. We don’t know when that will be, but we remain vigilant to leading indicators. If companies succeed in passing rising input costs through to consumers and generating unexpected earnings growth, markets will continue grinding higher. If not, then we are set up for a significant correction. No one can know how this will turn out.
The Traditional 60/40 Allocation Model may not help. Millions of investors rely on static allocation strategies because their advisors recommend it. This concept relies on bonds generating reasonable income and appreciating in down markets to even out stock volatility. Neither of these is likely in the foreseeable future, given current interest rates and inflation pressures on bond values.
Integras Partners’ layered risk investment strategies will once again prove invaluable in navigating these next few years as markets gyrate from fear to euphoria and cycle through again. Our paradigm allows the peace to enjoy today while keeping long-term assets invested for future growth. Separating conservative assets to provide several years’ cash flows insulates most of your money for growth, providing the time needed to ride out market cycles and achieve desired returns.
We are also tactical beyond being strategic. There is a better than even chance that equity markets continue grinding higher this year in the absence of bad news. Our strategies are currently overweighted to materials, industrials, consumer discretionary, and the financial sectors. We are content keeping our current equity exposures as the first wave of quarterly earnings reports have greatly exceeded estimates. We complete our planning discipline by cascading outsized gains into more conservative strategies to sustain income, dictated by each client’s custom income needs. For other illiquid assets – such as houses, cars, collectibles, etc. – if you are pretty sure you won’t want it a few years from now this is a great time to be a seller.
While we do feel rather positive about the remainder of this year into 2022, our fiduciary responsibilities keep us grounded in understanding risks to investor capital. Please recognize that while the economy will keep humming, the market already has.
So, as we flow money in our client’s shorter-term spending accounts, we encourage them to freely spend it!
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