Monetary policy moves
Tapering fears seem to be all the rage on the monetary policy side. That said, we think that tapering will prove to be a nonevent. The US Federal Reserve has taken baby step after baby step to prepare the markets for the eventuality of tapering. We expect the Fed to slowly unwind its asset purchase program, easing their purchases in a widely telegraphed manner, and possibly starting by simply slowing purchases of mortgage-backed securities. It will most likely be well into 2022, if not beyond, before we actually see the balance sheet beginning to shrink.
We believe that the economic data at this point in the cycle is irrelevant to the Fed’s tapering timeline. They are now calendar dependent and will commence tapering regardless of the data. The more important transition impact should come from the commencement of rate hikes. Increases in interest rates are much more important to the overall backdrop, and the start of a normalization of policy rates seems at earliest to be a 2H22 event if not later.
The key point here is that interest rate increases do not imminently follow tapering. They follow two distinct reaction functions and there tends to be a lag between the two. This lag should provide time for the markets to adjust accordingly. Remember, it’s not just about Fed tapering and rate hikes. It’s about financial conditions. Rate hikes and asset purchases are but line items within this broader context which, in aggregate, is the more important metric to follow. And we expect financial conditions to remain very accommodative.
Looking at the data, we see inflation normalizing back to pre-Covid levels. But the recent spikes we are currently seeing appear to be less structural, more temporary, and mostly Covid-related. Of course, we won’t deny that prices are rising and that these issues are adversely impacting our wallets. But the root of these price increases – will they ultimately be resolved through higher interest rates, tax hikes or spending cuts? We think not.
Consumers and markets in specific segments are beginning to react to some of these pockets of spiking prices. We are seeing this self-governing/self-correcting mechanism at play in the housing market, where signs of softening are taking place. This is not to say that the market is cooling off and rolling over. But rather, it will probably settle in at higher levels reflecting a stepped-up new equilibrium price. The pace of price increases should ease off as consumers step back and are no longer willing to pay elevated prices. We are seeing signs of this spreading to other kinds of durables as well.
Robust growth despite peak
As we move through the year, tougher year-over-year data should ensure that second quarter gross domestic product (GDP) will mark the peak in quarterly growth rates. But while momentum may be peaking, growth is likely to remain robust through the remainder of 2021 and well into 2022.
Fiscal policy has truly been unprecedented in response to this crisis. But as vaccination rates climb and economies around the world continue to reopen, fiscal policy looks set to hand the reins over to the private sector to drive growth moving forward.
Recent estimates of the latest US stimulus checks suggest that upwards of 70% has yet to be spent. The stockpile of excess savings now stands at over $2.6 trillion. With household balance sheets robust, this should be a considerable buffer that is likely to sustain elevated, albeit more moderate, levels of consumption and growth. And as fiscal measures fade, the recovery in the labor markets will gain ever more importance. While recent jobs reports have underperformed and left many searching for answers to these labor supply constraints, these frictions are likely to work themselves out as the recovery continues. In short, fiscal spending may fade, but the effects remain in the pipeline. Don’t bet against the US consumer.
Tax hike risks
The Biden administration certainly swung for the fences when it released dual infrastructure spending packages focused on physical and human infrastructure for a grand total of nearly $4.3T in spending financed via corporate and personal tax increases. But these proposals were simply a starting point for negotiations and have met fierce opposition from both sides of the aisle.
Tax increases are a nonstarter with the GOP, and negotiations to close the gap between Senate Republicans and the White House have proved challenging. While some small bipartisan groups within the House and Senate are attempting to work out a palatable deal, the Biden administration appears to be pursuing a dual track approach and the focus may shift back towards reconciliation as the path forward for some of the grander ambitions of the proposals. While that would seem to increase the chances of tax changes being passed along party lines, there remains considerable pushback within moderate Democratic ranks to elements of the Biden proposals.
Should a partisan package be passed via reconciliation, corporate tax changes are easier to garner support from the Democratic base, but the final package is likely to be watered down. Personal tax increases are a tougher sell, particularly for some higher-income and higher-tax states. As a result, increases in personal taxes are likely to be far more restrained as well. While it seems likely the top tax rate may be restored to 39.6%, capital gains tax increases are likely to be well below current proposals.
Tax changes certainly add to the looming wall of worry. While recent history holds few case studies in tax changes, the few examples suggest that what really matters to markets is the earnings cycle. Tax changes are a modest headwind, but offsets from infrastructure spending and potential productivity gains add to an already supportive earnings backdrop.
Financial conditions should remain extremely loose for the remainder of 2021 – and that creates a supportive backdrop for equities. We expect the Fed to remain highly accommodative for the balance of the year, with tapering concerns being a nonevent (actual balance sheet reduction will likely hit in mid- to late 2023) and rate hikes remaining on hold well into 2022, if not early 2023. In addition, real rates remain negative, leaving few choices in terms of alternative options in which to put money where returns may be able to outpace inflation. And if we are proven wrong on our transitory inflation outlook, what is the best hedge? Equities!
As we continue to improve vaccination rates, the economy should fully embrace the economic reopen. And this means that we would expect to see consumers spend more money on the services side of the economy versus the goods side. We believe consumers want to get out and about and reengage those experiences that they missed during work from home. That shift should help the service side begin to accelerate, with profits increasing meaningfully in the coming quarters. We see this occurring in the current retail sales and labor market data already.
We also see the global recovery taking place in a staggered fashion. The US has seen the best progress in terms of vaccination levels from a regional perspective thus far. Europe stumbled but appears to be back on track. And Asia has been slow to see vaccination rates reach critical levels, with penetration rates in Japan, for example, extremely low, followed by emerging markets. Against this backdrop, the reopening of the global economy seems to be happening in stages. We could see the equity leadership baton be passed from the US to Europe in the coming months as the Eurozone recovery roadmap begins to unfold in a similar fashion to what we’ve seen here in the US. Ultimately, this rotation could finally make its way to emerging markets, but with a somewhat bifurcated response where Asia lags the rest of the emerging world.
In the near term, cyclicals should continue to benefit. In the broader context, value should perform better than growth and small-caps should outpace large-caps. This doesn’t mean we should completely abandon growth stocks and by default tech, which is a large allocation within that growth basket. We continue to highlight the fact that not much has changed over the past 12 months that warrants a sharply higher long-term growth regime. We expect the global backdrop to return to its pre-Covid trajectory – modest growth with modest inflation. This backdrop should see a rotation back to the search for what is scarce – growth. In this environment, tech should reassert its leadership position.
Lastly, we remind investors that stocks go up in bull markets and they go down in bull markets. Corrections are par for the course. We should certainly expect at least one 10% or more correction between now and year-end. However, corrections do not signal an end to the up-trend. Until the US Federal Reserve becomes restrictive (which is still a long way off), we expect equities to finish 2021 at levels higher than where we are today.
Fixed income for risk management
Across the bond universe, there are few opportunities for any attractive nominal yield, let alone a positive real yield. In inflation-adjusted terms, one has to move out the risk spectrum all the way to high yield and emerging markets debt to find any sort of positive yield. For all the claims of equities being overvalued, most fixed income markets are trading at far richer multiples than equities.
So what to do? We continue to stress that risk management is a critical element of the portfolio construction process. While we don’t overly focus on day-to-day volatility, it is important to maintain ballast in a portfolio to manage true risk-off scenarios. Despite the lack of compelling yield, high quality fixed income continues to be the most reliable equity risk offset – and within that bucket, specifically nominal treasuries. While we don’t expect yields to run away to the upside, particularly as inflation fears continue to subside, we do expect yields to drift modestly higher. As such, duration risk looks less compelling, particularly in the wake of the aggressive rally in the long end of the curve.
One of the few opportunities within fixed income continues to be within municipal debt. While high quality muni yields have pushed back inside pre-crisis levels, they have weathered a difficult environment for quality fixed income, with the muni-treasury ratio continuing to compress. High yield munis, on the other hand, have yet to recover their pre-crisis lows in spreads. With the reopening and normalization well under way, municipal issuer revenues have sharply recovered, leaving many issuers in a rare surplus position and contributing to lower muni supply. Continued uncertainty on the infrastructure front has only exacerbated this dynamic as many issuers await further insight into infrastructure plans and potential funding. On the demand front, the search for yield continues to drive investors into any pocket of opportunity. Also, looming tax changes only add to already robust demand.
Within credit, both investment grade and high yield continue to look extremely rich, though both remain supported by the same persistent global search for yield. With high yield setting new record lows on a yield basis, leveraged loans continue to offer a modest yield pickup. This trade may run into headwinds, however, as the fear of inflation fears continues to fade. The other opportunity to monitor for the later parts of 2021 is within emerging market debt. Much as the risk cycle and reopening cycle should align to support emerging market equities, those same dynamics should support a recovery for emerging market debt.
Forecast: Higher by year-end
As always, the devil is in the details and the market requires a nuanced view, but with a critical lens there are certainly still opportunities to be found for those willing to look. While uncertainty persists and the wall of worry grows ever higher, we continue to remain constructive on both the economic recovery and the outlook for markets moving forward and expect risk assets to be higher by year-end.