The world economy is set to grow at its fastest rate in decades, powered by fiscal stimulus, vaccination progress and excess savings built over the past year. Economic forecasts have seen a steady stream of positive revisions over the past few months and GDP growth for 2021 is expected to be the strongest in forty years. With many economic readings already above pre-pandemic levels (e.g. ISM manufacturing, corporate profits, etc.), and others well on their way (e.g. employment), the handoff from recovery to expansion is at hand.
A key question going forward is not whether the data will be strong, but whether it will be strong enough to stress the current consensus call on the Fed and force the market to price in a more aggressive interest rate path. Low interest rates and accommodative monetary (and fiscal) policy have been a key driving force behind investors’ willingness to allocate more and more money to stocks. Despite trading at all-time highs, last quarter was the first time since the Global Financial Crisis (GFC) that we have seen significant inflows into domestic equity mutual funds and ETFs.
Recoveries tend to have loose policy backgrounds, and this one has been turbo-charged (i.e. despite only a fraction of the GDP damage relative to the GFC, we have had four times the stimulus). Expansions, on the other hand, historically carry with them tighter policy. As we move from recovery to expansion, investors will need to decide how to price in a shifting policy landscape. Will the ensuing expansion bring more restrictive policy? If so, is the current optimism regarding the outlook misplaced?
We don’t think investors should fear the handoff. We believe a sustained expansion is coming, interest rates will continue to adjust to the robust outlook and, while rising inflation over the coming months will test some nerves, policy makers seem committed to looking through it and holding the accommodative line.
For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. Since the beginning of the pandemic we stated that the retrenchment in economic activity, while necessary, is self-inflicted, not structural, and prone to snapping back as re-opening resumes or vaccines enter the narrative (read previous market commentary here). We are seeing that snapback happening now with the recovery in full stride.
While we recognize a sustained expansion is quite different than quick normalization, we suspect favorable policy decisions, economic growth, and earnings will continue to support a further grind higher in equities. We have noted for months that the promise of vaccination-induced economic normalization could lead to pronounced investor enthusiasm as investors discount what the backdrop will look like six-to-twelve months from now. Arguably, a lot of that optimism is in the price now, but we believe upside remains, and we see no reason to change that view.
March closed out a strong quarter, the fourth straight (the S&P 500 was +5.8% in the first quarter, the Russell 2000 was +12.4%). As the recovery broadened, former laggards continued to pick up relative strength (e.g. materials, financials, economically sensitive groups like energy, etc.). The rise in rates added fuel to the rotation as many recovering groups (e.g. banks) benefitted from the steepening yield curve. We see ample room for these rotations within the market to continue, but don’t want to completely fade secular growth stocks that have been recently under pressure. In fact, March closed with many large-cap growth stocks beginning to resume leadership roles. We continue to believe there is room for both.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends, influenced by our recessionary and bear market views, are increasingly painting a more optimistic picture (positive).
The current macro discussion starts with an understanding of vaccination trends (and thus the reopening). Forecasts continue to show declining new cases, suggesting that ‘herd immunity’ will be essentially attained much quicker than expected. Coupled with the recent passing of a new $1.9 trillion stimulus bill, all signs lead to a robust rebound in economic growth in 2021. And this is before the infrastructure and family stimulus packages are included. We believe US GDP growth will be the best in forty years in 2021.
The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, a series of government support packages and a commitment by the Fed to highly accommodative policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. While we begin to transition to an expansion, we believe they will continue to be tailwinds and see little tightening in the cards before mid-2022. The Fed is anchoring short-term interest rates and has expressed unequivocal accommodation, despite longer-term rates sniffing out a recovery and pushing higher. We will need to monitor any change here, but so far, the rate backup feels warranted, and hasn’t altered the Fed’s stance.
The current technical backdrop remains in decent shape. Most major indices remain in well-defined price channels with shallow pullbacks doing little to alter their longer-term trend. Internal metrics are a little extended (e.g. the percentage of stocks trading above key moving averages), and sentiment is a bit stretched (e.g. AAII “bulls” are the highest in years), and those factors increase the odds of tactical consolidations. However, we still don’t think investor sentiment is euphoric. There are still trillions of dollars in money market funds and, despite the advance, flows into equities are far below those of bonds and cash. We feel pullbacks present opportunities to deploy capital for the long-term.
Rotation within the market continues to be a weekly theme. Recovery optimism will boost cyclicals, value and yields one day, only to see longer duration assets (e.g. Treasuries, growth stocks, etc.) take the lead the next day. We expect this churning behavior to continue as uncertainty over the pace of the recovery remains. Despite the back-and-forth among asset classes, we were glad to see the Volatility Index, the VIX, close below 20 for the first time in months.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Earnings estimates continue to be revised higher and we suspect 2021 will end with profit levels at record highs. Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. Valuation dispersion is at record levels with a big gap between the secular growers and more economically sensitive recovery plays. During the recent rotation, it has been the cyclicals that have benefited most. We expect that trend to continue, albeit with less dispersion.
The credit backdrop has improved with both investment-grade and high-yield spreads vs. Treasuries back to pre-pandemic levels. Because continued tightening here is consistent with a rally in stocks, it has been encouraging to see. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations’ confidence in their outlook continue to improve, we expect share buybacks, and M&A, to follow.
In sum, we are comfortable with the upcoming shift from recovery to expansion. We believe the shift in narrative, while subtle, will carry with it challenges and opportunities. Interest rates will be the fulcrum by which the story is played out, and we suspect they are biased higher. Our forecast for a sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to de-stabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.