Business cycles are comprised of concerted cyclical upswings and downswings in the broad measures of economic activity. Investors constantly try to understand where they are in the cycle (e.g., expansion, peak, contraction, trough, etc.) to help navigate the financial markets. This particular business cycle is unique in that all phases may have happened in a historically short time. The current economic recovery has been one of the fastest on record, with real GDP likely to surpass its previous record high (2019) this quarter.
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. Many economic readings are already above pre-pandemic levels (e.g., ISM manufacturing, corporate profits, etc.). That favorable backdrop helped push stocks higher in May, with the S&P logging its fourth consecutive monthly rise.
As the recovery matures, growth rates will start to decelerate as we lap early days of the pandemic-induced shutdown. The move from accelerating growth to decelerating growth is a natural progression of any business cycle, but investors will need to get used to the concept. 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, the cycle has matured to the point where a healthy portion of that optimism is now priced in. But, we believe the market today has yet to fully reflect the above consensus growth we expect in the coming quarters. With trillions still parked in money market funds, it is clear many investors remain under-exposed to that attractive growth setup.
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. For well over a year we stated that the retrenchment in economic activity in 2020, 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 economic recovery in full stride.
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 are increasingly painting a more optimistic picture (positive).
The current macro discussion starts with an understanding of vaccination trends (and thus the reopening). Coupled with the passing of several stimulus bills, all signs lead to a continued rebound in economic growth in 2021 and 2022. And, this is before the infrastructure and family stimulus packages are included.
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. Despite a more seasoned 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 increased inflation expectations.
We don’t think investors should fear the pickup in inflation readings or the Fed’s reaction. We believe a sustained expansion is the base case, and interest rates will continue to normalize to that outlook. While rising inflation over the coming months will test some nerves, policy makers seem committed to looking through it and holding the accommodative line.
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. There have been five tests of the 50-day moving average (S&P 500) this year, each met with a staunch defense. Leadership has turned less risk-on (e.g., IPO/SPACs are performing poorly, volumes are anemic, stock reaction to quarterly earnings results has been muted, and equity inflows are slowing), and we suspect that reflects some healthy skepticism. Internal metrics are a little extended (e.g., the percentage of stocks trading above key moving averages), and sentiment is mixed, and those factors increase the odds of tactical consolidations. However, we still don’t think investor sentiment is euphoric.
Absent a negative catalyst, stretched technicals and bullish positioning alone are unlikely to cause a sharp correction, despite making the market more vulnerable to bad news. We feel pullbacks present opportunities to deploy capital for the long term. Rotation within the market continues to be a weekly theme. Recovery optimism, and higher inflation forecasts, 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 most major indices continue to hover near all-time highs.
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. Recent earnings results have underpinned the acceleration theme. Of course, we are focusing on sustainability and fully recognize supply chain constraints along with input cost pressures may impact the linearity of upcoming quarters, if just temporarily. Labor supply shortages also bear watching.
Valuations are stretched in some pockets of the market, but only slightly above long-term averages in others. The pace of the expansion in corporate profits has bested price, so multiples are now lower than where they were at the start of the year. Valuation dispersion remains at record levels with a sizable gap between the secular growers and the 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 continues to improve, we expect share buybacks, and M&A, to follow.
In sum, we are comfortable with the maturing recovery. We believe pressures are building, the bar is higher, but systemic risks are low given the accompanying growth backdrop. A key question going forward is not whether inflation will pick up (it already is), 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. The final word on tax increases and infrastructure spending could have an impact, albeit more pronounced at the sector and industry level (as opposed to the overall market). Our forecast for a maturing, but 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 destabilize, 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.