2023 US Stock Markets: The Year of the Giant?
The answer to the common question, “how is the US stock market doing and what are its prospects for the rest of the year?” is never as straight forward as it seems. The US market includes a combination of benchmarks with divergent track records and future prospects. Consider the key US indices and their performance year-to-date through 5/31/23:
This snapshot clearly illustrates a dichotomy: while one index has flourished, most have floundered. Notably, the technology-dominated NASDAQ Composite has rocketed +23.9%, which may seem surprising given its reputation as being highly sensitive to negative macro conditions. This prompts the question: why have these stocks soared amidst aggressive Federal Reserve interest rate hikes, rampant inflation, predictions of a US recession, banking industry turmoil, and a sluggish global economy? The data suggests that some investors, in their pursuit of relative performance, have needed to ignore these significant red flags. Consequently, risk-averse investors committed to a diversified portfolio are fighting an uphill battle in achieving competitive relative performance.
The pronounced disparity between the performance of the market-cap-weighted S&P 500 Index and its equal weight counterpart is primarily the consequence of the stellar performance of the largest companies – perhaps to an unprecedented degree. The six largest companies have been particularly impactful:
These giant companies have an aggregate market cap of $9.4 trillion, which constitutes 25.8% of the S&P 500 market-cap weighted index. A mere 12% of S&P 500 stocks outperformed the index over the past 60 days, as of 5/26/23 (source: Schwab). Only three of the industry sectors (communication services +33.0%, technology +34.4%, and consumer discretion +18.9%) have posted positive returns year-to-date. This stands in sharp contrast with a -11.7% plunge in the energy sector and a -9.1% drop in the utilities sector, with the remaining five sectors in negative territory.
Why are these extraordinary trends happening and will they continue? While there is no definitive answer, a possible explanation is that many investors anticipate a robust recovery from the dire conditions of 2022 and are willing to overlook a possible recession in order to make sure they do not miss the new bull market when it comes. In addition, the mega-cap stocks mentioned above are benefiting hugely from the recent frenzy surrounding artificial intelligence. We are concerned, however, that this extremely narrow market leadership is not sustainable. This investor behavior is more akin to the mania seen at the end of bull markets, such as 2000, 2008, and 2021. In our estimation, a restored bull market will include broad participation, and thus we continue to recommend investors maintain diversified portfolios.
Economic and Financial Market Outlook 3Q 2022
Almost all the largest world economies, including the United States, are experiencing a growth slowdown and troubled financial markets. Consumers and businesses continue to grapple with soaring inflation, which in the US and Eurozone has topped 8.0%. The focus is now on the response of central banks to combat inflation and whether they can do so without excessively damaging their economies. While prices in the US likely will remain uncomfortably high throughout the summer, our view is that inflation is peaking and will ease to below 5.0% by year-end. This would permit the Federal Reserve to stop raising the Fed funds rate, which will pave the way for an economic rebound and a turnaround in slumping stock markets. The major risk is that the Fed will raise rates too high for too long and trigger a recession of increased severity. Even if this scenario occurs, we think that in its severity it will be typical of the average recession in the past 70 years. Similar to previous recoveries, we expect large equity gains in the first months, or even weeks, of the rally.
US first quarter GDP came in at –1.4% and forecasts for the second quarter show an increased likelihood of consecutive quarters of negative growth. There will be a debate over whether this constitutes a recession (we note that NBER is the official judge of the beginning and end of recessions, and typically give their opinion long after the fact). Rather than laboring over semantics, it is most useful to acknowledge that the economy is weakening: the high rate of inflation is taking a toll on the economy and Fed rate hikes are intensifying pressures on growth. We pointed this out in our May 12 blog, “The Risk of Recession is Rising.” Since then, several leading economic indicators soured, including new orders in purchasing manager surveys, the Conference Board Leading Economic Index, job openings, auto sales, and home sales. A turnaround will require substantial moderation in inflation to restore confidence and spending. Recent developments have been constructive on this front: a sharp decline in industrial commodity prices and even gasoline have contributed to a recent easing of input costs. An improvement in supply chain bottlenecks would provide further relief. But the key to decreasing inflation in the coming months will be the cooling economy.
The major US stock indices are officially in a bear market: the NASDAQ composite plummeted 22.4% in the second quarter alone and 29.5% for the half year, while the S&P 500 dropped 16.1% in the second quarter and produced the worst first half returns since 1970. Many of the leading US corporations have suffered major first half stock price plunges:
|Stock Ticker||1H22 Performance|
Our view is that for equities to reverse this downward trend, there needs to be a sign that the Fed will end its anti-growth policy of monetary tightening. As we mentioned above, this will only happen once inflation is deemed to have been sufficiently subdued. If our forecast that inflation will moderate over the next several months is correct, and, in response, the Fed indicates an end to their rate hike cycle in a timely manner, then there is a strong probability that the stock market will bottom in the second half of the year and commence a new bull market. There is solid historical evidence to expect the eventual market recovery will be fast and strong. The past three bear market lows in 2020, 2009, and 2002 were followed by 3-month advances of +35.1%, +40.2%, and +20.0%, respectively.
We acknowledge that there is a rising risk that the US economy will suffer something deeper than a modest recession. The major threat is a policy error from the Fed. Historically, the full impact of higher interest rates has not become evident until six to nine months later. This means that the Fed will be raising the benchmark interest rate based on an assumption of future conditions, which will make it easy to overshoot. On the other hand, if the Fed wavers too soon and does not sufficiently tackle the inflation problem, a prolonged period of stagflation and market turmoil could result. We are monitoring closely the US labor market for evidence of a wage-price spiral, which inflamed the inflation problem in the 1970s but has yet to occur this year. Another risk is the geopolitical threat of Russia further upending the global energy trade. Russia is one of the top three oil producing nations and provides most of the natural gas the EU consumes. A disruption in the flow of these natural resources could cause another massive spike in oil and natural gas to record highs.
Most developed international economies are experiencing the same threat of inflation and economic deterioration as the US. From The latest inflation data in the EU is 8.1% year-over-year, Britain is 9.1% and Spain has reached double-digits. The only exceptions are China and Japan, at 2.1% and 2.4% respectively (The Economist 7/2/2022). Like in the US, the European Central Bank, as well as the central banks of Britain, Canada, and Australia, have telegraphed their intention to tighten monetary policy. The consequence has been a growth slowdown in these countries with the additional threat of an energy shortage in the Euro Area, which may make consumer hardship worse than in the US. Indeed, the euro has declined to a 20-year low and reached parity with the US dollar. In contrast, Chinese policymakers, spared from high inflation, are taking steps to stimulate their economy and growth has recently accelerated back above 5.0% despite rolling COVID-19 lockdowns. We recommend investors focus on individual companies benefiting from long-term secular trends with strong fundamental growth opportunities in the Euro Area, Canada, and Australia. While Chinese equities are attractive from a valuation and earnings perspective, the regulatory risks remain elevated.
The benchmark US Treasury bond has continued its march higher, reaching above 3.0%. This has by some measures resulted in the worst first half ever on record for US Treasuries (index inception 1973). While higher yields appear tempting to bond investors, real returns (inflation adjusted) are worse now than when interest rates were near zero. We reiterate our view that bonds do not offer a competitive medium- or long-term return profile compared to inflation and stocks. We think the principal benefit of bonds is their role in portfolios as a volatility stabilizer and continue to emphasize quality and short duration in bond selection.
Reflections on the Current US Stock Market Correction
Our January 13 Economic and Financial Market Outlook opened with the comment, “uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets.” Through the first two months, this has certainly been the case. Well before the Russian invasion of Ukraine, a barbaric and inhumane catastrophe that saddens us greatly, the S&P 500 Index had already approached a correction, which we define as a 10% or greater decline. By the 23rd of February, as Russian armies prepared to launch a full-scale invasion of Ukraine, the S&P 500 had retreated 11.2% and the technology-heavy NASDAQ had fallen 17.9%. Within the S&P 500, 40% of stocks had experienced a 20% or greater sell off. A discussion of the current correction, which places it in historical perspective, is useful to guide investors through the volatility. Though the stock market’s sudden retreat has been startling, it is worth keeping in mind that including this correction, the S&P 500 has provided strongly positive returns over the past 1-, 3-, and 5-year periods. We also think it is most probable that the current correction will resolve without a recession and corresponding bear market.
Corrections are not an uncommon occurrence, with 24 instances since 1974, or about one every two years. Only 5 of these 24 turned into a full-fledged bear market with at least a 20% decline. The remaining 19 recovered to reach new highs and continue a prior bull market. The average duration from peak to trough has been 177 days, with a median duration of 87 days. So far, the duration of this year’s peak on January 3 to trough on February 23 was 51 days. If this correction proves to be typical, we are already more than halfway through it and the worst may be behind us.
The consensus view is that there are two major developments behind the retreat in equities. One is the threat that rising inflation will prompt the Federal Reserve into excessive rate hikes, which has led to several recessions in the past. The optimistic view is that the Fed will be able to tame inflation, and restore its own credibility, without causing a recession. Many investors are skeptical. The recent surge in inflation increased fears that the Fed would need to adopt more restrictive policies more quickly than anticipated. There is a widespread view that the US economy is not strong enough to absorb higher interest rates. We do not think that the expected 4 or 5 rate increases in 2022 to 1-2% is high enough to meaningfully upset economic growth. The Fed is determined to avoid recession speculation and possible financial market dislocations and yet be strong enough to have a propitious impact on inflation. We also expect a gradual improvement in supply chain disruptions and reduced labor shortages to slow the rate of inflation. Our conclusion is that inflation will peak in the first half of 2022 and trend lower by year-end, so that a corresponding Fed-induced recession will be avoided.
The second threat is that the Russian invasion of Ukraine will create significant global economic upheaval with highly uncertain negative consequences. It has already caused a further jump in the cost of most commodities, which makes the Fed’s task of subduing inflation even more problematic. An area of special concern is Russia’s substantial oil and gas exports, which could result in significant shortages and price shocks if these exports are shut down. Currently, Europe relies on Russia for nearly 40% of its natural gas and 25% of its oil. However, apart from energy the Russian economy is too small, about 2% of global GDP, to have serious impact. Similarly, the ongoing plunges in the ruble and Russian banking system, while shocking, is of minimal influence outside Russia. We do not know Putin’s ultimate objectives, but we do not think he is willing to risk an expansion of warfare by attacking NATO member countries. Although the Russian invasion of Ukraine will have huge humanitarian and geopolitical consequences, we do not think that it will derail the global economic expansion.
The two threats to the US economy and stock market come at time when the economy is exhibiting impressive strength; this provides a major argument against the likelihood of US recession and bear market this year. Economic indicators remain very strong despite the lingering effects of the COVID-19 Omicron variant. The unemployment rate remains low at 4.0% and labor markets should be able to withstand rate increases of 1-2%. Real GDP expanded a massive 6.9% in the 4th quarter, and manufacturing and services purchasing manager reports indicate huge demand for and production of goods and services. US consumers are as healthy as they have been in decades. Consumer confidence has dropped below the all-time highs reached in 2019 but is still above the 10-year average. Corporate profits in the 4th quarter experienced their 4th consecutive rise of at least 30%. With mask mandates ending and local economies fully reopened from COVID restrictions, a 2022 recession seems extraordinarily unlikely.
It is never comfortable when stocks fall to this degree, but our advice in the January Outlook remains appropriate. Although we did not foresee the crisis in Ukraine, we expected heightened volatility this year. Despite the seriousness of world events, our long-term view of the global economic expansion is unchanged. As we wrote in January, we continue to recommend that “investors focus on their long-term strategy, exercise patience and discipline … and avoid chasing short-term trends.”
Economic and Financial Market Outlook 4Q 2021
We expect the global economy to continue its rebound from the COVID-19 Recession of 2020, fueled by reopening economies, unprecedented fiscal and monetary stimulus, and pent-up demand. However, recent developments have tempered the heady optimism from the first half of the year. The Delta variant’s rapid spread, worldwide supply chain disruptions, a sudden rise in inflation, a deteriorating Chinese economy, and the possibility of a US debt default and government shutdown have eroded confidence in the recovery’s duration and strength. Investor sentiment turned pessimistic in response to these developments; for the month of September, the S&P 500 Index slumped -4.8% and the international benchmark MSCI ACWI-ex US Index gave back -3.7%. Despite the recent pullback, looking forward we think that the positives still outweigh the negatives. The most probable outcome is that the global and US economic expansion will continue through 2022, though at a less robust pace than previously forecasted. Fundamentals supporting higher equity returns remain intact and investors should stay disciplined and focused on their long-term strategy.
When we wrote our last Outlook in early July, the Delta variant had yet to significantly affect the US. Since then, Delta has brought upon another wave of the pandemic, infecting millions and causing tens of thousands of deaths. The human cost has been profound. Although the virus surge caused immense human tragedy, the economic impact in the US has been relatively limited in contrast with other countries. Despite escalating COVID-19 cases and hospitalizations, restrictive shutdowns were limited, and consumption stayed high. Bolstered by stimulus measures, household savings and balance sheets improved to record highs and debt servicing payments as a percent of income reached record lows.
Consumption remains about 70% of the US economy, and consumers are the wealthiest they have been in decades. With the economy reopening, competition for labor has been fierce, resulting in huge employment gains, job openings, and rising wages. The likelihood of a recession is remote. However, inflation, supply chain and labor shortages, political uncertainty, and Federal Reserve policy have combined to limit growth. We anticipate progress on these issues in the fourth quarter and that they will not be as large of a drag in 2022:
- Inflation: We are in the middle innings of an above-target inflationary period, beginning in the spring. It appears that the initial pent up demand surge is waning, but inflation remains high and tends to go up faster than it comes down. The inflation rate will decline, but prices are not likely to retreat to prior levels.
Commodities like copper and wood have returned to more normal levels following a large spike, and demand for certain big-ticket items, like automobiles, have pulled back from peaks. Higher inflation than the 2008-2019 period may persist, but if this moderating trend continues the specter of excessive inflation will recede. Nevertheless, we acknowledge that the near-term impact is troublesome. The September University of Michigan Surveys of Consumers Report stated the problem concisely:
“Even if transient, higher inflation has already decreased living standards, and further damage is anticipated as just 18% of all households anticipated income gains would be larger than the expected inflation rate.”
- Supply chain and labor shortages: The global supply chain has not been able to adjust adequately to the surge in demand. It has not been uncommon to see empty shelves in stores or to experience month-long waits for household durables, like refrigerators. Semiconductors and shipping containers are a notorious headache. Supply chain issues and labor shortages are being cited more often in corporate earnings reports as a factor negatively impacting margins and profits. If production can ramp up and deliveries can accelerate, then the economy can grow higher for longer. The global supply chain is not static; it will adapt. The question is how quickly it can overcome major bottlenecks.
- Political uncertainty: The situation here is simple, though the stakes are high. If the US defaults on its debt, which would be without precedent, the consequence would be perilous. Fortunately, congress can avoid this ominous fate by simply raising the debt ceiling. Until there is an apparent path toward addressing this serious matter, this risk will remain at the forefront. A government shutdown is an additional potential hurdle, but the consequences are less dire than a default. We think that cool heads will prevail, a budget will pass, and essential government services will remain operative. As in the past, it may take a last-minute, highly contentious compromise, and our expectation is that these obstacles will be cleared before the end of the year.
- Federal Reserve policy: There is speculation that the Federal Reserve will commence a tapering policy (a reduction in its $120 billion per month bond purchases), which will result in a stock market setback. We expect the Fed will taper late in the fourth quarter, but we think it will be gradual, widely anticipated, and not upset the stock market. There is also speculation that runaway inflation will force the Fed to prematurely hike short-term interest rates, but we think the Fed will stick to its timetable of late 2022 or 2023.
The uneven nature of the recovery is likely to continue, but the powerful trend of economic expansion remains the strongest argument in favor of higher stock markets. While US equities have recently pulled back from highs, the 2021 calendar year has thus far produced solid returns. We expect the bull market to continue before year-end, buttressed by strong corporate profits, pro-growth monetary and fiscal policies, and large cash positions on the sidelines. As in the recent past, the primary investment alternatives to stocks, in particular money markets and bonds, remain unappealing.
The most notable feature within international economies is the wide gulf between developed and emerging countries in their ability to combat the virus, recover from last year’s downturn, and provide positive equity market returns. In stark contrast with their emerging market counterparts, wealthy countries benefited from mature healthcare infrastructure, purchased and administered vaccines effectively, and provided fiscal stimulus directly to their citizens. This difference is reflected in the year-to-date 6.9% return of the developed markets ETF iShares MSCI EAFE compared to –2.5% in the emerging market ETF iShares MSCI EEM. Emerging market economies have endured additional stress from a softening Chinese economy, which has been weakened by a fresh round of anti-business policies from its government. Our view is that the prosperity gap between emerging and developed economies will persist for several quarters. Europe, Australia, and Japan have high vaccination rates and are reopening their economies; they will quickly catch up to where the US is now in the recovery process. It is worth noting, however, that this will unleash pent-up demand, which could put further strain on global supply chain issues. Emerging economies and stock markets will struggle until they make substantial improvement in their ability to handle the virus.
As in past outlooks, we continue to recommend the best approach to international equity investing is to focus on the ability of individual companies to thrive despite current economic realities. For example, some commodities companies will benefit from rising global inflation and some semiconductor companies will profit from huge demand. Investments in China, in the past so beneficial, now have higher risk and should be considered only with considerable caution despite strong earnings potential. Also attractive are European companies strongly positioned to profit from the reopening trade as virus concerns recede.
Rising concern for inflation is putting upward pressure on bond yields despite the Federal Reserve’s policy of maintaining a low interest rate environment. For example, the yield on the benchmark 10-year US Treasury has risen from a low of 1.17% as of Aug 4, to a current 1.58%. The yield may well rise further (and the price decline) in the short term as the general economy continues to improve and the Federal Reserve begins to unwind its bond purchasing policy. We thereby recommend that investors emphasize short-maturity bonds despite their relatively unattractive yields.
Economic and Financial Market Outlook 2021 Q3
Our 2021 forecast, which we have held since our first quarter Outlook, remains intact: a synchronized global economic expansion is underway, will extend into 2022, and will support another year of rising stock markets. The International Monetary Fund in April projected 2021 global GDP growth of 6.0% and The Economist projects this gain will be led by the US (6.0%) and China (8.5%). We acknowledge that the extent of economic progress for most countries, including the US, will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement fiscal and monetary policies. We observe significant divergence in the speed and magnitude of country recoveries, but overall growth should provide solid opportunities for equity investors.
The US economy is experiencing a stronger than expected vaccine-powered recovery, led by consumer spending. In response to recent indications of strength, on July 1 the IMF raised its 2021 US GDP estimate from 6.4% to 7.0%. Going forward, extremely accommodative monetary policies adopted by the Federal Reserve in combination with highly stimulative fiscal spending by the US Congress and Administration will be a major support. A bulge in household savings rates during the pandemic coupled with employment gains in the millions and rising wages will further boost consumer spending. Another development is a potential surge in home equity loans arising from the large increases in property prices at this time of very low interest rates. Additional positives include the pent-up demand in capital expenditures and a pickup in international economies.
The US stock market continues to be highly attractive. Corporate earnings have mushroomed far above analyst expectations so far this year: based on consensus analyst projections (FactSet, 6/17/21), we expect 2021 year-over-year S&P 500 profit growth of 61.9% for the second quarter and 34.8% for all of 2021. Public companies are eager to restore share buyback programs and raise dividends, both of which are positives for their stocks. There is still $4.5 trillion in money market funds on the sidelines (Investment Company Institute, 7/1/21) that could flow into equities as investors reallocate their portfolios. The S&P 500 Index currently trades at a forward P/E ratio of 21.7x, which is reasonable compared to the 5-year average of 18.0x. In other words, the forecasted rise in corporate profits will allow for stock price appreciation without stretching valuations.
Most international economies are not as far along in the recovery process as the US, with some faring better than others. This divergence is reflected in investment returns: Euro Area stock markets year-to-date are up 14.7% versus a more meager 5.4% gain for emerging markets. Another example is Japan, with expected GDP growth of only 2.2% this year and a corresponding equities gain of 5.2%; in contrast, France is anticipated to grow 5.5% and its stock market has soared 18.0% (The Economist, 6/26/21). Political developments are having a negative impact on equities in certain countries, including China, Hong Kong, and Brazil. Although some markets may prosper and others may falter, many individual companies will capitalize on the strong global expansion. Moreover, countries currently struggling with the virus will prevail eventually and subsequently experience an economic recovery. With billions of vaccines already manufactured, we think this will occur sooner than later.
Risks to a global stock market advance which we consider noteworthy include:
- Runaway inflation in the US: indicators are for longer-term inflation to remain low, but surveys show that individuals are becoming increasingly concerned.
- Policymaker errors by central banks and/or government authorities.
- A new virus or variant outbreak, which will lead to a restoration of restrictions.
- Supply shortages of labor and goods, slowing the rate of economic progress and seriously hampering certain industries and companies.
- Deteriorating international relations, particularly between the US and China, which would negatively impact trade and the ability to fight the virus.
Each of these challenges already exist to some extent, with the possible exception of excessive inflation. However, their severity hasn’t reached the point to derail the current bull market. We do not expect these threats to fade completely, and as always, we will keep a close watch regarding their impact on the positive case.
Investors are highly sensitive to the yield on the US 10-Year Treasury Note because it is an indicator for the outlook for inflation, future Federal Reserve policy, prospects for the overall US stock market, and the relative return on industry sectors and growth versus value styles. We anticipate the Federal Reserve will resist pressures to taper or raise short-term rates at least through 2021, and thus we expect only a gradual rise in the 10-Year yield from the current 1.32% to 1.50-1.80% by the end of the year. As competitors to equities, money market and bond yields continue to be unattractive. Bonds remain important as portfolio stabilizers but are less appealing as a source of income.
We wish all our readers a safe and pleasant summer.
The Marietta Investment Team
Marietta Supports Repairers of the Breach
In the first quarter of 2021, Marietta raised funds through our Jeans for Charity program for Repairers of the Breach. This nonprofit organization is the only daytime resource center for adults experiencing homelessness, and it has been serving the Milwaukee community for 30 years. Their services include a medical clinic for uninsured and underinsured adults, an emergency warming room, a learning center for basic adult education, and meal distribution through the Breach Cafe. We are honored to support their mission to provide life-saving, life-sustaining, and life-restoring programs in the Milwaukee community.
Marietta Returns to Money Life with Chuck Jaffe
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Economic and Financial Market Outlook 2021 Q2
We continue to hold to our January 6th forecast that a synchronized global economic expansion in 2021 will support another year of rising stock markets. The International Monetary Fund recently (04.06.2021) projected 2021 global GDP growth of 6.0% led by the US (+6.4%) and China (+8.4%). Similarly, JPMorgan expects U.S. GDP growth of 6.4%. Both forecasts revised upward their growth targets from earlier in the year. We are more optimistic; U.S. GDP growth will be at least 7% if the pace of reopening continues. This acknowledges that the economic path forward for most countries, including the U.S., will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement effective fiscal and monetary policies. In 2020 there were investor fears of a severe and prolonged virus-related recession, global GDP shrank by -3.3%, and every major economy except for China suffered negative growth. Now, all major regions are expected to grow at above average rates, COVID-19 cases are well off their peaks (though concerningly rising in some parts), and staggering amounts of financial relief is breathing life to the economy. We are closely watching the progress to overcome the pandemic as well as any signs that recovery efforts trigger excessive inflation, but we believe we are in the early stages of a new bull market. At this time, we recommend investors take a disciplined approach and stay with their long-term strategy.
The US economy will enjoy a strong rebound this year as the COVID-19 threat subsides and economic restrictions lift, with monetary and fiscal stimulus providing additional support. The COVID-19 situation has clearly improved: over 3 million vaccine doses are administered on average each day, over 25% of the US adult population has now received two doses, and hospitalization rates continue to decline. As a result, states and cities have further eased emergency restrictions. As the entire country has begun its long-awaited “reopening,” the labor market has drastically improved. The unemployment rate has come down to 6.2% from a high of nearly 15.0% and the US added over 900,000 jobs in March. Besides benefiting from reopening, US households have been supported by monetary and fiscal policies. The $1.9 trillion stimulus passed in March and the Federal Reserve’s commitment to keep interest rates low have put the US economy on steadier footing. While many people have not felt the recovery yet, consumer confidence is on the rise and average household savings rates are at elevated levels (see chart).
The US is further along in its vaccination efforts than most, but as other countries undergo a similar process and reopen with increased immunity in the coming quarters, the US economy will further benefit from the virtues of a broad-based, synchronized global economic expansion. This optimistic outlook assumes that vaccines stay effective against the prevalent COVID-19 strains and new coronavirus variants do not spread to an extent that lockdowns are brought back.
At the other end of the spectrum, we must be watchful that the stimulus and easy monetary policy does not lead to an overheated economy with excessive inflation. At this juncture we do not think inflation will be a drag on the economy. We have already seen reports of short-term higher prices, but we think this is due to businesses trying to catch up to growing demand with pandemic-idled production capacity. The March Producer Price Index (PPI) showed 1.0% month over month price increases, the second highest on record. These are extraordinary numbers but we expect that once producers can increase hiring and production capacity, the inflation pressures will subside. Over the past decade, the greater threat has been disinflation rather than inflation and we should not lose sight of the fact that it is healthy for inflation to run at or slightly above the Federal Reserve’s 2.0% inflation target.
The fundamental backdrop is positive for US stock markets. The Federal Reserve has promised to continue accommodative policy and a faster-than-expected recovery should enable companies to report stronger earnings and give better guidance. FactSet estimates full-year corporate earnings will surge over 23% year-over-year, which we consider conservative. This large increase in profits will moderate what currently appear to be lofty P/E multiples. Moreover, alternative investments to equities, such as bonds and money market funds, provide low and unattractive potential returns, further justifying elevated stock market valuations. Coming off a deep but short-lived recession, the market is experiencing a period of transition. Historically stock market recoveries from recession have resulted in a change in leadership. Whereas growth and momentum stocks, led by information technology industries, are favored leading up to recession, value and economically sensitive stocks found mostly in the financial, consumer discretion, and energy/commodity sectors come to the forefront during recoveries. This has been the case since the positive vaccine news broke on November 6, 2020 with the Russell 1000 Value Index surging 23.1% while the Russell 1000 Growth Index improved a more modest 6.0%. Similarly, stocks of businesses that were depressed or even shut down during the pandemic have been catching up to the companies that were minimally affected over the past year. The worst stocks of 2020 performed the best in the 1st quarter of 2021. It is possible that this trend will continue near term, but we prefer companies that can demonstrate earnings and revenue growth from pre-pandemic levels. Certainly, investors should hold some investments with improving prospects due to the reopening (travel/leisure, entertainment, manufacturing), but we continue to emphasize companies with strong fundamental attractiveness that benefit from trends that will run long past the point of full recovery.
The pace of recovery across regions is striking. Nevertheless, IMF forecasts that every major economy will recover from recession this year and continue growing in 2022. We think this will create numerous and significant investment opportunities across countries and industries. The Eurozone should bounce back to 4.5% growth in the second half and the UK will see full year output at 5.0-6.0%. In the near-term we favor developed economies as they will likely recover more quickly. These regions also have value-oriented sectors like financials and industrials. China and India are bright spots in the emerging world and are expected to grow at 8.4% and 12.5% this year and moderate in 2022. Mexico will likely experience above trend growth as well given its close relationship to the US.
There are always threats to an optimistic outlook and we closely monitor risks that could disrupt economic growth. Again, first and foremost, is the continued presence of COVID-19 which has begun to rise again in Europe, South America, and India. We are also cognizant of global supply chain shortages, particularly in semiconductors. Further, we think rising nationalism is a significant risk as people in various countries push for less globalization and it could negatively affect international trade. Lastly, as always, we want to keep watch on geopolitical tensions, especially with respect to China.
Across the world, but especially in the U.S., interest rates have turned higher in anticipation of stimulus-fueled spending and economic growth. While the move has been sudden, the 10-Year US Treasury yield jumped from 0.92% to 1.74% during the last quarter, rates are still exceedingly low. The 10-year rate is still lower than 2019 levels and near the lows for the entire 2009-2020 expansion. Rates will likely move higher as this expansion matures but bond investors should not expect a return to a pre-financial crisis yields. This may provide an opportunity to select some bonds at better prices for fixed-income portfolios but we still recommend underweighting this asset class.
One year ago, we wrote at the outset of the pandemic that one key question was “When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?” One year later we can finally see the light at the end of the tunnel as the reopening gets underway. Economic indicators are turning decidedly positive and global stock markets have advanced in anticipation. This process will take place over the next few quarters and it will not be a steady journey, but there are better days ahead.
As always, stay safe and healthy and be optimistic for the future.
The Marietta Investment Team
Marietta Supports Revitalize Milwaukee
In the fourth quarter of 2020, Marietta raised funds through our Jeans for Charity program to donate to Revitalize Milwaukee, a local nonprofit that provides free critical home repairs and other services to low-income veterans, seniors, and people with disabilities. Revitalize Milwaukee is the largest provider of free home repairs in Southeast Wisconsin and they strive to ensure affordable housing and revitalize under-resourced Milwaukee and Waukesha neighborhoods. We are proud to support their mission to transform and strengthen our community.
Economic and Financial Market Outlook 2021 Q1
The tumultuous 2020 calendar year has finally ended. Despite enduring a global recession, most of the world’s stock markets recovered to finish the year with solid gains: the US benchmark S&P 500 Index returned 18.4% while the MSCI All-Country World ex-US Index rose 10.3%. When we issued our last Outlook on October 13, we noted that a heavy fog had obscured financial market forecasting. At that time, major questions regarding the future course of COVID-19, the response of policymakers, and the impact of US politics, were impossible to predict with conviction. We also anticipated this uncertainty to lift by year-end and improve visibility into 2021. This has happened and, on balance, the developments have been positive for financial markets. The consequence has been surging global equities propelled higher by a growing consensus view, which we share: a synchronized global economic expansion will gain steam in the second half of 2021, resulting in another year of rising stock markets.
The greatest factor affecting economic progress remains the battle against the coronavirus. The consensus forecast expects COVID-19 to become more severe in the US and Europe in the first few months of 2021, which has already led to increased restrictions in some countries. However, if vaccine distribution estimates are correct, by the end of the first quarter a hundred million or more people should be inoculated globally and the virus will commence a steady retreat. This positive outcome would lead to the beginning of a “return to normal” by the end of summer. In the US, the current record-high household savings rate indicates pent-up demand and should boost consumer spending in the medium-term. Corporate profits are poised to rebound faster than the economy, surging over 20% in 2021. All eleven S&P 500 sectors are projected to report year-over-year earnings growth. Huge corporate cash positions could spur a new wave of stock buybacks, dividend increases, and mergers and acquisitions activity. In short, the end of the COVID-19 pandemic would likely be accompanied by flourishing economies and stock markets.
The role of the world’s central banks in supporting economies and lifting equity markets should not be underestimated. For example, the Fed has promised to maintain historically low interest rates relative to other recoveries. In 2003, interest rates were between 4.0-5.0%. Following the Great Recession, the yield on 10-year Treasuries vacillated between 3.0-4.0%, whereas currently the yield is about 0.9%. The resulting boost to stocks is twofold: near-zero interest rates support economic growth, but also reduce bond yields to such a low level that the asset class ceases to be a substantial investment alternative for investors seeking capital appreciation. Sovereign wealth funds, pension plans, and retirement plans with balanced investment portfolios are already experiencing pressure to increase equity ratios as their only hope of achieving total return objectives. The power of the Fed is on full display. Generations of investors have learned wisdom in the phrase, “don’t fight the Fed.”
Despite strong tailwinds, our near-term enthusiasm is tempered because the strong equity gains in 2020 occurred in the absence of corporate profit growth, resulting in high valuations. While we think the overwhelmingly positive economic fundamentals will prevail, the road ahead is likely to sustain setbacks and challenges; expensive stock markets pricing in considerable optimism frequently lay the groundwork for corrections. Our view would be any pullback would likely be short and provide a buying opportunity. Our forecast for the year is that 20%+ growth in corporate profits will reduce current sky-high multiples, and US equities will provide a solid 8-10% annual return.
A key strategic question for both US and international investors is where to invest? Should investors favor the growth stocks that performed so well in the second and third quarter of 2020, led by technology and companies benefiting from the “stay at home” economy? Or should investors take the leap of faith that the positive forecast is correct and invest in downtrodden industries such as travel, transportation, banks, and commodity producers? We recommend a broadly diversified blend of the two strategies with a strong emphasis on high-quality, well-established companies which will almost certainly survive, if not thrive, if the bright outlook dims.
We emphasize that our positive case and strategy recommendation applies to both the US and international stock markets. In the fourth quarter, the 12.2% return of the S&P 500 Index was overshadowed by the 18.4% surge of the iShares Emerging Market ETF (EEM). This is not surprising, since emerging markets and highly volatile commodity stocks have been market leaders in the early stages of recovery following each of the last two recessions. Emerging markets are also benefiting from weakness in the US dollar, which is partially a consequence of Federal Reserve policy. Euro Area GDP is expected to grow at 5.2% with a hefty 30%+ increase in corporate profits, both at a faster pace than the US. With European stocks trading at lower valuations than their US counterparts, value-oriented investors may look to the region for opportunities.
The 2020 bear market and its ultimate resolution has reaffirmed our view that keeping a long-term perspective is highly beneficial to improving investment results. We find it especially gratifying to guide our clients through turbulent markets such as last year.
We wish our clients and readers a healthy and happy 2021.
The Marietta Investment Team