Economic and Financial Market Outlook Q3 2023
Prepare for a Soft Landing
The global economy continues to slow, but the US and euro area should avoid recession, albeit narrowly. We expect a positive global GDP growth surprise of 3.0% to 3.5% for 2023, based in part on the anticipated boost from coming stimulus in China. In the second quarter the views of the most probable US scenario shifted from recession to “soft landing,” which reflected the capacity of the economy to withstand inflation and higher interest rates. We now estimate the likelihood of a recession to be below 20%. The improved environment raises prospects for the US stock market and reduces the probability of a renewed bear market. We are cautiously optimistic regarding a further advance of the S&P 500 Index, but we note that this Index over the last six months has featured extreme divergence in the performance of different industry sectors and market capitalizations. This is unhealthy, and a near-term correction is possible. The arrival of more favorable macro conditions should broaden participation and makes a future market advance more sustainable.
US Economy Refuses to Quit
So far this year, the US economy has exhibited surprising strength. In the first half of 2023 there was plenty of bad news: the Federal Reserve hiked rate above expectations, inflation declined at a disappointingly slow pace, major banks failed, the government tottered on the brink of default, international economies were weaker than anticipated, manufacturing indicators contracted, and recession predictions were ubiquitous. Yet the economy continued to grow. US GDP rose 2.0% in the first quarter, and we expect a similar result for the second quarter. The major support for the economy has been the labor market: the unemployment rate has settled near a 70-year low and job creation has been vibrant. Home prices and sales have remained firm despite a sharp increase in mortgage rates, and consumer sentiment and spending data have been encouraging. As the quarter drew to a close, there was a notable jump in optimism that the soft-landing scenario was the most probable.
What does a soft-landing look like?
Over the next two quarters, we expect GDP growth to approach 0.0% but remain positive, as the lagging impact of previous Fed rate hikes takes its toll. Annual CPI inflation will continue to decline gradually from its current 4.0% but remain above the Fed’s 2.0% target. We estimate two more quarter point rate increases, the first in July and the second in September. By the end of the third quarter, the Fed will be satisfied with the reduction of inflation from its peak of 8.3% in 2022 to below 3.0% and decide to pause rather than raise rates further but we do not expect any decisions to lower rates until well into 2024. Despite higher rates, the labor market will stay strong with the unemployment rate below 4.0%. As was true in the first half, this positive scenario will be driven by the resilience of consumers and businesses spending and investing despite the headwinds of inflation and worries of an impending recession. The housing and auto markets should remain healthy. Recent, successful stress tests administered to banks have been encouraging and we think another banking crisis is unlikely. While all of this should be welcomed as good news, conditions are intended to remain tight to slow the economy and GDP will be on the cusp of contraction. There remains a lot of progress to be made before we are on a path of healthy, sustainable growth.
US Stock Market Resilient
The unexpected strength of the US economy drove equity markets to advance in the first half of the year. In the face of a slowing economy and a forecasted recession, high inflation and rising interest rates, and fear of government default, the market rally was certainly a surprise to investors. While the S&P 500 index had the strongest performance, most broad market indexes provided positive if unspectacular single digit returns:
7 of the 10 Industry sectors of the S&P 500 Index returned less than 10%, and 5 were negative or flat: consumer staples (0.0%), financials (-1.5%), health care (-2.3%), utilities (-7.2%), and energy (-7.3%).
In sharp contrast is the truly remarkable performance of technology stocks and especially the largest stocks by market capitalization (see our 6/2/23 blog, “2023 US Stock Markets: The Year of the Giant.”). For the six-month period, the technology heavy NASDAQ Composite and the information technology sector of the S&P 500 Index rocketed 31.7% and 42.1% respectively, and the six largest companies measured by market capitalization rose an average of 85.3%: Alphabet 36.3%, Amazon 55.2%, Apple 49.7%, Meta 138.5%, Microsoft 42.7%, and Nvidia 189.5%. These giant companies have a combined market cap above $9.4 trillion, or about 26% of the total S&P 500 Index. This is the reason the S&P 500 Index (+15.9%) was such an outlier in the first half. As we pointed out in the blog, the S&P 500 Index was not representative of overall stock markets and well-diversified portfolios saw more modest single digit returns in line with most other indexes.
For the rest of the year, we expect the path of inflation and the response of the Fed to be the major focus of stock investors. Based on our forecast for a continued decline in inflation, we expect the market rally to extend through the end of the year. Although additional rate hikes are coming, investors expect this and the modest increases should not pose a significantly larger obstacle than the previous 500 bps. We project corporate earnings will turn positive again in the third quarter and accelerate in the fourth quarter, justifying current higher price multiples. Our positive forecast includes a broadening of market participation away from a reliance on the largest stocks mentioned above.
International Green Shoots
In China, the financial market situation has turned ambiguous after a brief surge earlier this year. A short-lived rally in stocks faded as the economic headwinds arose. In response, the government has resorted to stimulus measures to invigorate the economy, and we anticipate more in the pipeline. Contrary to the rest of the world, China has faced deflationary pressures, underscored by June’s negative core CPI. While deflation has presented a challenge for the world’s most populous country, it has benefited the rest of the world where inflation is still an obstacle.
Turning to the European Union, the economic landscape more closely resembles the US, albeit on slightly weaker footing. Harmonized CPI inflation has cooled from 8.5% in February to 5.5% in June as growth stalled. Though consumption and manufacturing have been contracting, we may be seeing early indications that the worst is behind us. If this is indeed the case, the EU will emerge from this slowdown without a substantial rise in unemployment, which could lead to a rapid recovery. A noteworthy risk remains the ongoing conflict in Ukraine, with the potential to cause supply shocks and exacerbate geopolitical tension.
Recoveries in other international economies have added to our cautious optimism. India’s growth has accelerated even while inflation has retreated. Similarly, we are seeing robust momentum in Mexico and much of Latin and South America, despite some political turbulence. Japan, too, presents an encouraging picture with a 17-month high in consumer confidence and a low unemployment rate of 2.6%.
Fixed Income and Higher Rates
The recent bond selloff has brought rates back near the highs set late last year. The 10-year Treasury yield approached 4.0% at the end of the quarter and briefly exceeded that in the early days of July. As investors’ appetite for risk assets like stocks grew, coupled with their acceptance of higher fed fund rates through 2024, perceived safe assets like treasuries were out of favor. As a result, new fixed income investments are providing the most attractive real yields in over a decade. The yield curve remains inverted which means both that there is still an expectation for recession in the near future and the best yields are in short maturity bonds. In this environment, it is worthwhile for balanced portfolios to consider whether bond investments can now be a greater part of their strategy but we continue to recommend that investments focus on high-quality and short duration selections.
Economic and Financial Market Outlook Q2 2023
The rising risk of a US recession has diminished our cautious optimism for global equity markets, as stated in our January Outlook. The first quarter introduced new challenges to growth, including persistently high wage inflation, OPEC’s oil production cuts, and a banking crisis. These negative surprises are concerning and elevate the likelihood of a more severe downturn in the US. In fact, most countries are experiencing declining economic activity, though a soft landing is still possible. Investors with an elevated concern for preservation of capital may consider adopting defensive strategies until conditions improve.
Clouds over the US Economy
The US economy is mired in a difficult environment marked by slowing GDP growth, high inflation, and a Federal Reserve committed to raising interest rates further. The Economist April 8-14 consensus forecasts 2023 US GDP growth to slow to 0.8%, from 2.1% in 2022. The labor market remains a bright spot, with unemployment rates near all-time lows. This has sustained robust consumer spending, though consumers have progressively reduced their savings and relied more on credit for purchases. Though the strong labor market indicates that the US is not currently in a recession, it also has the effect of keeping wages stubbornly high. This creates sticky core inflation and puts pressure on the Federal Reserve to implement additional rate hikes, which impedes economic growth and can cause unintended consequences, like the banking crisis in the first quarter.
Bank Crisis Update
Almost a month has passed since a massive withdrawal of deposits at Silicon Valley Bank on March 9 led to its sudden collapse and triggered a bank crisis. Within a week, several other banks required a rescue. Fears spread that problems in the banking system were systemic and would endanger the entire global banking industry (see Marietta blog Bank Failures Increase Uncertainty 3/21/23). In recent weeks bank stocks have stabilized, although at a lower level, and fears of a prolonged crisis have subsided. The relative calm is due in part to autopsies of the failed banks, which indicates the bankruptcies were a consequence of mismanagement and not a systemic weakness. The stabilization was also in part a consequence of the rapid and effective action taken by the Fed and the Treasury Department.
At this point there is temptation to declare that the bank crisis is over. We think this view is premature, though the risk of a financial meltdown similar to 2008 is unlikely. The new emergency lending facility, the Bank Term Funding Program, is a very positive step forward, as is the government’s readiness to protect depositors. But there is still room for negative contagion to resurface, especially as the Fed funds rate goes even higher. One potential threat is that a huge flow of funds out of bank deposits into money market funds and US treasuries will diminish banks’ willingness and ability to loan, which will slow the economy. Worth noting is the April 4 warning by Jamie Dimon, chairman and CEO of JP Morgan, “the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come.”
Resilient US Stock Markets
US stock market indices have been resilient, continuing to advance from October lows. However, S&P 500 earnings have fallen for two successive quarters, with projections for the first quarter indicating a third consecutive decline. As companies factor in the negative surprises from the first quarter, it is probable that management teams will issue further downward guidance. This combination of lower earnings expectations and higher stock prices has stretched valuations, pushing up the S&P 500 forward price-to-earnings ratio to 18.0x, above the 10-year average of 17.3x (FactSet Earnings Insight 4/6/23). As equities have gotten more “expensive,” yields on money markets and short-term bonds have risen to a level where they are a legitimate competitive investment. This is a relatively recent phenomenon; it has yet to be seen whether this will significantly impact the price investors are willing to pay for stocks, though the massive movement out of low yield money market funds indicates that investors are paying attention. Though the near-term outlook is muddled, we remain confident in our view that equities will provide investors with solid long-term returns. Investors should focus on adding exposure to quality companies with talented management teams, strong balance sheets, manageable debt levels, and growing market share. Special attention should be given to those companies benefiting from China’s reopening and a weakening dollar.
The International Opportunity
Despite strong growth in India and China, over 90% of international advanced economies are expected to endure declining growth in 2023 (International Monetary Fund, April 11 World Economic Outlook). We expect global growth to decline from 3.4% in 2022 to 2.8% in 2023, in-line with the IMF projection. Although this still constitutes a soft landing, there is a greater risk to the downside. The major negative developments causing this decline are high inflation, synchronized tightening monetary policy, the banking crisis, and the consequences of Russia’s War in Ukraine. A notable gap has opened between GDP growth expectations of 5.2% in China, and, in contrast, 1.6% in the US and 0.8% in the Euro Area. Much of this difference may be attributed to an estimated 2023 inflation rate of only 2.0% in China versus 4.5% in the US and 5.3% in the Euro Area.
We reiterate our view from our last Outlook that long-term investors consider adding more international stocks to their investment portfolios. The US dollar peaked in October and international stocks have rallied over +23% since, measured by the MSCI All-Country World ex-US Index (ACWX). The anticipated economic weakness in the US could push down the dollar further, continuing this trend. Despite this quiet rally, valuations remain compelling at 13.0x 2023 earnings. Developed international company earnings are expected to rise in the first half of 2023, in contrast to the US where they are expected to fall. Not all opportunities are created equal, and our focus is on high quality companies benefiting from long-term trends, including the burgeoning Chinese consumer, the proliferation of semiconductors, and resilient global household spending.
Bonds a Practical Alternative
As concerns for the economy have increased and the inflation rate has slowly come down, yields have reflected this by declining from March highs. In this period where there is a rising risk of recession, quality remains a prime consideration. We reiterate that short-term treasuries offer the best risk reward over money markets and longer-term bonds.
Economic and Financial Market Outlook Q1 2023
Heading into the new year, almost all major economies are enduring broad-based challenges. The major issues that disrupted financial markets in 2022 are still apparent: high inflation, restrictive monetary policy, continuing COVID outbreaks, and an energy crisis brought on by the Russian invasion of Ukraine. After the declines of 2022, financial markets reflect the rising risks that have beset the global economy. In the US and the EU, central bankers seek to curtail high inflation without hammering their economies into a severe recession. In China, the focus is on reopening from years of zero-COVID policy shutdowns and implementing stimulus measures. While the present obstacles look daunting, if the major policy initiatives show signs of progress in the first half of 2023, then this could be the beginning of a multi-year advance in global stock markets, anticipating a global economic recovery in 2024.
In the US, the Federal Reserve continues to aggressively raise interest rates and thus far has attained some success in lowering inflation. November core PCE, the Fed’s preferred inflation measure, retreated to 4.7% from 5.0% in October and 5.2% in September. We expect the Fed to stop rate hikes in the first quarter after an additional 0.50% or 0.75% increase. This restrictive stance will push inflation down over the course of the year at the expense of economic growth. There is already weakness in the housing, auto, and manufacturing markets. On the other hand, unemployment has stayed historically low, and the economy has added jobs for 24 consecutive months. We project 2023 US GDP to grow less than 1.0%, but not dip into a deep recession, though a short and shallow recession is possible.
US Stock Market
US equities look to bounce back from a dismal 2022. The major indexes fell into bear territory and while there was a slight recovery in the fourth quarter, the S&P 500 closed the year down 19.4% and the NASDAQ 100 was off 33.1%. Despite these numbers, there is reason for cautious optimism. Most of the factors that contributed to the selloff are moderating: inflation is slowing, the Fed is nearing the end of its rate hikes, and excessive earnings multiples have declined, though they remain near long-term averages. As we stated, we are expecting low growth, possibly even slightly negative growth, but an economy that bends without breaking should support modest advances in equities this year. Corporate earnings are expected to grow 5.3% this year which is a slight acceleration from 2022. The financial media seems to believe that these expectations will decline but that was also the case in 2021 when corporate earnings were resilient. Lastly, even though our optimism exists despite last year’s returns, there is a case to be made that one can be optimistic because of last year’s returns. Since World War II, there have only been three times when the S&P 500 had consecutive negative annual returns. Historically, after a decline of 20% or more in the S&P 500, the index has increased an average of 14%, 33.6%, and 61.5% over the following 1-year, 3-year, and 5-year periods, respectively. As long as the economy holds up, US equity investments will have a positive year in 2023.
We are upbeat on international markets in 2023 as China ends their zero-COVID policy, EU inflation data eases, a mild winter calms fears of gas shortages, and global economic resilience surpasses last year’s grim expectations. The shift in China occurred late last year, when mass civilian protests led to a drastic policy change focused on growth. Since then, Chinese authorities have:
- Eliminated nearly all COVID restrictions
- Added 16 support measures for property sector, including a pledged $256B in available credit to bailout cash-strapped developers
- Cut the required reserve ratio 25 bps effective December 5, 2022 – with signals for more if needed
We think many economic forecasters underestimate the ability of the Chinese government to stimulate growth and, like other reopening countries, experience a swift rebound. If we are correct that China will grow above expectations, it will have a profound effect on the global economy, improving the prospects for many international economies and companies. The EU will welcome a boost to offset the restrictive monetary policy enacted by the European Central Bank. The ECB is raising rates to fight high inflation, though their tightening policy thus far has been modest compared to the Fed (2.0% benchmark rate vs 4.5%). Recent data suggests that inflation in the key economies of Germany, France, and Spain is moderating, giving the ECB the possibility to achieve their target inflation goals with less economic fallout. A major tailwind has been the precipitous fall in the price of natural gas, alleviating concerns of an expensive, and deadly, winter.
International Stock Markets
We recommend that long-term investors consider adding more international stocks to their investment portfolios. International stock market indexes trade at considerable valuation discounts to their US counterparts. On December 31, the MSCI All-Country World Index ex-US benchmark traded at a 11.8x forward P/E ratio, compared to the 18.8x forward P/E ratio of the S&P 500, a 37% discount. There are companies exhibiting strong balance sheets, talented management, and earnings growth that will benefit from improving economic trends both abroad and in the US.
Recession concerns for the US and the EU drove a dramatic selloff in bonds pushing yields to levels not seen in a decade. Although the interest rates appear attractive, with inflation still above 5%, real yields on bonds are negative for most investment grade issues. Our recommendation remains to focus on short-dated bonds. Investors with a mandate for fixed income could consider medium-term bonds but should still overweight short issues to protect against losses if rates continue to rise. Quality should be favored as well, while below investment-grade presents unappealing risk versus return potential.
Economic and Financial Market Outlook Q4 2022
Speculation regarding the path of inflation and central bank policies will dominate global economic and investment forecasts for the foreseeable future. In the US, the Federal Reserve has unmistakably articulated its full determination to drive inflation down to 2.0%, accepting that there will be collateral economic pain. Consequently, we anticipate the US economy will weaken through the remainder of the year and into 2023, hindered by increased borrowing costs, further declines in key commodity prices, and sustained strength in the US dollar. Early indications suggest that the Fed’s aggressive policy has been somewhat successful so far in softening the spikes in prices and wages. While there remains a long path ahead to reach comfortable financial conditions, we think that a sufficient improvement will occur in the first half of 2023, warranting the Fed to pause and possibly end the interest rate hiking cycle. However, the path of inflation has so far defied most forecasts, so we caution against overconfidence in any prediction. The health and resilience of the global economy will be the key in the coming months. We think a soft landing is certainly possible, but not necessarily probable.
The increasing bite of rising interest rates on the US economy is becoming ubiquitous. Prices across various sectors are down from highs (energy, agricultural commodities, automobiles, housing), and, most important from the Fed’s perspective, the wage-price spiral has yet to develop. Spending on goods is waning, though services demand remains high as consumers shift toward pre-pandemic behaviors. Also normalizing are supply chains, with bottlenecks easing. In combination, these developments are encouraging signs of easing inflation. More worrisome is that historically, the impact of monetary policy is delayed before it is fully realized. To date, the labor market is holding up well and unemployment remains historically low. But with the Fed increasing benchmark rates faster than any time since the 1970s, there is a heightened threat of an overreaction, and similar policy errors have triggered steep recessions. We lean to the view that short-term rates will rise to about 4.5% by early 2023 and that the Fed will pause at this point to better gauge progress in reducing inflation to their 2.0% target. This would be the best hope for a soft landing. Our greatest concern is that inflation does not fall as expected, forcing the Fed to act more aggressively, thereby increasing the risk of a sharp downturn.
Stock markets continue to experience large swings as investors weigh the likelihood and severity of an imminent recession. The most widely held negative outlook is that the Fed will not be able to tame inflation with 4.5% benchmark interest rates and that additional larger hikes will be necessary. As we said above, we think the most likely outcome is a Fed pause in 2023. There will be near term pain but, in our opinion, that is already mostly reflected in this year’s lower equity prices. We think it is too late for investors to reduce risk by lowering equity ratios, but too early to be aggressively positioned for a sharp upturn. In other words, our recommendation is that patience will be rewarded at this time of heightened uncertainty. Our advice is to:
- Maintain discipline in adhering to long-term investment objectives and asset allocation targets. The eventual sustained rally from lows will be seen by many as a head fake, and those that sit on the sidelines run the risk of missing the upturn all together.
- Structure broadly diversified portfolios across industry sectors. Timing the eventual market bottom will be supremely difficult, so portfolios should contain equities positioned to outperform both from positive and negative outcomes.
- Concentrate holdings in companies exhibiting ability to meet or exceed sales and earnings expectations in a difficult environment. There will be companies that do not fare well in the weakening economic conditions, and investors should seek to avoid disappointments.
- Overweight holdings in the US, which provides more strength and stability than can be found in international equity markets. While equity valuations in international markets could be seen as compelling, the challenges for companies abroad are significant, as described below.
- Remain flexible and open-minded. A major characteristic of the current bear market is that surprising macro shifts can meaningfully alter the probabilities of various scenarios.
Stock market bottoms usually occur following capitulation at a time when risk is paramount and fear is rampant. Worth noting is the current bear market’s length (9+ months) is already equal to the historical average. Stock valuations will recover at some point. Those that are invested in the earliest days of the inevitable rally will benefit the most.
The major international economies and financial markets are also struggling. On October 4, the International Monetary Fund (IMF) issued its Annual Report titled “Crisis Upon Crisis.” Managing Director Kristalina Georgieva introduced the report with the alarmist statement, “the global economy is facing its biggest threat since World War II.” A sobering roster of multinational crises have combined with country-specific problems, such as the property sector turmoil in China, to reduce prospects for future global growth:
- Rising inflation, especially in food and energy
- Russia’s invasion of Ukraine and the formation of geopolitical blocs
- The international energy supply crisis, especially in Europe
- Currency upheaval, marked by the surging US dollar
- The lingering COVID-19 pandemic, especially in China
- Excessive commodity price volatility
- The massive destruction of wealth from stock and bond market plunges
With so many obstacles, it is not surprising that GDP forecasts have retreated steadily throughout the year. On October 6, the IMF lowered its global growth prediction to 3.2% in 2022 and 2.7% in 2023, much lower than the robust 6.0% reached in 2021. This would be the weakest growth since 2001. Of the key economies, only China is expected to expand next year: the US is to slow from 1.6% in 2022 to 1.0% in 2023, the Euro Area from 3.1% to 0.5%, Japan from 1.7% to 1.6%, and China from 3.2% to 4.4%. The IMF inflation outlook calls for more short-term pain: 8.8% in 2022, a decline to 6.5% in 2023, finally returning to a more normal 4.1% in 2024.
The outlook may not be as ominous for international stock markets as it first seems. All the crises, listed above, are well known. Governments, business leaders, and central banks are increasingly adopting stronger and more effective measures to ameliorate the negative conditions. Further, investors have been dealing with these problems for the past year, and arguably their concerns are already apparent in stock market valuations. Our recommendation for international investors is similar to our advice for US investors: emphasize a diversified portfolio of high-quality companies able to maintain sales and earnings growth in highly volatile markets. We think this approach will be more successful and less stressful than trying to pick the winning country or industry sector ETFs, or to bottom fish stocks with cheap prices but troubled fundamentals.
Bond yields have soared (with bond prices falling precipitously) in response to Fed policy. US 2-year Treasuries ended the quarter at 4.2%, climbing from 2.9% reached on June 30, and far above the 0.7% at the beginning of 2022. For the first time in over a decade, investment grade bonds are offering something in the ballpark of a reasonable yield. However, we emphasize that interest rates are still lagging inflation. Further, we expect the value of longer-term bonds to continue to slump as the Fed Funds rate is projected to hike another 1.0% – 1.5% in the next three months. For investors who desire fixed-income exposure, we continue to focus on short-maturity bonds and to avoid increasing duration or lower quality to pick up yield.
Economic and Financial Market Outlook Q3 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.
Economic and Financial Market Outlook Q2 2022
Entering the second quarter, the outlook for the global economy is uncommonly uncertain. The result is above average volatility in financial markets and rapidly shifting investing trends. In the US, the key issue is rising inflation and the response of the Federal Reserve as it attempts to pilot a soft landing (raising interest rates without causing a recession). In our March 2 blog and January 13 Outlook, we expressed confidence that the Fed would be successful. We still adhere to this view but acknowledge that inflation has proved to be more intractable and economically disruptive, which makes the Fed’s task more difficult. In addition to rising inflation, international markets will need to cope with the negative economic consequences of the Russian invasion of Ukraine as well as potential hurdles impeding a pickup in China. Although our forecast carries less conviction than usual, the most probable scenario is that 2022 US GDP will remain positive in the coming quarters, inflation will gradually subside below 5.0% by year-end, corporate profits will rise around 10.0%, and the S&P 500 will be higher at year-end than it is now.
The US economy currently faces persistently high inflation. Monthly readings of core CPI (ex-food and energy) have risen each month since last September, with the latest reading at 6.5%, the highest in 40 years. In response, the Fed has indicated that it is ready to push through faster rate hikes and balance sheet reductions, which will slow the economy in hopes of dampening upward price pressures. We are intensely focused on the success of this course of action. Achieving a soft landing will enable the economy to continue its growth trajectory and prolong the post-pandemic recovery. However, if inflation continues at a high pace without relief, consumers and businesses will have to curtail spending and the Fed will take even more aggressive measures, increasing the likelihood of recession.
The exceptional strength of the US economy has thus far blunted the negative impacts of high inflation. The unemployment rate of 3.6% has only been lower once in the past 50 years (3.5%, Oct. 2019). GDP grew 5.7% in 2021, the fastest year since 1984. The US consumer, the backbone of the economy, is solid; balance sheets are healthy, credit utilization is low, and wages are rising. Household cash exceeds debt for the first time since the early 1990’s. Nevertheless, two recession indicators occurred in the first quarter: a spike in oil prices and the inversion of the yield curve (when short-term rates go above long-term rates). Of these two, we are less concerned about oil as it has already stabilized well below the peak. The yield curve inversion, on the other hand while a more reliable predictor, has in the past delivered false signals and on other occasions preceded recession by as long as three years. The robust US economy, in particular the consumer, provides some room for error to navigate a soft landing or, at worst, fend off recession for at least 12-18 months. We expect GDP growth to remain positive every quarter this year, measuring 3.5% for the year.
US stock markets swooned in the first quarter in response to escalating threats to the burgeoning economic expansion. Major benchmark indices are still mired in a correction, with the S&P 500 producing the first negative quarterly returns in two years. The forward P/E ratio of the S&P 500 index has dropped to 19.0 from the 21.3 recorded at the end of last year, with growth stocks experiencing an especially large multiple contraction. This indicates that current equity valuations are not alarmingly high considering the expected double-digit rise in 2022 corporate profits. If investors gain confidence in the resilience of corporate earnings and/or a successful soft landing, stock markets should make a sharp advance. However, if the Fed makes a policy error and leads the US toward recession, additional negative returns can be assumed before equities begin a new bull market cycle.
Investing in international equity markets carries additional uncertainties and risks. In the EU, in addition to a more acute impact on consumption from higher energy and food prices, Russia’s invasion of Ukraine has dragged down sentiment, even while economies enjoy a boost from the lifting of COVID-19 restrictions. Alternatively, China is still imposing a “zero COVID-19” policy, which is negatively impacting growth. Encouragingly, however, China policymakers have pivoted to stimulating the economy and committed to achieving a 5.5% GDP growth rate in 2022. This stimulus may serve as the bedrock for a continuation of a strong global economic expansion. China and the US, in combination, account for 42% of global GDP. Our projection is that global GDP will slow to 3.8% in 2022 from 5.9% last year. The concern is that some economies may experience hard landings though the consensus view remains optimistic. The most recent forecasts cited in The Economist (04/09/2022) are encouraging:
Region 4Q2021 GDP 2022 GDP
China 6.6 5.5
Euro Area 1.0 3.3
Japan 4.6 2.8
Canada 6.7 3.8
If the forecasts are correct, policymakers will have avoided a hard landing scenario and equity markets will rise.
In the bond markets, the strong economy, surging inflation, and anticipation of aggressive Fed rate hikes has swiftly pushed yields higher. The benchmark 10-year Treasury rocketed from 1.52% at the beginning of the year to 2.77% on April 11. Many investors fear that high inflation will result in a further updraft in interest rates, which could result in negative real (inflation-adjusted) returns on bond investments. In our view, bonds still do not offer a competitive return profile compared to inflation and stocks, though if held to maturity they offer portfolios protection from volatility. We normally emphasize quality and short duration in bond selection, and we think this advice is especially relevant now in order to protect principal in these uncertain times.
Economic and Financial Market Outlook Q1 2022
Uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets. Investors agree that the major issues include inflation, COVID-19, central bank activity, labor and supply chain disruptions, the potential for international upheaval, and developments leading up to the US midterm election. What is hotly debated is how these issues will interact to impact the investment results for the year. The three most prominent scenarios currently debated in the media are highly divergent and range from strong optimism to alarming pessimism: moderate growth, hyperdrive economy, and recession risk. As the year progresses, we expect incoming data to change the prevailing viewpoint, resulting in sudden and dramatic shifts in financial markets. At this point, we do not think any one of the three scenarios warrants a greater than 50% probability for the year, and we advise against excessive reliance on any one of these investment narratives occurring comprehensively. Rather, our recommendation is that investors focus on their long-term strategy, exercise patience and discipline, emphasize quality and diversification, and avoid the temptation of market-timing or chasing short-term trends.
We assign a 50% probability to the moderate growth scenario, which most closely reflects our current US outlook of 3-4% GDP expansion, a 10-15% rise in corporate earnings, and an advance of 8-12% in the S&P 500 Index. The “Goldilocks” forecast, which we consider the most correct, anticipates meaningful progress in the COVID-19 battle in the first quarter; we do not expect the Omicron variant to significantly damage the economy for the rest of the year. This will permit a boost to employment, consumer and business spending, and corporate earnings. The most likely threat to the recovery will come from the potential emergence of a new virus variant. We also agree with the moderate growth scenario’s assertion that inflation will rise early in the year, but then stabilize. A modest decline in inflation could occur as supply chain disruptions are ironed out, pent-up consumer spending during the COVID-19 period is satisfied, demand shifts from products to services, the more restrictive policy of the Federal Reserve takes hold, extraordinary fiscal stimulus policies lapse, and a gradual decline in labor shortages reduces the risk of a wage/price spiral. A relaxation in the threat of runaway inflation will permit the Federal Reserve to initiate its highly awaited rate hike cycle in a gradual and non-threatening way to the stock and bond markets.
The second scenario, which we accord a 35% probability, assumes that the economy becomes overheated, and inflation spirals out of control. As in the moderate growth scenario, the expectation here is that the virus situation ceases to impact negatively the economy. However, labor shortages and wage gains persist, and consumers and businesses adopt inflation as a major consideration in their decision making. Supporters of this scenario also point to the likelihood that a concurrent reopening of international economies will elevate commodity prices, including oil. The result will be a rise in both GDP and inflation, somewhat reminiscent of the 1970s. In the meantime, the Federal Reserve will confront a rising criticism that they have responded too slowly, too indecisively, and in short, that they are behind the curve.
The most pessimistic scenario, which we designate a 15% probability, projects the likelihood of a surprise recession and bear market. Here the thinking is that inflation will rise dramatically and prompt the Federal Reserve into aggressive and repressive rate hikes. This is a development which has punctuated the US economy several times over the past 50 years. While we think this scenario is unlikely, we are carefully watching recession indicators including the Treasury yield curve, the unemployment rate and initial jobless claims, the price of oil, corporate profit margins, manufacturing and services PMIs, consumer confidence, and housing prices.
Each of the three above scenarios is associated with distinctive investment style outperformance. If the moderate growth forecast is correct there will be a double-digit stock market gain and a modest rise in bond yields. Growth stocks in the technology and consumer discretion industry sectors will lead the market higher, much as they have over the past decade. The hyperdrive economy scenario will produce a surge in the economy and corporate profits. The tide will be strong enough to lift all equity boats, but the leaders will be value stocks in the financial, materials, and industrial sectors. In the recession risk scenario, the market could well drop 20% or more and the best place for investors to limit losses and avoid volatility will be in the consumer staples and utilities sectors. Our current view is that investors should stay diversified and emphasize stocks of industry leading companies with strong management, and attractive recent earnings momentum and future potential.
Conditions in the international economies and financial markets resemble the US. The IMF projects 2022 GDP to increase about 5.0% in both the developed and emerging country groups. We predict, however, considerable divergence as countries battle COVID-19 with mixed success. China and Europe will be the keys to the general outcome. The situation in China is worrisome: the government is taking ever more severe steps to impose its control over significant sectors of the economy, and at the same time, adopt restrictive policies to combat the virus. Also looming is a potential real estate crisis which could threaten a national financial upheaval. These myriad challenges are expected to slow the recovery and further exacerbate supply chain disruptions. On the other hand, if the government is successful in its virus containment measures and simultaneously stimulates the economy, there could well be a large boost to global demand. The stocks of Chinese companies were severely damaged in 2021 and we think a period of improved credibility is necessary to restore long-term investment prospects.
The economies and equity markets of Europe have been underperformers relative to the US for so long that it would be easy to dismiss the possibility of a renaissance. Yet, this may happen in 2022. European companies and economies are in the best position relative to the rest of their international competitors as they have been in years, sporting solid GDP growth, higher vaccination rates, strong corporate balance sheets, and healthy consumers ready to spend. The political authorities and the European Central Bank are determined to keep economies open and vibrant. European stocks, particularly in the financial, industrial, and consumer sectors, could well provide positive earnings and stock price surprises.
A major factor influencing all financial markets, in particular the bond market, will be the response of investors to the new policies of the Federal Reserve. We think that a key component of a moderate growth scenario will be a rise in bond yields, with the yield on the benchmark 10-year US Treasury Note topping 2.0%. In the hyperdrive economy scenario with higher inflation, the 10-year US Treasury Note could even top 3.0%. We do not consider these yields to be competitive with the total return potential of common stocks, and bonds with maturities more than 10 years could well experience a negative total return. The major attractiveness of bonds will be to provide portfolio stabilization in the event of a surprise recession and bear stock market.
Economic and Financial Market Outlook Q4 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 Q3 2021
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
Economic and Financial Market Outlook Q2 2021
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