- Stronger-than-expected economic growth broadens amid an acceleration of vaccinations globally
- The Federal Reserve and the markets seem to agree that inflation will remain temporary
- Expect more modest fixed income returns but don’t eliminate the asset class
- Amid fresh all-time highs, equity market choppiness could present buying opportunities
- Key risks: policy missteps, unfavorable tax changes and further virus complications
The brighter days we forecasted for 2021 as we emerged from the pandemic have turned into a red-hot global economy, fueled by progress on vaccinations, pent-up consumer demand and continued fiscal and monetary support.
With the U.S. and China leading the way, we’ve seen stronger-than-expected economic growth, robust corporate earnings and elevated investor confidence extending the global equity bull market. U.S. stocks have led the rally, delivering double digit returns in the first half of the year, with some indexes reaching record-highs. Meanwhile, fixed income markets have delivered modest returns, with investors being rewarded for taking more risk.
Yet concerns are mounting that such a strong economic rebound could be too much of a good thing.
While our outlook for the remainder of the year is generally positive, we are seeing the consequences of abundant fiscal and monetary policies play out in the form of higher inflationary pressures, growing concerns about the withdrawal of monetary policy support, uncertainty about the direction of interest rates, and the potential for higher taxes.
Let’s take a look at our outlook for growth, inflation, and the Fed for the rest of this year, and what it could mean for financial markets and portfolio positioning.
An Unbalanced Boom
For the most part, our expectations for a strong global recovery from the pandemic-induced recession have come to fruition, with the strength of the rebound largely dependent on the pace at which countries have vaccinated their people, as well as the amount of fiscal and monetary support (see Exhibit 1). The U.S. economy has benefited from a tremendous amount of fiscal stimulus and one of the most successful vaccine rollouts, with 67% of its population over the age of 18 having had at least one shot. There has been more than $5 trillion in pandemic relief passed in the U.S., with the potential for another $1.2 trillion in infrastructure spending spread over eight years, as well as an additional $1.8 trillion via the American Families Act.
China, which was the first country to recover from the initial wave of COVID and rebounded strongly in 2020, has seen more moderate growth in 2021. The recovery in the Eurozone and many emerging economies has lagged behind, largely because of a resurgence of the virus and more lockdowns, as well as initial challenges with vaccine deployment. While the pace of vaccinations has picked up in Europe and China, the progress across emerging markets is mixed. We have adjusted our forecasts accordingly, increasing growth expectations for the U.S. and China to 6.8% and 9.0% respectively (from 5.5% and 8.0% at the beginning of the year), and lowering our forecast for the Eurozone to 5.1% from 6.9%.
Exhibit 1: U.S. Leading the Economic Boom
With personal consumption accounting for 70% of U.S. GDP, the resilience of the American consumer continues to be a critical component of the recovery. Consumer confidence has almost returned to pre-pandemic levels, with the Conference Board’s Consumer Confidence Index rising to 127.3 in June. The Index showed significant improvement in consumers’ assessment of present and future economic conditions compared with May's reading. Even as their short-term inflation expectations increased, consumers still indicated a willingness to continue spending in the near future. Improved optimism, pent-up demand for goods and services and a high personal savings rate should bode well for a healthy level of consumer spending for the rest of the year.
Nonetheless, while direct fiscal stimulus has helped the U.S. consumer spend and save, the U.S. labor market has only recovered 15.2 of the 22 million jobs lost between February and April 2020. This is despite the unemployment rate dropping from 14.7% at the height of the pandemic to 5.9% in June 2021. As illustrated in Exhibit 2, employers are beginning to fill jobs, with last month’s payrolls reaching their highest in 10 months. Even so, payrolls are still 6.76 million below their pre-pandemic levels as virus concerns, childcare responsibilities and expanded unemployment benefits keep people out of the workforce. We believe these factors will wane in the coming months, which should help support hiring. Still, the recent increase in average hourly wages – mostly driven by service sectors competing for staff – is something to watch to see if it contributes to inflation.
Exhibit 2: What is the Labor Market Signaling?
Inflation and the Federal Reserve
Rising inflation is evident in many parts of the world, driven by pent-up demand, supply-chain bottlenecks and the “base effect” of comparing prices to 2020’s depressed levels. Inflation is particularly high in the U.S., jumping to levels not seen in nearly 30 years and raising concerns that price pressures could be permanent. Exhibit 3 shows the Fed’s preferred measure – the core Personal Consumption Price Index which excludes food and energy – rose 0.5% in May and 3.4% higher year-over-year.
Exhibit 3: Rising Inflation
The Fed acknowledged the better-than-expected growth and inflation pressures at its June policy meeting, by ramping up its projections for 2021 GDP growth (to 7% from 6.5% in March) and core inflation (to 3.0% from 2.2%). Although the Fed believes price pressures will be temporary, its Federal Open Market Committee members did discuss a timeline for tapering purchases of securities it began last year to inject liquidity into the system. The Fed also signaled a sooner-than-expected rise in short-term interest rates.
The challenge for the Fed and other central banks will be striking a balance between keeping economies strong enough to return to full employment without igniting more permanent inflationary pressures. We anticipate, as the Fed does, that while inflation may run hot over the next few months price pressures should then moderate, albeit to a higher level than pre-crisis trends. Over the longer term, we expect demographics and innovation to place downward pressure on inflation.
We would not be surprised if the Fed begins to telegraph some degree of tapering at its Jackson Hole Economic Symposium in August. However, we believe an increase in short-term interest rates is unlikely until at least late 2022. We expect the Fed will want to communicate its normalization process well in advance so as not to disrupt markets.
Rates Modestly Higher as Economy Grows
At the beginning of 2021 we expected interest rates on intermediate and long-term Treasury bonds to increase, in line with a V-shaped economic recovery. However, the Democratic sweep of the Georgia Senate runoff elections and resulting Democratic majority in the U.S. Senate raised the probability of more fiscal stimulus and even higher rates. Additional government spending would likely result in economic growth and inflation above our original forecast.
The bond market priced in strong growth and higher inflation in the first quarter, with the 10-year U.S. Treasury yield peaking at 1.74% at the end of March. Since then the 10-year has settled around 1.30% as of July 14, flattening the Treasury yield curve to a more typical level. We think the bond market is essentially signaling it agrees with the Fed that inflation is likely temporary. Inflation expectations, as measured by the 5-year Treasury Inflation-Protected Securities breakeven rate, have also come down from their peaks earlier in the year, suggesting that near-term price pressures are likely to abate.
Exhibit 4: The Bond Market is so far Shrugging off Inflation Concerns
As economic growth continues, we anticipate U.S. intermediate and long-term rates will move modestly higher, to at least the highs seen at the end of the first quarter and perhaps slightly higher by year-end. Our outlook is for the U.S. 10-year Treasury yield to trade in a range of 1.25%-2.25% for the remainder of the year and end 2021 below 2.0%. The fact that there is still a large amount of high-quality sovereign bonds in negative territory should keep a cap on how high U.S. domestic interest rates can rise.
As for corporate bonds, the economic recovery, strong corporate earnings and robust global demand for yield should continue to support credit markets during the second half of the year. That said, with corporate spreads on investment grade and high yield bonds at record lows, the degree of outperformance for higher quality bonds will diminish. Emerging market bonds, which had a difficult start to the year given their increased sensitivity to rising interest rates, still offer attractive yields relative to U.S. investment grade and high yield corporate bonds.
Municipal bonds have benefited from the strong economic rebound and material windfall from the Biden Administration’s $350 billion pandemic relief for states. For tax-sensitive investors, municipal bonds remain attractive, even though the spread between AAA-rated municipal bonds and AAA-rated Treasuries is currently at all-time lows. We expect demand for municipals to continue being supported by the perception that taxes for the highest income earners will rise, and by improved fiscal conditions of states and localities.
Resilient Equity Market, but the Ride Could get Bumpy
Global equities have had a strong run so far this year, pricing in much of the good news about the economic recovery and strong earnings growth. 2021 looks to be the year in which both domestic and non-U.S. corporate earnings growth will equal or surpass 2019 levels. We have recently increased our original estimate of 2021 S&P 500 operating earnings to $180-$190 up from $165-170. For 2022, we see the pace of earnings growth slowing to $200-$210 for the S&P, given expectations for moderating economic activity and the potential for a higher corporate tax rates.
The outperformance of the S&P 500 has increased valuations, as measured by the price-to-earnings (P/E) ratio. At the end of the second quarter, the S&P 500’s P/E is still about 21x the consensus for 12-month forward earnings – far above the 10-year average of 17x but at least down from 23x at the start of the year. Developed international equities, as measured by the MSCI EAFE Index, as well as emerging market equities, based on the MSCI Emerging Markets Index, are trading at discounts relative to the S&P 500, at 15.9x and 14.1x respectively. The composition of both indices provides exposure to more cyclical parts of the market, which should continue to benefit from a broader reopening.
When comparing stock valuations to bond valuations, we can calculate an equity risk premium, or ERP. Stocks are attractive relative to bonds when the ERP – or the yield on S&P 500 earnings less the 10-year Treasury yield – is greater than zero. So, as Exhibit 5 illustrates, with rates this low stocks continue to look modestly attractive versus bonds. While some investors have raised concern about inflation’s impact on earnings multiples, Exhibit 6 shows that even if inflation were to move into the 2-4% range, multiples have historically held up. It is not until inflation rises above 6% that higher prices have a deteriorating impact on mulitples.
Exhibit 5: Stocks Attractive Relative to Bonds
Exhibit 6: Low Inflation Supportive of Current Valuations
However, while we continue to favor stocks over bonds, equities are more susceptible to a pullback given the strong rally off the lows, uncertainty about whether inflation is temporary or not and whether that will result in a policy change sooner than expected. On a positive note, we believe we are still in the middle innings of this bull market. But if we look at every bull market since the 1940s, history suggests that the second year of a bull market can be more volatile and less rewarding than the first. As the chart below illustrates, the first year of this bull market has been stronger than the average return of nearly 50%, but it is clear to see that investors should expect a bumpier pattern of returns. That said, stocks have returned on average about 10% in the second year.
Exhibit 7: Year Two Returns in Bull Market More Challenging
In our view, the economic expansion is mid-cycle. But gains will be harder to come by as the U.S. economy moves beyond peak growth to a more mature phase of the recovery. This stage of an economic cycle calls for a balanced, diversified, and active approach to investing.
Modestly higher interest rates, still accommodative central banks and a continued rebound in earnings should support equities moving higher over the next 12–18 months.
In spite of U.S. equities’ leadership so far, we continue to favor domestic equities over non-U.S. equities, given the strength of the U.S. consumer and expectations for continued strong economic activity. We have a neutral allocation to large cap companies, given their steady earnings potential, and have a small overweight to domestic small cap stocks, which have benefited from the global reopening. While we believe cyclicals should continue to do well, we advocate a balance between value and growth sectors of the market.
Global diversification also remains an important part of our asset allocation strategy, as economic activity in other areas of the world should pick up amid a broadening of vaccine rollouts. We maintain a small underweight to international developed equities, given the reopening delays in parts of Europe as well as the moderate recovery in Japan. A broadening global reopening along with a flat to weaker U.S. dollar and relative attractive valuations should help support emerging market equities, where we have a small overweight.
We continue to expect a more muted total return potential for fixed income securities in coming quarters, given our expectations for higher intermediate- and long-term rates. This is partly why we remain underweight the asset class. Nonetheless, we continue to believe that fixed income can provide a ballast in portfolios in times of equity volatility. We remain underweight U.S. Treasuries and favor credit, including investment grade, high yield, emerging market debt and municipal bonds.
We also have a slight overweight to diversifiers to buffer against the expected pick up in volatility. Private equity and real estate can provide attractive sources of return and can benefit from an overall economic recovery. Customized hedging solutions are also valuable for those investors who have capital on the sidelines, to gain exposure to the potential growth in the market while providing downside protection.
Exhibit 8: Asset Class Positioning: Investment Strategy Committiee Recommendations
Overall, we are optimistic about the prospects for continued global growth for the remainder of this year and next. However, we may be entering a more challenging period as financial markets wrestle with inflation, policy uncertainty and the possibility of higher taxes – all of which have the potential to cause market volatility. Yet, given the strengthening economic backdrop, historically low interest rates and an abundance of cash sitting on the sidelines, any market pullback is likely to be short lived.
In our view, the next 12-18 months can still be a rewarding time for investors. We continue to believe that broad diversification within portfolios and a commitment to a well-thought-out plan will serve clients well in this next phase of the cycle. Disciplined active wealth management, due diligence to uncover opportunities, and thoughtful, nimble advice will help clients navigate the quarters ahead.