Economic & Financial Market Outlook - Spring 2021

With the arrival of Spring, the U.S. economy appears to be well on the way to a full recovery. Economic growth, a very respectable 4.3% in Q4 2020ⁱ, is poised to accelerate sharply in the coming quarters on the back of rising consumer spending boosted by stimulus payments. We estimate quarterly GDP growth on an annualized basis could reach the low double digits by mid-year, while full year 2021 growth could well exceed 7%, the strongest growth since the early 1980s.

The U.S. economy is benefiting from several tailwinds. After an uncertain start, the COVID-19 Vaccination Program is moving forward rapidly and will allow reopening to continue apace. At the current daily vaccination rate of approximately 3.3 million doses per day, Bloomberg estimates 75% of the U.S. population will be vaccinated by the end of July.

Relative to its peers, the U.S. responded very aggressively to the pandemic from an economic policy standpoint. $5 trillionⁱⁱ in fiscal stimulus has been approved, and more is on the drawing board. Consumers have amassed nearly $2 trillionⁱⁱⁱ in savings over the past year, and it is a safe assumption that they are prepared to spend a large portion of those savings as their lives return to normal. And, the surge in stock and home prices has added another $8 trillion^iv to household net-worth further buttressing consumers’ spending confidence.

Monetary policy has also been expansionary to an extent not before seen with the Fed. slashing rates, backstopping credit markets, and buying longer-term debt. In both actions and words, the Fed has made it clear that restoring lost jobs and limiting economic scarring are its primary objectives rather than preemptively containing higher inflation.

Globally, the U.S. and China will be the twin pillars of growth this year as their economic outlooks improve. Other geographies are faring less well. As Europe struggles to vaccinate its population, GDP estimates are edging lower. Emerging economies are also in a difficult spot as the pandemic rages and rising U.S. interest rates constrain their ability to respond financially.

All things considered, 2021 is likely to be a banner year for the U.S. economy barring unforeseen developments with the virus. Looking to 2022 and beyond, the question remains whether the decisive response of U.S. policy makers to the pandemic will generate unwelcome consequences such as high inflation and/or if a precarious amount of new debt could inhibit longer-term growth.

This year’s rosy economic scenario has resulted in a mixed bag in the financial markets. The prospect for equity investors is relatively strong with rising valuations supported by robust earnings. In contrast, bond investors are facing headwinds as nagging inflation concerns dampen optimism.

The bad news first. Economic optimism, accompanied by rising inflationary expectations, is driving bond yields higher and, consequently, prices lower. In fact, it was the worst quarter for the Treasury market in 40 years^v as selling continued unabated in March. For the quarter, the Barclays Bloomberg Aggregate Index (Agg) and Intermediate Gov’t/Credit Bond Index lost 3.4% and 1.9%, respectively. Only high-yield has bucked the trend with a 0.8% gain in Q1vi making it the single major fixed income sector in the black year-to-date. Municipal bonds were another relatively bright spot. Returns slipped only fractionally in the quarter, buoyed in March by the passage of the American Rescue Plan which promises substantial aid to local governments.

Although long-term bond yields have moved higher, short- and medium-term yields remain low and anchored to U.S. Fed policy, which Chairman Powell has clearly articulated will remain accommodative for at least the next few years. Bargains remain few and far between in the fixed income markets. With the yield curve steepening, investors may want to move out on the curve in the 8-10-year range but temper interest rate risk by purchasing bonds with higher coupons, so-called “cushion bonds.” We continue to employ multi-sector funds that manage duration as well. The increased issuance of taxable municipal bonds offers opportunities to pick up some additional yield while maintaining a strong credit profile. However, as noted in recent months, an above average allocation to cash may still be the wisest course.

Equity markets continue to enjoy strong returns. The S&P 500 Index increased 6.2%, including dividends, in the first quarter of 2021, following a total return of 18.4% in 2020. Although concerns regarding stretched valuations have increased, they have been largely eclipsed by optimistic narratives related to COVID-19 vaccines, the economy and corporate earnings growth in 2021. This bullish consensus is further supported by accommodative U.S. Federal Reserve policy and aggressive fiscal stimulus spending.

Benefitting from a reopening economy and fiscal stimulus, we see the potential for S&P 500 Index earnings per share to far surpass pre-COVID-19 levels by the end of 2021. This positive earnings momentum may carry over into 2022; however, potential increases in corporate tax rates and regulation could act as an offset.

The S&P 500’s price/earnings valuation of 22.7x, based on the mid-point of our 2021 earnings estimate ($175), is significantly above the historical average of about 16.0x. Yet, with the U.S. Fed’s extremely accommodative stance, low interest rates and limited inflation pressures, we would expect to see stocks trade at higher-than-average P/E multiples and view a 16x-21x P/E multiple range as reasonable. Nevertheless, current valuation levels are elevated and may not fully incorporate underlying risks or provide room for additional upside.

While mindful of valuation, we recommend maintaining current exposures to U.S. equities to take advantage of favorable economic and earnings potential through the end of the year. We are less sanguine regarding international equities, particularly in European markets given the continent’s COVID-19 struggles and a less robust earnings outlook. Emerging markets, however, are starting to look attractive on both an earnings growth and valuation basis. Regardless of geography, the improved economic environment and rise in interest rates is likely to continue to support recent trends in market leadership that favors value over growth stocks.

Sources:
I BEA, FACTSET
ii Business Insider
iii Moody’s Analytics
iv Federal Reserve Flow of Funds
v Barron’s ICE Index
vi Morningstar Direct

Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results and the opinions presented cannot be viewed as an indicator of future performance. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with your Portfolio Manager, Financial Counselor, Relationship Manager, attorney, or tax professional regarding your specific investment, legal or tax situation. 2021-21 (04/21/21)