March Begins With Market Battle: Stronger Growth vs. Higher Long-Term Rates
Markets begin the month of March seeking to balance improving economic and corporate earnings outlooks with those of rising long-term interest rates and renewed inflationary concerns. In many ways, this environment personifies the inherent contradictions often facing investors. Once a given set of market worries begin to subside, a new set quickly emerges, often driven by reconciliation of the previous ones. Sort of like a broken-down car that once repaired drives too fast.
As we mark the anniversary of the fastest market decline in history, the primary worries of those brutal five weeks we faced last year at this time have now officially transitioned into a mirror-like setting. As COVID-19 vaccine distribution continues to ramp up and a new entrant prepares to meaningfully increase supply, expectations of gross domestic product (GDP) growth for 2021 are now increasing to levels deemed unimaginable only about six months ago.
Given this rapidly changing playing field, we feel it is important for investors to recognize the following:
Most forecasts of economic growth have risen considerably in the past several weeks. The Atlanta Fed is now projecting U.S. GDP to reach annualized growth of better than 8% for 1Q21. While this estimate will be subject to numerous adjustments over the next several weeks, it is now more likely, given reported month-of-January increases in personal income (+10%) and consumer spending (+2.4%), we could see at least a mid-single-digit annualized increase for GDP in the first quarter. This is well ahead of consensus expectations of about 1% when the year began.
We now believe annualized U.S. GDP growth for calendar year 2021 could be on pace for a range of 6%–7%. This is largely based on faster-than-originally anticipated vaccine distribution and escalating levels of aggregate household savings, which as of the end of January totaled just below $4 trillion, more than twice the cumulative amount of a year ago. When combining these developments with higher personal income and consumer spending, pent-up demand in 2H21 could be quite large, potentially allowing aggregate U.S. GDP to re-achieve pre-virus 2019 levels by the end of the year.
Vaccine distribution is increasing, and a new entrant will be adding materially to supply. According to Bloomberg Vaccine Tracker, as of the end of February in the U.S. more than 75 million people had been administered at least one dose of either Pfizer’s or Moderna’s approved vaccine, with the daily rate now exceeding 1.7 million. On February 26, a Food and Drug Administration expert panel granted an approval recommendation to Johnson & Johnson’s single-dose vaccine, which is expected to increase overall public access an incremental 20 million doses by the end of March and 100 million by the end of June. This welcome news potentially moves the needle on herd immunity (also known as the light at the end of the tunnel) toward potentially being a 2H 2021 event.
Fiscal stimulus now speeds toward Congressional approval. With the Biden Administration’s $1.9 trillion American Rescue Plan now heading toward a Senate vote under the formatted rules of budget reconciliation, a simple majority is all that is needed for approval and dissemination into the economy by the beginning of 2Q21. Focusing on direct payments to individuals and families, financial assistance to local governments and small businesses, and wider vaccine distribution, this legislation should add some serious wind to the economy’s sails.
Corporate earnings growth is looking to accelerate and could eclipse pre-virus levels by year end. According to data gathered by Factset Earnings Insight, analyst expectations for underlying S&P 500® company operating earnings growth for CY21 now exceeds 23%, which if achieved would place such aggregate profitability about 10% higher than its annual pre-COVID level for CY 2019. If accomplished, this fully completed recovery would be about two years ahead of where most expectations stood just last summer.
Federal Reserve remains accommodative with no signs of any policy changes. As expressed in recent congressional testimony and other public appearances, Fed Chairman Jay Powell has continued to communicate expectations of continuing Fed policy dedicated to its current target range on the Federal Funds rate of 0–0.25% and monthly open-market asset purchases of $120 billion. This ongoing policy environment, in our opinion, should continue to be a catalyst for the economy and the markets.
All of this, in our opinion, should be interpreted as good news for the economy and the markets. However, with this good news comes the evolution of new market concerns and, specifically, those of higher long-term interest rates and potentially rising inflation.
Longer-term interest rates have seen a rapid increase through the first two months of the year. This is evidenced by a sharp rise in the 10-year Treasury yield, which reached 1.54% as of the market close on February 25. This is a considerable increase from its 2020 closing level of 0.93% and last August’s record closing low of 0.52%. Long-term, risk-free rates have now reached comparable, or in some cases, higher yields than in the pre-virus days of January 2020. Consistent with our previous commentary, we believe bond investors may want to consider remaining short on the curve and below benchmark durations as the increase in longer-term rates and yield-curve steepening plays out.
For the most part, the recent rise in long-term rates is attributable to favorable circumstances. Developments contributing to the rise in longer-term rates over the past several weeks, in our judgment, have included much of what we have mentioned above, including expectations of stronger economic growth, the anticipated passage by Congress of an additional $1.9 trillion in fiscal stimulus, rising corporate earnings growth, and continued accommodative monetary policy from the Federal Reserve pertaining to short-term interest rates. We view these as constructive criteria for long-term equity and credit investors.
Potentially higher inflation is creating some market angst. Another factor recently impacting longer-term yields, far less friendly to investors, has been a concern of rising inflation rates. This has been driven by the prospect of higher-than-anticipated economic growth in 2H21 combined with the expectation of additional fiscal stimulus. Inflation, as measured by the Fed’s preferred metric, Personal Consumption Expenditures, has been running below its annualized long-term target of 2% for the better part of a decade now, however many are now speculating this target might be at least temporarily exceeded in the year ahead. At the current time, we view potentially higher rates of inflation in the upcoming year as within reason, and believe the Fed’s new policy of a longer-term approach to combatting rising price levels is unlikely to lead to policy actions in the foreseeable future. Nonetheless, given this renewed market focus, investors may want to consider re-engaging inflation-protected portions of their portfolios.
While rising long-term interest rates impact stock prices in isolation, factors contributing to higher yields could prove helpful to equity valuations. As we have mentioned in previous Outlooks, we prefer to gauge stock valuations from a perspective of comparative earnings yields to long-term interest rates. While higher rates in and of themselves may detract from the appeal of current stock valuations, there is a flip side to consider in potentially rising earnings yields resulting from a stronger pace of economic growth and more fiscal stimulus. In balancing the two, we continue to see the broad equity market as reasonably valued.
The rise in longer-term rates could still contribute to short-term stock price risk. As we have also mentioned in previous pieces, the upward move in major equity indexes since late March of last year has been nothing short of historically breathtaking, as can be seen in the total return of the S&P 500 from March 23, 2020, to February 11, 2021, of better than 80%. Following such fast and furious appreciation in such a short time, regardless of the rationale of which we see mostly as valid, it would still be naïve in our opinion to believe that the risk of a 10% correction off this most recent February top is not currently running high. However, should we see such a downward adjustment, we would likely view it as a buying opportunity for investors.
Credit spreads have not yet widened due to rising long-term rates. While stock prices of major indexes have declined over the past few weeks, differentials of high-yield and investment-grade yields to comparable maturity Treasury bonds (ICE BofA High Yield and Corporate Option-Adjusted Spreads) have remained at their narrowest margins in more than a year and at pre-virus levels. This perhaps indicates the market believes factors contributing to higher rates are, on a net basis, favorable for the credit markets.
The increase in longer-term rates has been accompanied by strong value stock performance and this is likely to continue. With the increase of longer-term interest rates since the year began, the market has also seen a meaningfully higher return of value stocks in comparison to growth stocks. Reasons for this include the favorable impact a steepening yield curve holds for bank and financial services stocks that comprise noticeable portions of value indexes, as well as the not-so-favorable effects higher long-term interest rates have historically had on the present value of growth stock earnings further out in the future.
Looking forward, we see the trend of higher long-term rates and a steepening yield curve continuing for the remainder of the year. Given all of these factors, we now see the upper bound of the 10-year Treasury yield potentially challenging 2.00% by the end of 2021. However, we also believe stocks will benefit from factors contributing to these higher long-term rates, such as stronger economic growth, more fiscal stimulus, accommodative monetary policy, and rising corporate earnings growth. While we could see short-term volatility as long-term rates continue to rise, and potentially even a full-fledged correction at some point in the months ahead, we continue to maintain our year-end price target on the S&P 500 of 4,200.
We therefore view the markets as currently being in a bit of an internal battle as they seek to reconcile the perceived risks of higher long-term interest rates and renewed inflation concerns with the favorable economic and earnings trends potentially creating those risks. This could result in a tug-of-war the markets will have to deal with in the months ahead and it could contribute to some short-term downside stock price risk that should only be expected given the immense move in equities and the credit markets since the end of last March.
However, all considered, we believe the combination of strong economic expansion and earnings growth mixed with fiscal stimulus and accommodative monetary policy can still provide a favorable backdrop for investors even in a somewhat higher, but still historically reasonable, longer-term interest rate environment.
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