Coming off a year of pandemic, economic contraction, market collapse and resurgence, we expected 2021 to be anything but typical, with hope for new traction against COVID-19, and a reopening and economic recovery like none seen before. Indeed, this year has not disappointed, as widespread vaccine distribution has allowed the emergence from lockdowns, which has contributed to a surge in economic activity and an impressive advance in risk assets. That said, the current environment carries multiple complexities: Massive stimulus and pent-up demand have contributed to fears of higher inflation, bringing Federal Reserve policy back into focus, while the potential for infrastructure spending and new taxes has added to market uncertainty. In short, investors are entering what may be especially unfamiliar terrain, requiring attention to portfolio positioning.
Rapid Growth, Cyclical Strength
The collective release of the population from their apartments and homes has led to extraordinary economic growth so far this year. Moving from depressed 2020 levels, U.S. GDP shot up 6.4% in the first quarter and an estimated 9% in the second, with increasing confidence toward around 7% for all of 2021—potentially the country’s best annual economic performance in decades. The Purchasing Managers’ Indices (PMI) measuring manufacturing and services activity have also been elevated, at around 61 and 60, respectively, for June. (Figures above 50 reflect expansion.) Meanwhile, equity markets have managed to work through pockets of volatility to achieve records, with the S&P 500 gaining about 15% year-to-date through June 30, largely driven by cyclical and value stocks that have historically benefited from the early stages of expansion.
Led by the U.S., Global Growth Expectations Have Accelerated
Change in Growth Forecast From Year-End (Percentage Points)
Source: Bloomberg. Consensus growth estimates as of June 22, 2021. For illustrative purposes only. Nothing herein constitutes a prediction of future economic or market environments. Due to a variety of factors, actual events, including the characteristic of economic or market environments, may vary significantly from any views expressed. Past performance is no guarantee of future results.
Focus on Inflation and the Fed
Investors are always looking ahead, and the dominant financial story of recent months has been inflation. Largely a non-issue since the 1970s, price inflation has recently surged in large part due to basic supply/demand imbalances, with suppliers unprepared to meet the ferocious jump in reopening-related demand, particularly for durable goods. Special issues associated with the pandemic have also been a factor, including supply chain glitches, component and labor shortages, and shifting demand preferences in the wake of the pandemic. Oil prices, briefly priced below $20 early last year, have swelled above $60, while many other commodities have also surged, even if retreating somewhat lately.
The Treasury market signaled new concern about inflation early in the year. The 10-year yield, which had been gradually creeping up since mid-2020, more than doubled to 1.75% in the first quarter before easing to its recent level of around 1.30% in mid-July. Meanwhile, a range of pressures has pushed further acceleration in prices, lifting the Consumer Price Index (CPI) to 5.4% in June—its highest rate in 13 years—while less volatile core CPI (excluding energy and food) also reached extremes (see display).
Inflation Has Been Flashing Red
Core CPI and Components
Source: Bloomberg, data through June 2021. For illustrative purposes only. Nothing herein constitutes a prediction of future economic or market environments. Due to a variety of factors, actual events, including the characteristic of economic or market environments may vary significantly from any views expressed. Past performance is no guarantee of future results.
For months, the Federal Reserve insisted that the current spike was largely temporary, driven by frictions associated with reopening that would ultimately fade. Having reset its policy framework last year, it was prepared to allow some overheating to safeguard recovery, with the understanding that price increases would retreat to its long-term target of 2%. However, by their June meeting, board members were changing their tune—acknowledging that higher inflation could persist longer than expected. In a pivot to more “hawkish” messaging, they began to contemplate when to start reducing their bond purchases (currently $120 billion per month in Treasuries and mortgages) and accelerated their forecasts for interest rate hikes, with two potential increases now likely in 2023.
The Fed remains committed to its narrative of “transitory” inflationary pressures, which it believes could start easing next year. Interestingly, bond investors reacted little to the recent developments, perhaps because they had already been priced in by the markets. For our part, we agree that recent pressures are largely transitory, and believe that inflation levels are likely to retreat from extremes as pandemic-related bottlenecks and labor issues ease, although price increases are likely to settle into a range that is above recent norms.
Admittedly, the Fed is in a tough spot in seeking to achieve its dual mandate of price stability and full employment. The jobs recovery since reopening has been slower than expected, with the unemployment rate hovering at around 6% despite a record 9.8 million available positions.1 Debate continues around the reasons for this gap, which may be a combination of workers’ anxiety about exposure to COVID-19, difficulty in finding childcare, and generous extended unemployment payments, which have created a disincentive to seeking work. Businesses in reopening-sensitive sectors like travel and leisure have had trouble recruiting for service positions, which has led to meaningful wage increases for low-wage jobs—something that is adding to inflation pressures. However, longer-term structural issues may also be at play, with many older workers choosing to retire and the economy becoming more digital, which has led to further automation and may require skills that many workers simply do not have. If these trends have raised the level of “full” employment, that might shorten the path to where the central bank would believe it appropriate to tighten monetary conditions.
Gauging Growth, Earnings and Market Performance
A key factor in the Fed’s calculus and market prospects more generally is the likely path of growth moving forward. Although the economy is hitting new records, we believe that the impact of reopening and massive fiscal stimulus is likely to fade, creating an overhang that reduces growth to about 3.8% next year and a closer-to-trend 2.5% in 2023 (both consensus). This provides some support for the Fed’s position on inflation, but we believe it also allows for continued optimism around stocks over the next 12 months, supported by loose financial conditions (see below) and strong corporate profits, as S&P 500 companies are expected to see a 37% increase in earnings this year and a 12% increase in 2022.
Financial Conditions Remain Loose Even With Higher Treasury Yields
Source: Bloomberg. Data as of June 30, 2021. For illustrative purposes only. Nothing herein constitutes a prediction of future economic or market environments. Due to a variety of factors, actual events, including the characteristic of economic or market environments may vary significantly from any views expressed. Past performance is no guarantee of future results.
In terms of positioning, we are comfortable with an emphasis on value and cyclical shares (particularly in less expensive non-U.S. markets—see display), but at the same time we believe that price volatility could increase given renewed monetary uncertainty. In addition, potential from economic slowing from post-COVID highs suggests the benefit of some exposure to more defensive growth stocks, which have typically performed better toward the middle stages of recovery. Longer term, we also favor thematic opportunities tied to the digital economy, which we believe will become more pervasive in coming years. (Read our Solving for 2021 update for more details on these ideas.)
More Value May Be Available Overseas
U.S./Non-U.S. Performance Gap
Source: Bloomberg. Data through June 30, 2021. Indexed at 100 as of January 1, 1997. For illustrative purposes only. Nothing herein constitutes a prediction of future economic or market environments. Due to a variety of factors, actual events, including the characteristic of economic or market environments may vary significantly from any views expressed. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Looking at fixed income, the second half of the year could prove more turbulent as investors watch inflation numbers and the reaction of central banks. In general, yields remain quite low, while strong economic fundamentals have reduced the additional income provided by non-Treasuries. This reinforces the importance of casting a wide net to find opportunities, and to identify individual securities that have been mispriced by the market. Given prospects for tax increases, exposure to municipals remains a key aspect of high net worth portfolios. As always, we believe that alternative investments can help with issues of return potential and income generation, depending on the nature of individual goals and objectives.
Other Risks and Issues
Although inflation has been the focus of recent attention, it’s important to keep in mind other key risks. One important remaining risk is the pandemic: Although the developed world has made great progress in inoculating its populations, many poorer countries are lagging behind and continue to see elevated infection rates. Meanwhile, the spread of variants is a threat that reinforces the importance of continued success on vaccination. That said, the overall path is encouraging, and we anticipate increasing global control of the virus as we move deeper into 2021.
Global COVID-19 Daily Fatalities
Source: Goldman Sachs, as of June 30, 2021.
Also worth noting is the scope of potential U.S. spending and tax increases. As I write, the President and legislators continue to consider areas of common ground in traditional infrastructure, and much more partisan goals around “human” infrastructure and climate change, paid for with new taxes on corporations and wealthier Americans. Given the Democrats’ narrow majorities, the use of reconciliation to avoid the Senate filibuster appears likely, and, even then, moderates may not get behind the various tax hikes being proposed. Still, it seems prudent to expect some increases, which could have a negative marginal impact on economic growth and earnings down the road.
Finally, I would add geopolitics as a current worry that may not get enough attention. One might have thought that the sunset of a combative U.S. administration would bring an easing of tensions, and it’s true that the U.S. has rejoined various multilateral organizations and reengaged on climate. However, multiple tests remain, from the intensifying rivalry with China, to Russian cyberattacks, to Iranian and North Korean nuclear ambitions, to the security of the southern border. Of these, our relationship with China has particular potential to reshape the business landscape; in their research, our analysts routinely assess company positioning in relation to China and supply chains.
Although the current landscape may feel a bit unusual to many investors, it’s important to keep the challenges we face in context. Eighteen months ago, we were about to enter a nearly unprecedented health crisis that caused widespread misery and economic dislocation. Today, we have generally emerged from our households, the economy is strong, the stock market is near record levels and the virus appears to be on the run. Inflation, taxes, supply shortages, national rivalries—these are all problems that ebb and flow over time. What matters is the path forward, which, despite some uncertainty, remains reasonably constructive, in our view.