The current environment for the capital markets remains very dynamic as investors incorporate a multitude of factors into developing appropriate strategies for their portfolios. However, the central theme encompassing all these factors is the pandemic and its effect on business strategies, government polices and consumer behaviors.
Some of the major shifts in the capital markets that began in the 4th quarter of 2020 have continued into the new year – but not in a steady progression.
Improving economic environment
As positive evidence of the distribution and effectiveness of the vaccines became more apparent, the market continued to respond by factoring in the increasing probability of a durable re-opening of the economy. “Mobility” is a new metric that can only be measured through ubiquitous cell phone and GPS tracking.
This data is considered a good precursor to stronger economic activity. As the incidence of COVID infection has declined and vaccination rates have grown, mobility metrics have moved up considerably, indicating that people are starting to engage in the economy again.
Government policies have injected enormous amounts of cash into consumers’ pockets and provided access to abundant low-cost capital for corporations. Consumers have considerable wherewithal to spend and corporations are confident they have solid funding to accommodate increasing levels of demand.
As always, the bond market has been a key indicator regarding the direction of the economy. Since the beginning of the year, long-term interest rates are up 75 basis points while short-term interest rates, anchored by Federal Reserve (Fed) policy, have not changed. This movement of yields on longer maturity bonds rising faster than yields on shorter maturity bonds is known as a “steepening yield curve.” Historically this has been one of the best indicators of impending economic growth.
However, these developments have also contributed to growing anxiety about the potential for rising inflation after being dormant for so long. Treasury inflation protected securities (TIPS) are now pricing in rising inflation, commodity prices have surged, and housing prices have vaulted higher.
Meanwhile reported inflation statistics remain at about 1.5% and are not confirming the growing market concern. However, inflation is a lagging indicator. It is expected that inflation should hit at least the Fed’s long-held target of 2%, based on widespread shortages caused by the pandemic’s impact on supply chains, massive liquidity in the system, and pent up demand.
Rising rates and rotation
Rising interest rates and expected economic improvement continue to drive investor rotation from the long winning growth sectors of the economy to the economically sensitive areas of the economy and into the value and small cap equity sectors. It is also fueling growing interest in industries oriented to energy, financial services, and consumer discretionary products.
This rotational shift, which began with such startling force in November 2020, has shown some signs of waning recently. The small cap sector, which continued to surge at the start of the year, has now pulled back, and the old leading large cap growth sector is showing signs of reestablishing its strength. However, this may be just another blip in an up-and-down trend that characterized the 1st quarter.
Key “big picture” issues
What are the key areas that will influence the direction of the economy and the markets for the balance of 2021? While the following key areas are interrelated, most are currently moving in a trend that remains supportive of the economy and the equity market – but not the bond market.
- Vaccination. After a halting start, the national vaccination effort has really picked up speed. Significantly, mitigating the virus remains the single biggest issue to support economic activity and reinforce investor confidence that the country and the world is moving past the challenges of the pandemic. However, this vaccination effort is now a race against the COVID variants that are now accelerating and threatening to trigger a fourth wave of infection. Also, other parts of the world – especially Europe – are lagging in their vaccine efforts relative to the U.S.
- Employment. As the virus mitigation and vaccination efforts continue, the employment picture has significantly improved. It is expected that the surge in hiring will continue and that the return of paychecks will augment government support programs in providing healthy support to the economy.
- Consumer spending. The consumer seems poised to go on a spending spree as the economy reopens. Armed with a record level of savings, an improving jobs market and the rising wealth created by the surging stock and housing markets, the consumer will be a powerful contributor to growth as the year progresses.
- Supply chain issues. As pent up demand is satiated by expected consumer spending, supply problems may become more acute due to the significant challenges of rebuilding supply chains. There are some early indicators that inflation could be rising. If inflation shows signs of surpassing the Fed’s target of 2% and/or level of comfort, the equity market could be negatively affected. The bond market has already felt the impact of these concerns.
- Government spending. The Biden administration is now moving to enact an ambitious program to provide long-term support to the economy through infrastructure investment and social program spending. The price tag for this initiative is significantly larger than the emergency policy steps that were enacted over the past year, however the cost would be stretched over a longer time frame. Central to this plan is the proposal to significantly increase corporate and some personal tax rates, as well as to increase the rate on capital gains. The equity market may react negatively if there is trepidation that higher rates will significantly diminish corporate profitability.
- Inflation. There is also concern that such large spending programs on top of the trillions that have been spent on pandemic relief, and coincident with very easy monetary policy, could lead to inflation problems. An unanticipated surge in inflation could seriously depress bond and stock prices.
The fundamentals of the economy are quite sound. The consumer is in very good shape, corporations are dealing with the pandemic with surprising alacrity, and the government is in full-out support mode. It is hard to bet against such a triumvirate of support.
However, interest rates are rising as inflation concerns start to become manifest, and equity valuations are quite high. If the economy continues its rapid recovery path from the depth of the pandemic, corporate earnings should support high valuations. However, if earnings begin to disappoint and/or interest rates start moving to uncomfortably high levels (such as 10-year treasury yields at 2.5%), markets will likely falter.
Finally, tax policy is currently somewhat of a wild card given that policy ideas are just that – ideas, not legislation. However, if higher tax legislations were to become reality, it may be advisable to reduce equity exposure. Markets could give back the roughly 10% increase they enjoyed when corporate taxes were lowered in 2017.
As such, this is not a time to be aggressively positioning portfolios, but to remain invested with a slightly cautious bent. With interest rates in a continued modestly rising trend, defensiveness in the bond market still seems warranted. Value, small-cap and mid-cap sectors still seem to offer value, but their significant outperformance relative to the large cap growth sectors is not likely to persist.