“The recovery has progressed more quickly than generally expected and looks to be strengthening. But the recovery is far from complete, so, at the Fed, we will continue to provide the economy the support it needs for as long as it takes.” - Fed Chair, Jerome Powell – December 16, 2020
Overview
The first quarter of 2021 provided another solid gain for investors who left the pain of a pandemic induced correction in the rear-view mirror. As referenced in the heading above, the Fed has and will continue to remain an active participant in helping to ensure the economy fully recovers from the slowdown of 2020. Numerous asset managers are of the opinion that US GDP will grow north of six percent during 2021. This would be the fastest economic growth in the past 50 years. Anticipated economic growth has brought about a heated debate regarding when inflation might arrive and if it will impact potential Fed decisions, which in turn could have an effect on financial markets.
The Fed is justifying a policy of low interest rates for an extended period due to lingering effects from the pandemic. The rollout of vaccines and a natural evolution of a likely less deadly virus has meant a gradual loosening of lockdown conditions on the US population which has started to take effect during the end of Q1 and now into the beginning of Q2. We are already seeing these effects in unusually strong retail sales numbers and a continued decline in the unemployment rate. As outlined last quarter, the lingering effects of layoffs are isolated to hospitality, restaurant, and travel related industries. Lower paid workers have borne the brunt of COVID, and in contrast, homeowners with investment accounts have benefited financially during this period from asset price appreciation.
In periods of high liquidity (note Fed intervention and bond buying) and low interest rates, the natural result is appreciation in asset values. This has been hard for some people to rationalize due to the real human toll that has been brought about on some households due to COVID. Separating the current news-flow from the investment climate, while difficult at times, must be done. This has actually allowed clients to stay fully invested and continue to benefit from strong gains in equity markets during the first quarter of 2021. We continue to stay constructive into the rest of the year.
Economic Commentary
As mentioned above, there currently is a real bifurcation in the employment and wealth outlook for different segments of people in our country. Service workers and those most directly tied to industries that are impacted by COVID related shutdowns still have not fully recovered. On the other end of the spectrum, those with assets (and the more the better) have fully recovered, or are better off than when COVID started. Particularly those with a large portfolio of investable assets have benefited greatly in the past year.
This is just starting to be discussed, as it may be an unfortunate result from an aggressive Fed, but similar to the financial crisis of 2008-2009, many people were actually able to take advantage of a selloff in asset values. While a selloff never really happened in the housing market last year (things just slow down for a brief period), the equity markets saw a brief and very pronounced downturn. Many were able to deploy capital during a 1-2 month period of, in some cases, fire-sale prices. Now as we enter the 2nd quarter of 2021, equity and real estate values are setting new highs.
When asset values are high, people usually spend more because of a perceived “wealth effect”. What has changed currently, and the wrinkle this time is many people have been unable to spend as they normally would on travel and dining due to continued shutdowns. Asset values have been pushed higher and correspondingly interest rates have continued to drop. This scenario again benefits households with “flexible balance sheets” who can take advantage of leverage. This could foster a “perfect storm” scenario of three factors; low rates, increasing asset values, and a very strong economy. Combine this with continued support from the Federal Reserve through bond buying and we have equity and home prices that continue to push higher. These conditions have and should continue to support equity markets and when the economy reopens, strong consumer spending that will trickle through to a broader recovery in the entire workforce.
Against this backdrop the absolute cash level of US consumers should be addressed. Multiple factors like, low rates (interest mortgage expense among homeowners have been slashed due to refinancings), inability to spend widely on travel, and in many cases government stimulus check have went unspent and are sitting on the consumer balance sheet. In no uncertain terms consumers are sitting on a mountain of cash. This has garnered very little media attention, as more gloom and doom continues to make headlines every day. As COVID related lockdowns loosen going into the second half of 2021, we expect to see huge spending numbers from the American consumer.
According to data released from the Fed consumers have saved 42 cents of every dollar released through the recent round of stimulus checks with another 25 cents spent on paying down debt. In no uncertain terms, consumers have never had this much cash and experienced interest rates this low. Estimates vary, but approximately $3 trillion is sitting on the consumer’s balance sheet. This should provide a backdrop for continued economic growth.
Outlook
The effects of the pandemic on consumer behavior are clear. We have been the recipients of massive fiscal stimulus with out a normal mechanism to transmit these dollars into the economy. Now, we have to wait and see how long both, vaccines and the number of people who have recovered from the Corona Virus take effect. “We believe the US economy could grow at a pace not seen in 50 years starting in the second quarter of 2021 as more Americans are vaccinated”, and “the United States now has the highest daily vaccination rate in the world and accounts for around one in every four vaccines given globally per day”, Lazard Asset Management’s outlook for the second half of 2021.
These views from Lazard are not unique or an outlier. Consensus is building that we are virtually recovered from the pandemic. Our view, after much research on past pandemics, is that the Coronavirus will become a part of daily life, much like the H1N1 variant of Influenza A. We expect that later this year and definitely into 2022 we will largely be discussing the pandemic in past tense. Herd immunity is being discussed as a possibility by the middle of 2021, which seems like a natural evolution of both prior infection rates and vaccine rollout.
On the monetary front, we expect the Fed to stay accommodative, with rates historically low. The prior chart shows that we are back to interest rate levels experienced following the financial crisis, with the added benefit from multiple rounds of massive fiscal stimulus. The big debate currently centers over expected inflation and the Fed’s potential reaction. The Fed has double and tripled down on their pledge to not raise rates until well into 2022, and possibly 2023. For them to change course would be a HUGE credibility and reputational risk for the Fed, which we believe they are unwilling to risk. On the fiscal front we do expect that the Biden Administration will push through some sort of infrastructure bill. An upcoming infrastructure bill, coupled with a pickup in consumer spending and a waning pandemic should provide a tailwind to the economy and financial markets.
Summary
As was mentioned last quarter, we continue to be positive about the outlook for equities. Holding long dated bonds in this environment seems like an almost certain way to lose money, which is why we have pared back bond holdings and are leaving a portion of our normal bond allocation in cash. While equity valuations are high, they must be taken in a context of very low interest rates. Low rates reduce the discount rate that you apply to future cash flows when valuing an enterprise. Again, we expect low interest rates to continue to support equity valuations as the economy improves. We also will be making investments into established businesses (read not SPACs or risky startups) that will likely benefit from an evolving electrification theme.
Biden’s planned infrastructure bill will likely be supportive of many factors that will drive certain sectors of the economy. His goals have been clearly telegraphed to support labor (which will physically build infrastructure improvements), further support a “green” economy (which should mean development of both hydrogen and electrification infrastructure), and expansion of wind and solar in an effort to further reduce reliance of coal in the production of grid related power production. Please note: this has nothing do with a political stance, endorsement for or against any political party or “green” initiative. It is simply an acknowledgment that this is the investment climate that we are currently in and we want to have the wind at our back when making decisions for our client’s portfolios.