Presenters: HBKS Chief Investment Officer Brian Sommers, CFA, as interviewed by HBKS Principal and Senior Financial Advisor Matthew Costigan, CFP, CPA/PFS
Costigan. The U.S. economy is speeding up. What happened that has the economy growing faster than many economists expected?
Sommers. At the beginning of the year, COVID cases were spiking and the vaccine rollout was off to a rough start. It also appeared that the U.S. Senate was divided and might not pass the stimulus package. But by the end of the quarter our economy was recovering faster than expected.
We can point to a couple of reasons. Distribution of the vaccines is going much more smoothly than it was, so much so that many believe we will reach herd immunity by the end of May. Since the beginning of the year, infections and hospitalizations have been dropping rapidly, even if there was a bit of a surge in March. There are still a few hot spots in the U.S. and outside, including India. We’re vaccinating about 4 percent of our population per week and are close to 60 percent overall. Herd immunity is considered between 60 and 80 percent. As well, vaccination has dramatically reduced the risk of death or hospitalization if someone does contract COVID.
Also, a historic stimulus bill is on target to be passed. Many people are flushed with cash thanks to the previous stimulus checks and President Biden is proposing infrastructure spending that will add more money into the economy.
Costigan: People are feeling safer going out of their homes now. How is that affecting the economy?
Sommers. Airport traffic, restaurant dining and the like are up dramatically. According to The Economist magazine, the vast majority of economic activity was flat or down last year. But now, with more people more confident, we’re only about 20 percent below where we were at the beginning of the pandemic.
Costigan. How long do you believe the recovery will last?
Sommers. The rule of thumb is that the size of a rebound or expansion after a contraction is equivalent to the size of the contraction. If that holds true, it’s possible that we’ve already seen the majority of the rebound. But this rebound is going to be turbocharged by a fiscal and monetary stimulus, so it may be a longer lasting rebound than ordinarily.
Costigan. Are investors too optimistic in terms of how strong the recovery will be?
Sommers. It’s possible. In recent months both investors and economists have gone from being too pessimistic to too optimistic. At the start of the pandemic there was a dramatic reduction in activity being forecast as the economy was locked down, then through last year, forecasts were revised higher and higher. In March forecasts were dramatically higher and we saw the biggest gain in consumer confidence since 2003. In January there were fears the rebound would be delayed because of spikes in COVID cases and fear that the stimulus wouldn’t pass. But by March those fears had abated. Now there are different concerns. Some worry about the economy being over-heated.
Costigan. Are you concerned about the economy growing too rapidly?
Sommers. I think the probability is low that it will get overheated. The economy is probably going to revert to the slow growth we saw before the pandemic. The stimulus is likely to have less impact on growth than some people expect. Last year during the lockdowns consumers cut back on travel and entertainment but increased spending on household goods. There was a dramatic downturn in spending on big-ticket items as the pandemic started, but then quickly we saw a dramatic recovery. People were buying more homes, cars, and other big-ticket items than before the pandemic. People were staying home and spending their money on those items. That could have pulled growth from the future so as the economy opens up, the higher spending on travel and entertainment could be offset by a drop in spending on durable goods. That will hurt GDP growth because spending on durable goods has a long supply chain and a bigger impact on growth numbers as the transactions flow through that supply chain. So the burst in economic activity we get this year will probably be followed by a long, slow recovery.
One of the things driving sales of big-ticket items was, despite the shutdown, a 5 percent rise in income levels, including some people who lost their jobs getting more in stimulus than their wages when they were working. But stimulus checks and unemployment benefits will stop, and if employment doesn’t rise to pre-pandemic levels it’s possible that consumer spending may decline. Also, government stimulus packages provide rescue funds to prevent the economy from collapsing, not necessarily to drive new activity. As well, the Fed doesn’t plan to raise rates before 2023, but may cut back on bond purchases, which would remove some of current liquidity in the markets, another reason for slower growth.
Costigan: Will that huge amount of government spending cause inflation to soar?
Sommers: Not for the next several years anyway. It did rise 4.2 percent in March, the fastest pace since 2011, but in the long term we still remain in a downward trend. The spending in 2011 proved to have a transient effect, and it may this time as well: Fed Chair Powell believes the rise in inflation of last few months will be transitory. It seems to be caused by the demand for products versus supply, driven by stimulus checks, but suppliers don’t want to expand production because they don’t see that level of demand lasting. We’re seeing a shortage of goods and higher prices now, but if demand subsides, inflationary pressures will ease. Things like global competition, improvements in technology, just-in-time inventory management—they’re all still in place and keeping inflation low. We’ve never had a surge in inflation with employment levels as they are now. All the spending was necessary to avoid the collapse of the economy and we are confident that global leaders have the tools to battle inflation if it occurs. There have been efforts to generate inflation for some time and they haven’t been able to do it.
In Japan, it’s deflation. The government has been spending billions on infrastructure for decades. Debt as a share of total GDP in Japan was around 40 percent in the ‘90s and then to spur inflation they began spending, and the total government debt rose over the next decades to over 200 percent of GDP, remained there until the pandemic, then spiked to about 230 percent of GDP. Despite all that spending, inflation has remained rather subdued. There were spikes but they were short term. In addition to global forces keeping inflation low, Japan has been dealing with the huge debt they’ve run up over the years, an aging population, and high personal savings. The result is an economy with decent, but low growth, low unemployment, and social stability, but offset by low growth and low inflation. With all the spending around the world over the last year, it’s possible the U.S. and the rest of the world will go down the same path as Japan.
Costigan. What does all that mean for capital market returns over the next year?
Sommers. It’s very possible that this extremely optimistic outlook has already been priced into both bond and stock prices. The positive forecasts are being reflected in company earnings. We could see more volatility in the markets later this year and returns in stocks could be less than expected while bonds do better than expected if the pessimistic view comes to fruition. The PE ratios have risen with stocks over the year, which is a good measure of how expensive the market is; it’s a bit stretched but not at bubble levels. There are a couple of sectors where there might be a bubble, but there are also opportunities. A recent proposal that would double capital gains tax might cause a pause in the rally and in the longer term make stocks less attractive. But all that being said, stocks are likely to end higher this year, though returns will be choppier, and stocks leading the market will be different than those in the bull market which were large, high growth names in tech and the consumer discretionary sectors. They did well because they were leaders in trends that shaped that economy, like Zoom calls, shipping from home, working from home, cloud computing. It’s possible that growth in those names has been pulled into the present and they are priced for perfection and could slow going forward. Also regulators are taking a look at restrictions on those companies because of privacy and monopoly concerns, plus tax concerns in the U.S. and other countries that want to make sure companies are paying what they consider their fair share of outsized profits. Companies that are less expensive, like energy, utilities, financials, and industrials will benefit from increased activity as the economy opens and valuations are less expensive so we will see a shift to these companies. Smaller companies that provide the resources that allow these trends to continue but are under the radar are also likely to do well.
Costigan: What will happen in the bond markets?
Sommers. Rates have been rising. But if growth is disappointing, inflationary pressures will ease and rates will come back down. We believe rates will be stuck in the current range, a bit higher than for a while, but not trend much higher. But if growth is more moderate than projected, the Fed will not raise rates and the sellout in bonds might be overdone. Bonds over next few years might perform better than many anticipate. They are likely to maintain their status as volatility reducers and solid hedges against downturns in the stock market. With no recession in sight, we think a strong relative performance in high-yield and lower credit bonds should continue, and we recommend an allocation there as well.
Costigan: Do you see a shift from value to growth in equities?
Sommers. People have been anticipating that shift from value to growth for a long time, and every time we get somewhat of a shift we go back to the leadership of growth. Value stocks did better when we got good news, but when infections were up or growth data was disappointing, then growth stocks outperformed value. It makes sense. When the economy is not growing people look for growth wherever they can find it and it has been in these high-growth sectors. In a more sustainable economy, the financials, energies and utilities, the traditional value sectors—you can think of it as recovery versus lockdown—recovery stocks will do better and they happen to be value. But longer term, I think we’re likely in an environment where neither leads but the entire market advances.
Costigan: Do you see opportunities in emerging markets?
Sommers. Foreign stocks in general have lower valuations than U.S. stocks, but in emerging markets, a lot of growth has happened. As the supply chains for companies get reworked, they are pulling them out of China, but they are flowing through other Asian countries. We see bright futures for Asian emerging markets once we get past the pandemic. As well, the U.S. dollar is likely to weaken and that’s a positive scenario for emerging markets.
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