“Sixty years ago, Marshall Nirenberg and Henrich Matthaei began the process of cracking the genetic code. Thanks to their persistence and resilience, today’s scientists developed effective mRNA-based vaccines in record time, saving millions of lives from COVID-19. With the darkest days of the pandemic behind us, investors can also appreciate the resilience of the economy and financial markets and the hopeful prospect of brighter days ahead.” – Larry Adam, Raymond James Chief Investment Officer
As a backdrop, we’ll bring a bit of scientific language to our analysis this quarter as we celebrate the amazing feats of our scientific brothers and sisters. After all, as Carl Sagan said, “Science is more than a body of knowledge. It is a way of thinking.”
We begin with Isaac Newton’s Law of Motion, Force = Mass x Acceleration. Over the last year, we witnessed policymakers experiment with ways to force the economy out of its steepest dive since the Great Depression, applying massive fiscal and monetary stimulus at light speed. The Fed used the power of its record-setting $7.6 trillion (and growing) balance sheet while Congress voted $5.5 trillion of fiscal stimulus to fill the black hole COVID-induced lockdowns created. And the experiment’s not over yet. Chair Powell has said the Fed is “not even thinking of thinking about raising interest rates” as it downplays the risk of sustained, elevated inflation.
Meanwhile, Congress is in the midst of early negotiations for a multi-year ‘social’ and ‘physical’ infrastructure recovery package for later this year. With at least $2 trillion in excess disposable income and confidence growing, pent-up consumer demand should lead to a summer surge in economic activity. Given that consumer spending accounts for 70% of GDP, the demand for goods and services is the electromagnetic force that drives our economy. Of course, the biggest catalyst comes directly from medical science: enhanced COVID-19 vaccine availability and the related drop in cases, hospitalizations, and deaths are paving the way to a rapid, sustainable reopening of the economy. The stronger-than-expected force of these dynamics leads our economist to lift his expected 2021 GDP growth forecast to well over 5% from 4%.
Dissecting our growth forecast into major asset classes, we expect the supercharged economy (the best growth since 1984) to push both inflation and Treasury yields modestly higher. We’re forecasting the 10-year Treasury yield at 2% by year end, up from our original 1.5% estimate. We hypothesize continued Fed purchases, healthy demand from foreign investors, and the economy’s interest rate sensitivity to keep the rate beaker from boiling over beyond the 2% level and ruining the experiment.
Since the return profile of fixed income will be challenged in a rising rate environment, we continue to prefer investment-grade bonds over high-yield bonds. Dollar-denominated emerging market bonds may also be attractive, boosted by our expectation of a weakening dollar.
The astronomical amount of fiscal and monetary stimulus has propelled the Dow, S&P 500, Nasdaq and Russell 2000 to out of this world record levels. Despite the quantum leap, we expect earnings will still be under the microscope. The good news is that the kinetic energy of the economy requires aiming the forecasting telescope ever higher in this strong earnings environment. As a result, we have lifted our 2021 S&P 500 earnings forecast to $190 (from $175), which correlates to a year-end target of 4,180 (up from 4,025). As long as earnings growth remains robust, we expect the bull market to remain healthy.
Investors should appreciate the higher mathematics of fundamental analysis. Our favored sectors include Information Technology, Communication Services, Financials, Industrials, and Consumer Discretionary because of hefty visible earnings growth and attractive valuations. Not only are these sectors leveraged to the economy in the short run, but they also have had long-term secular growth trends accelerated by the pandemic (e.g., e-commerce, streaming, advertising, broadband expansion, and fintech). Don’t be distracted by the chaos of hot momentum trades, day traders, or all-or-nothing thematic calls (i.e., reopening trade vs. stay-at-home).
To elaborate, we’re cautious about some of the reopening beneficiaries (i.e., hotels, airlines, leisure facilities, etc.) as their strong rallies appear to be defying gravity given the lack of robust, if any, earnings over the next 12 to 18 months. Our observation is that selectivity will become more important at the sector, industry, and individual stock level as we begin the bull market’s second year.
We believe that the relatively higher growth trajectory of the U.S. equity market makes it more attractive than other developed markets. Given its superior vaccination progress, state of reopening and aggressive policy stimulus, the U.S. economy has generated the highest upward revisions to GDP forecasts among the world’s ten largest economies so far this year. Since Asian emerging markets are relatively less expensive, a substantial rebound in economic growth (both China and India are growing over 8%) should drive those markets as well.
As global economies emerge from lockdown and economic growth accelerates, commodities have benefitted. In particular, rebounding demand drove global oil from its state of inertia as crude prices have returned to pre-pandemic levels. However, now that oil prices are higher, watch for producers in the U.S., OPEC, and Russia to increase production. With supply and demand on the same wavelength, the recent price momentum is likely to be tempered by rising supply. As a result, we have only modestly raised our year-end West Texas Intermediate oil target to $70 from $65.
The start of 2021 has been far more enjoyable for investors than the start of 2020, and while market volatility is likely to be more palatable in the year ahead, it does not lessen the importance of adhering to your asset allocation. Pullbacks are an organic occurrence in the market and there is no shortage of possible toxic risks. In particular, investors must watch for boiling points in the economy, inflation, investor exuberance, partisan politics, geopolitical tensions, and vaccine-evasive variant COVID strains.
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Investment Strategy Quarterly
Investment Strategy Quarterly is intended to communicate current economic and capital market information along with the informed perspectives of our investment professionals. You may contact your financial advisor to discuss the content of this publication in the context of your own unique circumstances. Published 4/1/2021.
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