May Investment Comments
In the first quarter the S&P 500 returned more than 6%, a respectable start building on last year’s impressive gains. All eyes remain focused on the vaccine rollout and how quickly the economy can reopen more fully. Uncertainty persists regarding the course of the pandemic given the emergence of more contagious strains of the virus, but happily trends are in the right direction. The U.S. is on track to vaccinate three-fourths of the population by late June, though achieving that number requires overcoming vaccine hesitancy. However, much of the world is further behind, with emerging-market countries on pace to have closer to 30% of their population vaccinated by year end. Regardless, vaccine progress continues and should serve as a strong tailwind through 2021.
Helped by vaccines and trillions of dollars in government support, expectations for growth have been improving. The International Monetary Fund (IMF) recently bumped its forecast for world economic growth this year to 6% from prior estimates of 5.5%. This would represent the fastest expansion in at least four decades. Closer to home, the IMF estimates U.S. growth at 6.4%, fully recovering last year’s 3.5% contraction and then some. Economists surveyed by The Wall Street Journal anticipate momentum will continue into 2022 but slow to just over 3% growth. This would mark the strongest two-year growth in the U.S. since 2005.
Improvement in recent economic data supports these optimistic forecasts. Notably, the March jobs report was strong with 916,000 jobs added, the best result since August. The unemployment rate also fell to 6.0%, a pandemic low. Jobs growth is accelerating as states lift restrictions on business activity. Hiring rose in most industries, led by gains in leisure and hospitality, but there were also notable gains in public and private education, most manufacturing sectors, and construction.
Following the March report, the U.S. labor market remains about 8.4 million jobs short of its pre-pandemic level. Estimates are for employers to add more than 6 million jobs for the remainder of this year, marking the best 12-month stretch of job creation in decades. A U.S. Census survey conducted in the second half of March found that approximately 4.2 million adults aren’t working because they are afraid of getting or spreading the virus. This will undoubtedly ease as vaccines are administered. Some employers are currently highlighting difficulty in filling open positions, and as we progress through the year careful attention will be given to potential wage inflation and what that might mean for the overall economy.
The optimistic growth outlook has some questioning if significant inflation is on the horizon, and if so, how long the Federal Reserve will be able to maintain its ultra-accommodative posture. The central bank has pledged to keep rates low even if inflation runs somewhat above its 2% target rate. Despite progress to date, Fed Chair Jerome Powell has noted the economic recovery from the pandemic has been “uneven” and underscored his belief temporarily higher prices won’t lead to worrisome inflation. Higher inflation readings are anticipated in the coming months as low readings from last year drop out of the calculation and the economy manages through what are viewed as temporary supply constraints.
At its most recent meeting, Fed officials indicated they expect to hold rates near zero through 2023 and continue $120 billion in monthly asset purchases until the economy makes “substantial further progress” toward its goals of maximum employment and sustained, 2% inflation. The market sees a more robust recovery with sustainable accompanying inflation and does not think the Fed will be able to wait so long on rate increases. Market expectations reflect a belief the Fed will raise rates by the end of 2022 with three additional rate hikes by early 2024.
Another potential boost to growth could come from spending related to an infrastructure plan. Both parties generally agree that infrastructure investment is needed and would be good for productivity, but priorities differ and coming to agreement on the details is far from a given. Infrastructure investment has been a focal point for several recent administrations but the desire to get something done has not been met with much success, highlighting the difficulty in finding common ground.
Under President Biden’s proposed $2.3 trillion infrastructure plan money would be spent over eight years and paid back over 15 via higher corporate, capital gains, and dividend taxes. Notably, the plan calls for an increase in the corporate tax rate to 28% from 21%. The plan would direct over $600 billion to traditional infrastructure projects like roads, bridges, and public transit, while also directing funds to build charging stations for electric vehicles, expand care for the elderly, and increase rural broadband. Treasury Secretary Yellen estimated the plan would deliver a 1.6% boost to GDP by 2024. The relatively small proportion of funds going to traditional infrastructure and the planned tax increases have resulted in objections from Congressional Republicans and some moderate Democrats. If anything is ultimately agreed upon, it is a fair bet that it will be at a lower dollar amount accompanied by a more modest increase in the corporate tax rate.
This brings us to the market itself. Multiples remain elevated relative to historical levels. The S&P 500 is trading at over 22x forward earnings, above the five-year average of just over 18x. According to FactSet, Q1 earnings are expected to grow more than 24%, and in a sign of optimism, analysts have raised their estimates since the end of last year when they anticipated 16% growth in the year’s opening quarter. This is the opposite of the typical Wall Street dance, where earnings expectations are more commonly lowered through the quarter so that companies can clear a lower bar. Full year EPS growth is projected to exceed 26%. Given investor expectations reflected by elevated multiples, it will be up to companies to deliver robust earnings growth.
Expectations for a strengthening economy led to relative strength for cyclical stocks in the first quarter. Energy and financial stocks were the best performing groups after lagging in 2020. Traditional growth names have been hurt by a combination of higher interest rates—the 10-year Treasury note traded as high as 1.78%, up from 0.9% at the start of the year—and the relative abundance of companies expected to report strong growth in the near term. However, this rotation has reversed somewhat in early April as technology shares outperformed aided by interest rates that have declined modestly.
There remain pockets of froth in the markets. The first quarter featured the GameStop saga, about which there are now reportedly no fewer than nine movies in production, including for both HBO and Netflix. GameStop shares finished the quarter up more than 900% even after dropping more than 50% from peak levels. Bitcoin also nearly doubled in Q1, recently topping $60,000. Special Purpose Acquisition Company (or SPAC) issuance continues apace, and at least 15 companies with no revenue have either already merged this year or plan to merge with a SPAC in coming months at valuations in excess of $1 billion each. These are not things that typically happen in more sober times. Though it might be fun and even profitable to participate in some of these more speculative areas of the market, a sensible approach for investors in this environment remains the same—invest in a portfolio of growing, quality companies trading at reasonable valuations. This should continue to position investors well for long-term success.
James M. Skubik, CFA