We are now nearly seventeen months into a global pandemic battle, a battle no one foresaw. The history books will ultimately have the final say on this crisis, along with a better perspective on its ultimate social and financial costs. Thankfully we are much closer to this episode being over and hope that everyone’s family is safe and sound. Life, work and learning as we once knew it is thankfully returning.
We believe the policy response to the COVID crisis in the spring of 2020 signaled the beginning of the new economic and market cycle. Tens of trillions of dollars of both monetary and fiscal stimulus kept the shuttered global economy moving but not thriving. Thriving is what the global economy has started to do now that vaccinations have reached a majority of the populous. We are seeing “V-shaped” recoveries in much of the economic data we review daily. Manufacturing output and pricing data is noting an economic expansion consistent with the early stages of a new economic cycle. Retail sales and residential housing prices are both up sharply. Consumer spending and sentiment levels have soared as vaccination rates increased and stores re-opened. The current recovery is a “consumer-led” recovery. The U.S. consumer has the desire and, more importantly, the means to spend. After more than a year of below-trend demand, the U.S. consumer is back and back spending aggressively. Apparently, it is true: there is no crisis the U.S. consumer can’t spend their way out of.
We believe this economic acceleration will translate into earnings acceleration, also very consistent with “early cycle” trends. During the second quarter of 2020, earnings on the S&P500 collapsed as the economy was purposely shut. Those earnings have recovered very quickly, as have the equity markets. The reason the equity markets have nearly doubled over the past year is because earnings have nearly doubled over the past year. Earnings drive stock prices and we believe that earnings will continue to grow. Annualized earnings per share on the S&P500 should be approximately $210 by late 2021 and nearly $260 by late 2022. Those higher earnings per share levels will make today’s extended stock market valuation look far less expensive.
There are some areas of the market and economy that do not look “early cycle” however. More than thirty percent of the high yield bond market is rated just CCC (well below an investment grade credit rating) but the high yield market trades at just a 3.9% yield. In our view that doesn’t look like high yield at all, just yield. It’s the least appealing part of the fixed income markets at present and looks like very poor risk/reward in our mind. The high yield market looks very “late cycle” to us and an area best to avoid. Treasury yields have also moved sharply lower. During the second quarter, yields on the 10-year U.S. Treasury bond fell from 1.7% down to just 1.3%. Concerns over future economic growth and the prospects of the Fed changing their dedication to an accommodative momentary policy have pushed longer-dated Treasury yields materially lower. On an after-inflation basis, longer Treasuries look unappealing to us. What used to be “risk-free return” now looks like “return-free risk” in longer maturity Treasuries.
As always, there are a long list of factors to worry about. Inflation being more permanent than temporary, liquidity and regulatory conditions in China, and emerging geopolitical tensions to name but a few. But economic and market cycles largely come down to monetary policy and credit conditions. If credit is available and inexpensive to borrow, the economy will likely continue to chug along and earnings will continue to grow. At some point every crisis does come to an end and this one will as well. The Fed will likely see a need to taper their bond purchases of Treasuries and mortgages (quantitative easing) in early 2022. When they do so capital market participants will need to absorb and manage more of the risk themselves. History says that is likely a time for some extended market volatility. In our view it will not signal the end of the economic cycle but rather just a transition from “early cycle” to “mid cycle”. To paraphrase Winston Churchill, such won’t be the end but rather the beginning of the end. Economic cycles can last for years and seem to always end the same way: with sharply higher short interest rates trying to choke off inflation too late, a yield curve which is inverted, and credit conditions quickly evaporating. We think that is a long way off.
