As winter melts away, and the COVID-19 vaccination rollout accelerates, at least across developed countries, the global economy has reached liftoff. Interest rates are climbing and equity markets are hitting all time highs. Welcome to spring after a long cold year of winter. Our 2021 outlook in January, entitled, 2021: Break on Through to the Other Side, called for 2021 to be one of the strongest years, for economic growth, in decades as a combination of vaccines, and easy fiscal and monetary policies turbo charge the reopening of global economies. Recent economic data confirm that thesis. The U.S. has been remarkably strong; the March jobs report, from the U.S. Department of Labor, indicated the economy added over 1 million jobs in the month, led by the leisure and hospitality sectors. That same month, the U.S. ISM manufacturing index hit 64.7, the highest level since December 1983 and the ISM Services index rose to 63.7, the highest since the series commenced in 1997. Consumer confidence, car sales and housing prices all ramped up strongly. After a year of pandemic restrictions, the U.S. consumer is being unleashed. They have the desire, and they have the means (approximately $2 trillion in excess savings) to spend. Do not stand in their way! I expect the U.S. will see growth of around 7% this year, while some forecasters are pushing numbers as high as 9%. This will be the fastest U.S. economic growth that most of us have ever seen.
While the U.S. is clearly leading on this front, other developed economies are also seeing signs of a more modest spring acceleration. I expect most developed countries will mimic the U.S. in economic acceleration, but with a lagged liftoff, due to slower vaccine deployment, and a lower trajectory due to significantly more modest fiscal support. Meanwhile China, the other major global growth engine, led the world in exiting the pandemic last year, and is now starting to tap the brakes to slow the trajectory of its economy to prevent further overheating. I expect China’s growth will level off from here but will remain at a robust pace, north of 7% in 2021, versus the governments target of greater than 6%. Overall, I expect the global economy, led by the developed world and China, will experience a period of synchronised growth starting later this quarter and that is likely to continue well into 2022. While we may reach liftoff at different times, we will all get there. This is an important point to bear in mind as we re-enter stricter lockdowns here in Canada.
COVID-19 Not Done Yet
As vaccine rollouts continue to pick up pace, new variants of the virus are putting up fierce resistance, with cases reaccelerating and threatening to overwhelm many hospital systems. Many countries in the midst of this third wave are now re-imposing lockdown conditions. For some, it is a heated and deadly race between vaccines and variants. It is worth repeating a statement from our January outlook: “while the next couple of months will be extremely dire in terms of COVID-19 cases and deaths, this will likely be the last wave as vaccine rollouts continue to pick up steam”. It is the one forecast we wish we got wrong but is not unexpected. While further cases and lockdowns will delay some of the economic reopening surge, we expect that the increasing availability of vaccines and their deployment will enable most developed economies to beginning lifting restrictions as we progress into summer. Don’t overthink it, for developed countries, the vaccines are and will remain the biggest economic stimulants and re-opening enablers in 2021.
We do however, remain concerned about the potential negative impact, of COVID-19, in many emerging and frontier economies where it will be many months, and possibly 2022, before vaccines can be rolled out to the masses. This will clearly have a negative impact on those countries, and will serve as a headwind to a full global trade reopening. It may also provide an environment, similar to a petri dish, where the virus can mutate and potentially increase its spread. COVID-19 is not going away anytime soon, and ongoing precautions and booster shots will be required.
It is not just vaccines and the potential re-opening that are fueling economic recovery. Since the start of the year, the Biden administration has made it clear that they are going to push aggressively to enact more fiscal stimulus, targeted at both the lingering pandemic impact ($1.9 trillion already passed) and at longer-term infrastructure and structural growth drivers for the U.S. economy. Within the broader spending package, there is also a focus on pushing the U.S. economy farther and harder to increase U.S. competitiveness in many emerging technology and green related industries. This is, in part, a return to an industrial policy aimed at stopping the relative decline in competitiveness versus China in many emerging industries. Significantly, the new administration hasn’t adopted the “Tonya Harding approach to competitiveness”, (kneecapping your competitors) pursued by the previous administration, this policy is aimed at boosting U.S. capabilities and competitiveness, and not at merely degrading China’s. While it’s still very early days, and not the only focus of the infrastructure bills, this element of the program has wide bipartisan support and could herald a new era of pro-business and government collaboration to deepen and reshore parts of the U.S. industrial base. Washington consensus RIP indeed!
While the first US$2 trillion infrastructure proposal has been announced, we expect a further soft infrastructure proposal of up to another US$2 trillion to be announced in the coming weeks. While politics and negotiations, within the democratic party, will determine the ultimate size, composition, and the tax increase offsets, there is little doubt that more stimulus in the form of the two infrastructure packages will be passed in the third or fourth quarters of 2021.
While most of the already passed US$1.9 trillion stimulus package will fuel exceptional growth in 2021, with maybe a third tipping into 2022, one significant aspect of the upcoming packages is that they will be spread-out over the coming decade. This will provide support for a potentially longer and stronger economic cycle than the once-feared sugar rush followed by a fiscal-withdrawal fueled crash into 2022 that was eminently possible, given the immediate and front-dated nature of the packages. As we wrote last month: Post Bounce: Roaring 20’s or Lost Decade Hangover? although the path is not set, the actions of the current administration indicate that they have their eyes clearly trained on the issue, and will be hell-bent in trying to tip the balance toward a stronger for longer outcome.
Fed Bids Volker Adieu
With a rapidly accelerating economy on the back of vaccine rollouts, and fiscal stimulus being piled on top of fiscal stimulus, market expectations for economic growth, earnings and inflation have all risen considerably in the past quarter. With such a backdrop historically, and with the bond market chirping away about being behind the curve, we would normally expect the U.S. Federal Reserve (Fed) to be laying the groundwork to scale back monetary policy support. Indeed, we did see a modest attempt by the bond market in the first quarter, as the U.S. 10-year bond soared to 1.75% by quarter end, roughly doubling from the start of the year, and markets started to pull forward expectations for the first rate-increase into 2022, versus the Fed’s guidance of 2024. But despite the behaviour of the bond market, the Fed never blinked an eye and remained steadfast in their commitment to the new AIT (average inflation targeting) policy framework of letting the economy run hot and striving for maximum, not just full, employment.
For investors, the importance of the new policy framework at the Fed cannot be overstated. After forty years of policy, centered around fighting to contain inflation, they have slammed shut the door on the Volker era and embarked on a new quest of fighting to generate inflation. There is also a much-elevated focus on the Fed’s other mandated objective of employment, long second fiddle to inflation, but now seemingly elevated to at least equal status. There is also the potential, as policy objectives evolve in coming years, that the Fed will see income inequality and climate-related targets becoming part of the policy mix. Monetary policy is embarking on a substantially differentiated path as compared to the prior four decades. It remains very early days, and much of this is conjecture at this point, but investors must pay heed to the possible evolutionary paths of U.S. monetary policy as it remains the single most impactful day-to-day driver of markets through its influence on rates, yield curves and liquidity conditions.
For now, the message reaffirmed in the first quarter is that, the Fed remains committed to their new framework and will not be tightening in a pre-emptive fashion. Policy will be driven by economic outcomes, NOT outlooks. Their expected roadmap, based on their current outlook, will be a tapering of quantitative easing (QE), likely beginning at the start of 2022. If they reduce the current $120 billion per month pace, by say $10 billion per month, then QE will end by the end of 2022/early 2023. The first rate increase would occur sometime after the end of QE, which puts the earliest likely rate increase into mid-late 2023, versus the Fed’s current expectation of early 2024. So, if they are successful in getting inflation expectations sustainably back above 2%, maybe we will see the first rate hike pulled forward into 2023. Given the current guidance on their process, it cannot be much sooner than that. We shall see, but with their credibility is at stake, adherence to their process will be critical as they adapt to the evolving data.
Sum Inflation Fears
Markets and the Fed have now navigated the first mini inflation scare. There will be many more in the coming year as headline inflation data is set to rip in coming months as we start to overlap the start of covid shutdowns last year. Inflation data will be fueled by the weak pricing last year (base effects) as well as supply/demand mismatches as demand for some items and services surge as markets reopen but businesses struggle to ramp up supply chains and hiring to meet demand. Crazy pricing can already be found in some areas, check out lumber prices at Home Depot. We will see many more such examples in the coming six months as we journey toward some form of normalization. But even as these factors drive strong reported inflation, the Fed has, correctly, been adamant that they are transitory and will fade from the numbers into 2022, as base effects dissipate and supply/demand imbalances normalize. Their focus is on identifying structural inflation driven by an overall excess of aggregate demand over the supply potential of the underlying economy and with particular attention paid to the behaviour of aggregate wage increases relative to productivity gains. The Fed is focused on the longer-term sustainable path of inflation and inflation expectations, not the one-off impacts that come and go. The problem today, is the sheer magnitude of the one-off factors impacting the data make it very difficult to discern the true underlying degree of inflationary pressures. This is a condition that will persist well into 2022, as the data will remain noisy for some time. There will be a ripe breeding ground for inflation scares in markets for the next couple of years.
Brave New Policy World
One aspect deserving of attention, is the determination of this administration to not repeat the mistakes that were made following the financial crisis of 2008, when Biden was vice-president. The decade that followed 2008 was characterized, mostly, by tight fiscal policy and loose monetary policy. It was a decade associated with disinflationary secular stagnation and subpar economic growth in which inflation targets of 2% were never sustainably achieved and income inequality soared in the U.S. This administration will not repeat the past. The Fed’s new framework, along with the early aggressive fiscal approach of the new administration, is evidence that they want to set both fiscal and monetary policy levers to maximum looseness. It is an all-out bid to break-out of the threat of a disinflationary secular stagnation trajectory becoming imbedded into the U.S. It is not clear how far they will be able to drive this policy approach, watch the 2022 midterms for a potential loss of unified congress and a return to policy stagnation, nor what the potential outcome will be, if they are successful. This is an attempt to embark on a radically divergent policy path unlike any we have seen in our careers. It is an attempt to drive a different, more constructive, outcome from what was seen in the last cycle. It is the boldest attempt to reset the U.S. economic policy direction in a generation.
Success is far from certain. But investors should not be fooled into thinking this is the status quo or that recent decades provide a suitable roadmap. We have not seen this before and need to be vigilant and open to all possible outcomes. In regard to the question of will we emerge to a roaring 20s era or lost decade hangover, the tail risk outcomes associated with both results, is higher today than it was just a few months back. The only way to pay down current levels of debt/GDP is to grow our way out. The U.S., and likely Canada, will take on a lot more debt in a hell-bent effort to break on through to an era of faster, more prosperous and more equitable growth. Success will launch us onto a higher roaring 20s-style growth trajectory, while failure will saddle us with an even higher and increasingly unsustainable debt burden. This process will unfold over years, not months, and while we sure hope it can succeed, we will continue to manage portfolios with an eye on all possible outcomes.
With the macroeconomic outlook and markets broadly following our expected roadmap, our portfolios have been performing well. While much of the positive outlook is being reflected in market valuations, for now we are inclined to let it ride. We may have seen a peak in positive macroeconomic expectations, but the global economy is only just reaching the liftoff stage of the cycle. Economies, and markets, have a way yet to travel in this expansion, particularly with a lagging monetary policy response.
Using the Signature Global Income and Growth Fund for reference (see 03/31 monthly commentary here), we came into the year with and still maintain an overweight position in equities. Our equity exposure is tilted toward cyclical and economic reopening plays, U.S. housing exposure and financials. We retained a near maximum underweight exposure to government bonds and an overweight in investment grade credit. But we are getting a little twitchy, as we believe the easiest returns are behind us now, and markets will tend to grind forward from here. It is still a favourable stage of the cycle for risk assets but having reflected much of the good news in prices, the fundamentals, such as earnings, need to catch up and some of the speculative enthusiasm in parts of the market need to cool down. Equity markets overall, have adjusted well to the rise in rates albeit with significant underlying rotation between sectors, but this reflects a healthy broadening out of market participation in the face of the improving fundamental outlook. The recent pause and check back on U.S. interest rates is a similarly constructive development. Healthy markets should be a two-step forward, one-step backward affair, and not a one-way bet. We are overdue a healthy 5-8% market pullback, and I would look to use any such developments as opportunities to increase positions.
19 April 2021