April 2021 Commentary

Jack Brown, CFA

Executive Summary
The U.S. economy is primed to rally. Coupled with other factors, upward pressure will likely be applied to the yield of the 10-year Treasury Bond, a barometer for long-term risk-free rates. We suspect the potential rise in rates could take a couple of years to play out though may be substantial, possibly exceeding 3%.

Coinciding with a rise in rates, we expect the price-to-earnings (P/E) ratio for the broad stock market (i.e., S&P 500) to fall modestly from its forward P/E of approximately 22x today to slightly lower, normalized levels over the same timeframe.

A burst in economic growth, the threat of rising long-term rates, and the implications for valuations frames the battlelines for the remainder of 2021 and beyond.

The Economy is Primed for Growth
The Purchasing Managers’ Index (PMI) offers a glimpse into the minds of corporate managers in both the service and manufacturing sectors. Basically, the survey highlights whether business is expanding, staying the same, or contracting. Despite an economy that has not fully reopened, these measures are at high levels and indicate the potential for strong economic growth.

Time to Get Back to Work
Companies are not only expecting activity to pick-up but are actively hiring in large amounts as indicated by open positions – specifically, we look at the job openings as a percent of all jobs (total employed plus job openings). Companies have typically been slow to hire coming out of a recession. However, in 2021, companies are eager to hire resulting in record levels on this measure.

Uncle Sam is on Board
From the start of the pandemic and ensuing recession, politicians have been clamoring to throw money at the problem. This has been enthusiastically embraced by economists, the media, and both sides of the political spectrum – until recently. The result has been breathtaking. The Cares Act alone has put upwards of $2 trillion in consumer’s pockets.

While actual economic growth tends to be an argument against excessive federal budgets, the prospects of growth does not seem to
be. The voices of restraint are seemingly muted as fiscal planning remains aggressive on items such as infrastructure spending. While paying for this will be a problem for another day, funds are being deployed to various segments of the economy. In aggregate, government spending is at near record levels on a historic and relative basis – adding fuel to the economic growth fire.

The Banking System is Flush
The combination of stimulus checks and a decline in household spending led to higher consumer savings in 2020. As such, we see a build-up in the supply of money (i.e., M2 – a measure of the money supply that includes cash, checking deposits, and easily convertible near money such as money market securities, mutual funds, etc.)

Additionally, the Federal Reserve began acquiring large stakes of the bond market by buying U.S. Treasury bonds, Agency Mortgage debt, and corporate debt which show up on their balance sheet. A large amount of buying in the bond market puts upwards pressure on bond prices and downward pressure on bond yields.

When taken together, the banking system is flush with cash and excessive reserves. The result is higher asset prices and the fuel needed for a pick-up in bank lending and consumer spending.

Below, we see the year-over-year percentage change of money supply and Federal Reserve assets. While the Federal Reserve has been actively trading since the Great Recession (red line), the acceleration of money supply growth is a 2020 phenomenon (blue line).

Given the likely pickup in economic activity in 2021 and beyond, we believe the growth in money supply will return to normal levels as more money finds itself spent and not sitting idle. A return to economic growth would also incentivize the Federal Reserve to ease up on the buy-trigger. The combination of these two means a reversal of what we saw over the past year – specifically, higher consumer spending and lower bond prices (i.e., higher rates).

Growth and Rates Set to Climb
As highlighted above, we currently see record (or near-record) levels of:

  • Expected activity (i.e., PMI)
  • Job openings
  • Federal fiscal spending (Congress & Administration)
  • Federal monetary spending (Federal Reserve)
  • Money supply

The above list of statistical outliers created in 2020 makes a strong enough case, in our opinion, to lean towards a pick-up in actual economic growth and a rise in long-term rates and bond yields.

We compare in the following graph the year-over-year percentage change in nominal Gross Domestic Product (GDP) versus 10-year Treasury Bond yields. It helps to envision an environment where nominal GDP, including inflation, returns to levels consistent with the last decade (i.e., 4-5%) and with long-term yields closer to 3% or more.

Imagine, for a moment, a landscape where long-term Treasury yields are higher. In this environment, yields for other bonds are higher as well. For investors who are income seekers, a higher percentage of your investment dollars may very well find its way to the bond market and less in the stock market.

This is a rather simplistic argument for a lower P/E ratio for the S&P 500. However, the incentive of higher bond yields leads investors to take less risk by owning bonds instead of stocks. Specifically, as low yields provide little income today, investors seek returns elsewhere such as in the stock market. Though as yields in the bond market rise, the risk-reward trade-off pulls investment dollars to bonds.

Ironically, this switch to bonds occurs many times during an environment where earnings are likely growing at a healthy pace. Investors will be torn between the incentives of higher yields in the bond market or the prospect of earnings growth in stock market.

Conclusion
With a pick-up in economic activity, we believe it is reasonable to expect a pick-up in yields closer to levels seen only a few years ago. This rise in yields may provide incentives for investors to consider a modestly, larger bond allocation and a lower allocation to equities. As a result, the tension between economic growth and rising rates will likely provide periods of market jubilation and concern over the next few years. We believe the markets will continue to provide plenty of interesting opportunities to help achieve a range of goals for investors with a strategic approach to risk management and asset allocation.