April Private Client Letter

It has been just over a year since the equity markets hit their COVID-19 lows.  On Monday March 23rd, 2020, the broad indices all hit new lows after nearly a month of indiscriminate selling as the scope of the pandemic became clear.  Since then, the Dow Jones Industrial Average and the S&P 500 have both gained just about 80% and the NASDAQ 100 is up about 90%.  Many large cap stocks have doubled, tripled or more from their panic-induced 2020 lows.

The big economic story for this year will likely be the reopening of the economy and an expected surge of activity in the second half of the year.  Economists are bracing for additional stimulus spending and vigorous consumer activity to fuel strong growth in the months ahead.  Following more than $5 trillion in COVID-19 relief funds, President Biden recently announced an additional $3 trillion infrastructure package.

As I have expected, the pace of COVID-19 vaccinations continues to accelerate.  It is now believed most states will be offering vaccines to all adults by the middle of April and the U.S. could reach herd immunity by early summer. This progress gives people confidence to return to more normal life and has already led to widespread re-opening of businesses and the highest numbers of commercial air travelers in over a year.

The past year has produced an unprecedented degree of pent-up demand as consumers have been unable to consume goods and services as they normally would.  At the same time, the amount of liquidity in the system, as measured by M2 Money Supply, skyrocketed during the COVID related shutdowns. 

Accordingly, consumers now have access to record savings levels and will be eager to spend some of those dollars as the lockdowns are lifted.  Not surprisingly, Consumer Sentiment keeps rising as well, recently gaining another 1.9 points, or 2.29%, at 84.9.  Furthermore, Consumer Confidence soared 21.3% from last month.

Another component of the 2021 picture will be continued low interest rates.  At the March FOMC meeting, officials reiterated their position on leaving interest rates near zero for the foreseeable future (likely thru 2023) while raising their growth outlook. 

Market participants were encouraged by the Fed's upbeat economic outlook for 2021, which they raised from 4.2% to 6.5%.  That would put the full-year annual GDP growth rate at the fastest pace in 33 years.  This upgrade from the Fed is now consistent with the projections I presented in our Outlook 2021 report, published last January.

One very strong positive for the economy was the March employment report.  The economy added 916,000 jobs, marking the largest single-month increase since August.  Economists surveyed by Bloomberg expected an increase of just 660,000 jobs last month.  I expect similar gains in employment in the months ahead with some months even topping 1 million new jobs.

In addition to seeing the labor market get back to full employment, the Fed wants to see inflation get to 2% and make sure inflation is "on track to moderately exceed 2% for some time."  While the Fed believes inflation will move modestly higher later this year, they still believe it will be “transitory”.

This, of course, remains to be seen.  Current inflation numbers are backward-looking and the more sensitive indicators like oil prices and the CRB Commodity index are trending higher.  These readings, along with labor shortages and supply shortages, will put further upward pressure on inflation.  I continue to believe inflation pressures will appear over the coming months, as the economic re-opening continues to progress and pressure on prices come with a surge in spending.

Even though the Fed has pledged to keep short-term rates low, the 10-year treasury yield rose more than 80 basis points in the first quarter of 2021.  This would suggest that the markets are currently a bit more concerned about rising inflation than the Fed appears to be.

If, in fact, higher inflation is only transitory, that would be viewed as a positive by the markets.  Historically, yields tend to rise early on in bull markets and in economic recoveries because the outlook is improving.  The yield on the 10-year during the worst of the pandemic was only 0.54% while the S&P was at 2,237.  Now yields are about 1.7% and the S&P is trading above 4,000; both rising simultaneously.

Looking back, the 10-year yield was at 1.92% before the pandemic.  And prior to that, since 2012, the 10-year has traded roughly between 1.5% and just over 3%, all-while stocks have put in a record-setting move up.  I expect this next phase of the recovery will see higher long-term interest rates, higher inflation, and higher equity prices.  If higher interest rates and higher inflation levels persist into 2022, the trajectory for higher stock prices becomes less certain.

Big spending bills are a boon for the economy, while higher taxes are a strain on it.  The main negative for equities is higher taxes expected to offset President Biden’s $3 trillion infrastructure plan.  Given the Democrats' razor-thin margin in the Senate, there may have to be a significant amount of compromise to pass huge spending or significant changes to the tax code.

The market is off to a solid start this year.  It has also been a volatile and uneven start.  Still, the recovery seems to have found its footing.  For the balance of this year and into 2022, we believe the negatives of higher interest rates, higher inflation and higher taxes will be sufficiently offset by the strong economy’s positives and higher corporate profits.

-John E. Chapman