4/7/21: The US economy feels like an ash-emitting volcano ready to erupt. A favorable combination of pandemic fatigue, COVID-19 vaccinations (currently covering more than 30 per cent of the US population), nearly $2 trillion of spending cash on the sidelines and a snowstorm of government checks has created an economic growth cocktail the likes of which has not seen since the 1980s. President Biden’s pandemic relief program represents an unprecedented 25 per cent of GDP – and that doesn’t include the administration’s on-deck infrastructure plan.
The Quarter Behind Us
Today’s housing market exemplifies the enthusiasm. A year’s worth of stay-at-home orders forced Americans to rethink their living arrangements, prompting demand for residential real estate we haven’t seen since the housing bubble of 2006. In February, 6.2 million homes were purchased at a median price of about $317,000. That’s a 16 per cent median price increase over the last 12 months. Part of the pricing push is a dearth of supply of homes for sale: currently less than five months of inventory, which is at the 25th percentile of its historical range.
Meanwhile, the American job market is heating up: employers added 916,000 jobs in March. The gain was double that of February, reflecting business owners’ optimism that the end of the pandemic is in sight. More than half a million women joined the labor force in March, with economists crediting the return to in-person schooling as the impetus. Though the unemployment rate slipped to six per cent, more than eight million workers remain jobless.
Improving economic conditions, coupled with $1,600 government checks, have boosted consumer confidence to a one-year high, according to The Conference Board. Rising confidence reflects a revived economy fueled by vaccinations, business re-openings and warmer weather. Nonetheless, consumer confidence remains below pre-pandemic levels amid lingering health concerns and a recovering job market.
The prospect of a robust recovery was not lost on bond investors, who demanded incrementally higher interest to extend credit to the US Treasury. The yield of the benchmark 10-year note spiked to 1.7 per cent from 0.9 per cent at the beginning of the year. The move pushed intermediate-term bond prices down about 7 per cent for the quarter, representing the largest quarterly yield surge since Q4/16.
Credit conditions, however, have remained solidly in place, as lenders reckon the improving business environment increases their chances of getting paid back, even by weaker borrowers. The yield premium lenders require to extend credit to low-quality borrowers contracted through Q1, leaving spreads below pre-pandemic levels and the high-yield credit premium below the 25th percentile of its historical range.
Equities led most markets higher during the first three months of the year; global equities advanced 4.7 per cent for the period. Examining this from a regional perspective, equity market performance paralleled vaccine distribution. The US dominated global equities, gaining 6.2 per cent, while developed markets struggling to distribute the vaccine picked up 3.6 per cent. Emerging markets trailed the pack, advancing 2.2 per cent in the interim. Large-cap value as well as small- and mid-cap stocks led the US markets higher. Value-oriented equities – sectors like industrials, financials and energy – stand to benefit from an impending economic recovery, while growth sectors, like tech, tended to be insulated from the vagaries of the pandemic. Energy infrastructure, a poster child of reopening surged, nearly 22 per cent in Q1.
Analysts are penciling in strong corporate profits as we enter a rebuilding year. The consensus estimated earnings growth rate for the S&P 500 is 23.8 per cent for Q1. If actual profit growth meets their lofty expectations, that would represent the highest year-over-year S&P 500 earnings growth rate since Q3/18. The energy sector is expected to lead profit growth, with a whopping 123.4 per cent year-over-year growth estimate. Not surprisingly, oil prices have more than doubled from the $30/bbl level of this time last year. Financials, which suffered during the pandemic, are expected to record 13.1 per cent profit growth in Q1.
The Outlook for the Rest of the Year
The US economy is expected to enjoy one of its best years in decades, as economists are forecasting 7 per cent real growth in Q2 and Q3, and 5.7 per cent for 2021 as a whole – which would be the highest calendar-year growth rate since 1984. Additionally, inflation is forecast to consistently exceed the Fed’s 2 per cent target for at least the next six quarters. An increasing share of small businesses surveyed by the National Federation of Independent Businesses (NFIB) say they’re raising prices. History suggests that CPI inflation pressure is likely not far behind, which in turn implies that the Treasury’s benchmark 10-year rate, at 1.7 per cent, is too low for economic conditions.
Federal Reserve purchases of Treasury notes, currently set at about $100 billion, is the reason why rates don’t reflect economic reality. The Fed’s bond purchase program, enacted at the height of the financial crisis, was an emergency measure intended to encourage risk taking. Notwithstanding the “taper tantrum” of 2018, the Fed has maintained its bond buying program, and ramped it up during last year’s pandemic. Given the level of growth in store for this year, the Fed could find it difficult to justify a continuation of quantitative easing in the second half. That, combined with the Treasury’s multi-trillion debt issuance, would put upward pressure on interest rates as growth gets underway. Historically, the 10-year Treasury yield tracks nominal GDP, which is forecast to approach 10 per cent in Q2 and Q3 this year. Today’s 1.7 per cent 10-year yield is a far cry from reality. Cresset’s copper vs gold model suggests the benchmark rate should instead be 2.7 per cent.
Higher yields could pressure equity market valuations, which have long benefitted from ever-lower rates. During the 10 years through 2020, 164 percentage points of the S&P 500’s 267 per cent return was attributable to valuation expansion as a result of lower interest rates. The market’s earnings and dividend growth accounted for 7.3 percentage points of the nearly 14 per cent annualized return of US large caps between 2010 and 2020. Without the tailwind of lower interest rates, investors will need to rely on organic earnings and dividend growth for future returns. On that score, value-oriented equities, because they trade at a lower multiple, offer investors better opportunities. From an earnings and dividends perspective, over the last 10 years large-cap value expanded at an 8.4 per cent annualized rate while large-cap growth expanded by 2.5 per cent annually.
Private markets are a cheaper alternative to public markets in today’s environment, as evidenced by the explosion of special purpose acquisition companies (SPACs). These vehicles attempt to bridge the valuation divide between public and private companies by using public market capital to purchase private market companies. Private equity buyout multiples in the US averaged 11.4x earnings before interest, taxes, depreciation and amortization (EBITDA) as of 2020. While high by private market standards, private equity multiples remain less than half those of the public markets. After plunging last year, private equity deal volume is poised to bounce back this year, in part due to SPACs. According to Bain & Company, SPACs raised a stunning $83 billion in capital in 2020, mostly in the US, more than six times the previous record set just a year earlier.