April 2021 Newsletter
"Understanding is the first step to acceptance, and only with acceptance, can there be a recovery.” J.K. Rowling
“Carpe per diem – seize the check.” Robin Williams
During the last quarter Q1 2021, we have celebrated the first-year anniversary of the global Covid-19 pandemic. More than a year has passed since it started to weigh in on our lives and capital markets. As it has been said many times before, we were once again reminded of a dangerous four-letter statement; this time is different.
Only this time though, it has been truly different.
Business cycles and bull markets don’t die of old age. Typically, in debt-driven economies, during the later stages of the business cycle, interest rates peak, the debt service of goods and services purchased start taking funds away from new purchases, sales drop and the painful recessionary chain of events taking the economy to the next trough gets underway.
Back in March 2020, the first time in history, global economies shut down overnight purposefully for reasons unrelated to debt service ratios, interest rates, or other economic considerations. Economic activity came to a halt, and global equity prices have experienced the quickest drop in history, followed by the quickest recovery, which is still underway. To gain some perspective, the bear markets created by Nasdaq and mortgage bubbles burst in 2008 took approx. 2 years to reach their trough. In 2020, it only took 20+ trading days.
This newsletter will discuss our current position in this process, and what to expect in the near term. Our role is to understand and accept these conditions and seize the potential opportunities in this most hated bull market, which seems to be still alive and well, at least for the time being.
My Husband is a Boxer
In (older) comedy movies, there is a common scene where a rude and suspicious man bothers a woman out in the market place, or by her house, and she responds: “My husband is a boxer, don’t make me call for him, if I were you, I would leave before he sees you”. This threat usually works, independent of the truth or the lack of it behind it.
When the world has been bothered by the Covid-19 pandemic, it is responded by not one, but two boxers in the house, which are today’s main market drivers, and for us what to focus on: policy response (fiscal and monetary) and the success of the newly developed vaccines.
The size of the policy response has been the biggest in the history of policy responses, reaching $10 trillion in the US alone, expected to add a full point to the global economy. A full point represents a little less than a third of long-term global growth averages of 3%. Monetary Theory would argue, a stimulus package of this size would create hyperinflation. Modern Monetary Theory claims this is no longer the case because of globalization and automation. Inflation is the result of too much money chasing too few goods. We haven’t seen the too few goods problem for quite some time, and so the policy responses are getting more and more aggressive even in traditionally frugal countries like Germany.
The economic recovery is not only dependent on easy money policies, but also on the success of the vaccine roll-out. In some countries, like Israel, this has been a stellar process, and in some others, like Europe, not so much. The US success can be rated as somewhere in the middle, but good enough to give us some hope. As a result, 2021 global growth estimates have been revised to the upside by major institutions like the IMF and World bank to 6.5%, and the US 2021 growth forecast is around 5.5% year over year.
Following a 33.4% growth in the Gross Domestic Product (GDP) in the US in Q3 2020, Q4 GDP growth was 4% (Source: Bureau of Economic Analysis, www.bea.gov). This year’s results are too early to call but Q1 2021 forecast is 3% (Source: The Conference Board) and 5.5% as mentioned before. This result, points to further acceleration in growth in the coming quarters, with a potential spillover effect into 2022. This data point supports our current view of where we are in the business cycle as we’ve identified to be in mid stages. The recovery started with a typical low-interest rate and economic growth, and now being followed by rising interest rates with continued growth.
In short, easy money policies, and vaccine rollout have been relatively successful in creating a wave of economic recovery.
A key question to ask at this point could be: will rising inflation and interest rates push the FED to the corner and cause it to raise policy rates? Not in our view. The long-term US inflation rate is above 3%, and 10 year Treasury yield is over 4%, both of which currently hovers around 2%. The FED has adjusted its policy target from a 2% line in the sand to a gray “long-term average”. This means, even if inflation goes above 2%, FED could stay put arguing long term-averages still being below their policy target.
Investment Strategy Implications
Every period creates its winners and losers. During the early stages of growth with low-interest rates, cyclical sectors such as tech and consumer discretionary typically do better, whereas going into a rising interest rate environment, non-cyclical sectors, such as financials, materials, and healthcare may be wise to overweight. We will continue with our current allocation to asset classes (stocks, bonds, cash, alternatives) but within these asset classes, the current macro environment may represent opportunities to make some shifts.
A change in the existing strategy and portfolio design represents realized capital gains tax challenges and our trades will have to find a balance in this cost/benefit relationship.
Even after an impressive run-in stock values from their March 2020 bottom with over 60% in major US stock indices, our models still show an overweight equity position which we will continue to hold to stay true to our data dependent approach. Rising interest rates continue to put pressure on fixed income market values, which also supports our overweight position in stocks for clients whose investor profile is the right fit.
Who is the New Sherriff?
His name is Joe Biden. To close the loop and finish our Q2 Newsletter, the two main drivers, or the boxers in the house, namely the easy money policies and the success of the vaccine rollout, heavily depend on the direction the newly elected POTUS wants to take the country to. So far, especially with the infrastructure bill that is being worked on, and given the accelerated speed of the vaccine availability, the current administration has been playing to the tune of the global capital markets. The word “global” has been plugged in purposefully as the liquidity created in the US increases imports, which improves international trade.
As we step in to the mid stage economic growth cycle with rising interest rates, even though we believe the bull trend in the equity markets are in-tact, some tactical shifts maybe granted within the parameters of our asset allocation strategy to favor the current macro environment. As long as the policy response is favorable and the vaccine rollout is successful, the gradual re-opening of the economy is expected to support economic growth and improved earnings. The slack as seen in the relatively low-capacity utilization rate supports our view that a runaway inflation is a low probability event, and supports our general view of the economy and the markets.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy. The information provided is not intended to be a tax advice. Investors should be urged to consult their tax professional or financial advisers for more information regarding their specific tax situations.