New Cycle Emerging
While we have by no means reached the finish line for the Covid pandemic, the economic reopening boom is upon us and it looks as if we are exiting the final phase of the economic crisis. The acceleration in vaccinations, easing of pandemic restrictions and the latest $1,400 stimulus checks have combined to quickly ratchet-up expectations for economic growth, inflation and possibly interest rates. Consequently, with the rapidly improving outlook for the economy, stocks that were among the worst performers last year have led the pack this year, particularly those that are the most economically sensitive. For the first five months of the year, the S&P 500 gained 12%. Splitting the index into growth (new economy) and value (old economy), shows that value (up 17%) decimated growth (up 8%) so far this year. Smaller company stocks as a group are also thought to be more economically sensitive and gained 15% during the same time period.
Economists expect the U.S. economy to grow by 6.6% this year, which would be the highest level of growth since 1983. As recently as December, economists only projected solid but unspectacular growth of 3.7% this year, reflecting the reversal of pandemic-induced restrictions as well as continued low interest rates. Since then, Covid vaccines have been approved and rapidly rolled out and Congress approved two relief packages worth $2.8 trillion (equal to more than 3.7% of global GDP!). So, at the same time the economy was starting to come back from hibernation with consumers having ample savings to spend, politicians threw gas on the fire in the form of huge fiscal stimulus. Economists have been steadily revising their growth estimates upward to account for those factors and current estimates may still be conservative.
With all this sudden growth comes the fear of inflation. The most recent measure of the Consumer Price Index (CPI) jumped 5.0% in the year ended May and 0.6% from April. Core CPI, excluding the volatile categories of food and energy, climbed 3.8% over the prior year. Higher annual inflation figures will continue for a few more months, as prices dropped steeply in 2020 due to collapsing demand for many goods and services. Spikes in inflation will likely prove transitory, however, as stimulus money gets spent, pent-up demand is satiated, supply adjusts to meet demand and comparisons from last year normalize. Therefore, we expect to see inflation subside later this year.
Higher levels of inflation, temporary or not, have rattled the bond market with concerns that the Federal Reserve may have to increase interest rates sooner than anticipated. The yield on the 10-year U.S. Treasury note, a driver of interest rates across the economy, bottomed last August at a record-low 0.52% and ended the year at 0.91%. Widely expected to rise to between 2.00% and 3.00% (where it was for several years prior to the pandemic) over the next 12-24 months, the yield quickly shot up to 1.77% already in March. That created a great deal of churn and volatility in the stock market as investors rapidly rotated from growth into economically sensitive stocks. As the yield has recently stabilized and pulled back some, growth stocks again performed better on a relative basis. It wasn’t so much the yield level that created anxiety, but the swiftness of the change.
The Fed continues to maintain that it will remain very accommodative for a number of years to come. Its preferred measure of inflation, the price index of personal-consumption expenditures (PCE), has remained below the Fed’s 2% target for most of the past decade. The PCE tends to run below the CPI and the Fed has said it would start to raise interest rates from near zero when PCE inflation sustainably exceeds 2% and is headed higher, and when full employment has also been achieved. They recently projected that point wouldn’t be reached until after 2023, but the market is anticipating interest rate increases even sooner.
The labor market still contains a lot of slack. The unemployment rate in May registered 5.8%, near its lowest level since the pandemic began. However, payroll employment remains 7.6 million below its pre-pandemic peak. Millions more are out of the labor force entirely and not currently looking for work. Including those people, the unemployment rate would be above 9%. Clearly, it will take time to get everyone back to work and for the Fed to meet its full employment mandate and begin raising interest rates. Until we get much closer to that happening, the wage-price spiral that often drives inflation, where higher wages push prices up and then wages need to continue rising, is unlikely to emerge. This is another major factor behind the idea that a near-term bump in inflation is likely temporary.
We are at the beginning of a new economic cycle. The cycles typically run for several years. Corporate earnings will grow strongly during this period. Recently, earnings have been much more robust than expected and projections for future periods have steadily been ratcheting higher. Historically, stocks follow earnings and both peak around the same time. While the path can be choppy at times, we remain bullish on the stock market in general and growth stocks in particular.
Holger Berndt, CFA
Director of Research
hberndt@rssic.com
