Front and center are two topics that seem to be on investors’ minds: the equity market’s current valuation given its all-time high price level and are interest rates and inflation about to inflect higher.
The Biden administration appears to be set on providing swift and significant pandemic relief using the budget reconciliation process that only requires a simple majority. The $1.9 trillion – ‘American Rescue Plan’ would be in addition to the $900 billion that was put into the economy in December. The $1.9 trillion will likely be worked somewhat lower before it’s officially approved and signed – let’s assume that it’s close to about $1.5 trillion. The combination of the $900 billion and $1.5 trillion would eclipse the $2.3 trillion Cares Act passed in March. Notably this would be more than 10% of US GDP and it would be introduced into an economy that is already well into recovery vs. the Cares relief stimulus that went into an economy that was plummeting. GDP for the fourth-quarter of 2020 came in at 4% and the first-quarter of 2021 is forecast to be 3.4% according to Bloomberg’s composite of 66 economist’s estimates. The consensus forecast for full-year 2021 is 4.8% according to Bloomberg. This is much stronger than anything we’ve seen in over twenty years (the last time we had GDP at or above 4% was in 2000). Also, this stimulus will be hitting while Covid-19 vaccinations are ramping and cases are rolling over. Cases peaked in early January and are clearly declining (please see chart).
Furthermore, the U.S. manufacturing and services sectors are both improving at a rapid pace, unemployment and wages are getting better each month, and the housing market is exceptionally healthy.
All of this has led the bond market to push up five-year and ten-year breakeven rates (a market-based measure of expected inflation). They’re at eight- and seven-year highs respectively. And the commodities market is also showing upward price pressures. Demand for copper (a good indicator of global economic health) is surging – copper is now at an eight-year high. Corn and Soybeans are priced at eight- and seven-year highs respectively. Crude oil and unleaded gasoline prices have recovered to January 2020 levels. And shipping containers are in high demand and short supply due to increases in the shipping of global freight.
All of that being said there were almost 10 million fewer people working in January 2021 compared to February 2020. Fed Chair Powell on Feb 10th said that the actual unemployment rate is likely closer to 10% rather than the 6.3% rate for January as reported by the Department of Labor. This is largely due to people that have left the workforce. And getting inflation to lift has been elusive and problematic for the last ten years. In the few years prior to the pandemic during the Trump administration, we saw large amounts of fiscal stimulus via the 2017 tax cuts and increased deficit spending each of those years even though the economy was growing at about a 2.2% rate prior to 2017. This helped to get unemployment down to 50-year low levels but it didn’t lift inflation. The Trimmed Mean PCE Inflation Rate has been hovering at close to 2.00% but has not been able to stay on average at or above that level (please see chart).
The 10yr Treasury was at 1.92% at the start of 2020. It’s now at 1.34% and this is off of the August 2020 low of 0.51%. The key question is where does the 10yr rate go from here with all of the fiscal and monetary stimulus being thrown at the economy. Being long long-duration assets is risky in this environment especially when there’s a global push to get economies going at the same time.
The current forward P/E ratio of the S&P 500 stands at 22.9x – this is in comparison to the 19x over the last five years. The almost 23x looks fairly expensive, but when you compare the S&P’s earnings yield of 4.37% to the benchmark Treasury rate of 1.34% the equity market looks fairly reasonable (please see chart).
The Fed is currently buying $120 billion per month of Treasuries and mortgaged-backed securities – this puts upward pressure on bond prices and downward pressure on rates. This amount of monetary stimulus will likely remain throughout 2021. Again, no one knows where the 10yr rate goes in regards to its reflection of a much stronger US economy. As well, the Fed has adopted an average inflation targeting policy framework. This effectively means that they will allow inflation to run above 2% to make up for periods where inflation was running below 2%. So, until inflation starts to inflect above some level that causes the Fed to essentially blink, we look to have a healthy backdrop for the continued improvement in the US economy and a positive backdrop for equities.