The following are our key assumptions:
- COVID did not alter economic growth potential
- GDP estimates appear too optimistic
- The Fed is committed to supporting the economy at any cost
- The bias to rates is to the downside and structurally contained by debt and lack of GDP growth
- Valuations matter – key to this are low rates and low inflation
- Signs of inflation have emerged, but we believe they are transient
We have always maintained this pandemic exposed the weak underbelly of the current economy rather than destroyed it. Recall we were waiting on a fed rate cut before the pandemic. Structural things like debt, employment and demographics remain an impediment to growth. Even complete eradication of the virus doesn’t necessarily mean the economy will be on stable footing because it wasn’t before.
It’s perplexing that 2020 growth (or lack thereof) is seen as a distortion triggered by the virus, but the snap back in growth so far this year as a sign the economy is raging and strong. While headlines praise earnings surprises and higher guidance, CFOs had every opportunity to set a low bar and why wouldn’t they – given complete lack of visibility? The rebound may not continue as strongly for a few reasons. In the second half of 2021, easy year-over-year comparisons roll off. A stealth tapering begins with an end to moratoriums, an end to direct payments and an end to enhanced unemployment benefits – just recall the taper tantrum. We see quite a bit about Modern Monetary Theory (MMT) and its destabilizing potential, but we would posit we are firmly entrenched in MMT already. Once you start handing out money, it’s really painful to roll that back.
The Fed is committed to spending to support the economy, and this has been yielding tepid growth and inflation for almost a decade. But at what cost? Since the Great Financial Crisis, we’ve seen unprecedented intervention resulting in ≈2.0% GDP growth (average over the period 12/31/2008-12/31/2019) and no inflation. With a Fed so increasingly accommodative over the years with waning efficacy and growing reliance, it seems impossible to even nudge the punch bowl away.
We see rates remaining low, and range bound. We may be more likely to see benchmark 10-year interest rates at 0% before we see 3%. Real rates (actual rates decremented for inflation) have been negative for some time. Negative interest rates have an odd impact on consumer behavior and we only have to look to Japan as the test case. Savings rates jumped as the Bank of Japan tried to stimulate the economy. Interest rates remained below zero and, in anticipation of continued negative rates, people held on to cash. The very policy intended to trigger economic activity actually stunted it. No country with negative rates has been able to reverse this policy out of fear of crippling a fledgling economy.
Finally, there is a silver lining. Equity valuations (as measured by the S&P 500 12-month forward PE) are the highest they have ever been. Key to maintaining these levels are low rates and low inflation. Our position on rates is consistent and hopefully clear. Near term, we feel inflation, much like corporate earnings growth, is distorted by both COVID and the Fed’s response to COVID. Wages are rising in parts of the economy with typically high turnover and are being augmented by signing bonuses – making wage gains far less permanent. Cyclical industries like semiconductors have not historically allowed supply/demand imbalances to persist. This may result in overshooting as they hasten to ramp production to meet demand making input cost gains transitory as well. There are countless examples and counterexamples. The controversy surrounding inflation is probably the most contested by investors, so we remain vigilant and flexible in our outlook.
Author: Kimberly Woody, Senior Portfolio Manager – GLOBALT Investments.
Originally published by GLOBALT Investments, 8/5/21
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