The flood of money dropped on our economy from monetary and fiscal stimulus since the start of the pandemic will be the most in the history of our country on an absolute and inflation adjusted basis, and as a percentage of GDP. As the economy re-opens and we recognize the one-year anniversary of the lockdown, U.S. GDP and corporate earnings are growing at exceptional rates. U.S. consumer balance sheets are the strongest seen in decades. Household net worth is two times greater than when we exited the Global Financial Crisis (GFC) in 2009, or approximately $70 trillion higher. Home prices are rising at a rate not seen since the housing market peak in 2005. The lowest quality ranked companies can borrow at the lowest rates on record. In March the S&P 500 posted its highest 1-year return in over 60 years…quite likely the polar opposite of what many expected at the onset of the pandemic.
Unfortunately these conditions can’t last indefinitely. We believe we have passed the highest flood stage and are now entering a period where the flood waters may begin to recede.
A Pattern Repeated
Receding flood waters are not necessarily a reason to become concerned about risk assets. This is part of a cyclical pattern, and we are still early in this economic upturn. While the stock market has produced very strong returns, that doesn’t preclude an end to the rally, though it does suggest a more muted return environment. We believe the market is transitioning from the early cycle phase to the mid cycle.
Historically, the early cycle phase starts with the market trough in the depths of a recession. At this time valuations are typically low, the U.S. Federal Reserve Board (Fed) is at its most accommodative, and policy stimulus is increasing. During this phase, the market is characterized by P/E multiple expansion as investors expect an upturn in earnings.
S&P 500 Bull Market Total Return Distributions Since 1935
Generally the market rally during this phase has been driven by lower quality economically sensitive sectors. Typically stocks have seen their best returns for the cycle during this phase as can be seen in the chart.
The mid-cycle phase has generally arrived with the rebound in earnings, where market expectations for earnings become more realistic. The monetary and fiscal stimulus put in place during a downturn, typically has begun to translate into economic and earnings growth. Earnings, in contrast with price speculation, has tended to take over as the underlying market driver, and the stock market has started to go through a sorting out process. In the first phase, investors are generally more indiscriminate in their bullishness. In the second phase, often, investors now have earnings by which to judge. It has been typical for some earnings to do better than expected and others that do not and that can cause some stock performance dispersion.
While returns during the mid-cycle slowed, they have historically remained positive. Looking at the current backdrop, we believe investors can take some comfort in the U.S. consumer having on average a low debt burden, high savings, an encouraging employment outlook, and high net worth. The U.S. consumer is the engine of our economy and it is currently looking strong as we enter this recovery.
Considering the Next Phase
As we move into the next phase, there are important considerations for investors.
- Consider how far the markets have come.
- Concern regarding inflationary risks that could stem from the unique attributes surrounding this pandemic induced downturn and rebound.
As we look at the last three bull market cycles and transitioned from the early to mid-cycle phase, both valuations and margins were much lower compared with where they are now. Margins have been the most meaningful driver of earnings in the past 3 cycles accounting for more than 80% of the trough to peak move in Earnings Per Share (EPS). Sales growth and stock buybacks accounted for the other 20%. Note where margins are at the start of this cycle versus the past 3 cycles. For stock investors this is reality and it implies a more muted return outlook going forward. Margins are also important today as companies attempt to pass through rising input and transportation costs.
S&P 500 Index Profit Margin
Monthly data: June 1991 through May 2021
A similar backdrop exists for fixed income investors. Over the last 20 years, through May 31, 2021, the Bloomberg Barclays U.S. Corporate Index (consisting of investment grade corporate bonds) has delivered a total return of 5.7% annualized and the Bloomberg Barclays U.S. Corporate High Yield Index delivered a total return of 7.6%. While price gains from falling yields have helped returns, the income earned on bonds remains the largest performance contributor. Such meager starting yields as seen today diminish the forward return outlook for corporate bonds and much of the fixed income universe.
Index Yield to Worst
Monthly data: June 1991 through May 2021
These low yields and high hurdles for earnings growth bring to mind what Howard Marks, co-founder and co-chairman of the largest investor in distressed securities worldwide, describes as a “low return world.” While that term might elicit caution, in many cases some investors are actually taking on more risk in an attempt to augment returns. We are not necessarily an advocate of this approach, but we do see some positives coming from this risky behavior. Entrepreneurs are finding it easier to start a business in this environment. Certainly inexpensive and abundant funding availability plays a major role in this, but the pandemic itself seemed to push people out of their comfort zone and try new things. New business applications hit records during the pandemic with surges across all industries, even manufacturing. Deal flow in Silicon Valley is at frenzied levels. We believe this is a positive for our economy and for innovation.
Another factor to consider is something that could upset the markets - unanticipated inflation. Inflation is expected to be elevated over the next several months. What is in question is whether it continues into next year. Persistent and unanticipated inflation could create a challenging backdrop for most all fixed income asset classes as well as portions of the equity market. Additionally, unanticipated inflation could accelerate a tightening cycle by the Fed, something for which most markets would likely need to adjust. While we doubt it would trigger a bear market, it could lead to a correction.
We are not in this inflationary camp, but recognize that the current backdrop is unique. We believe it is appropriate to be open minded with a willingness to follow the data. To help gauge the path of the recovery and inflationary risks we will be watching and reporting on significant changes in the following:
- Corporate profit margins and other metrics that indicate the breadth and magnitude of the ability to pass through price increases
- Expansion of wage growth beyond lower income services jobs
- Persistence of supply constraints
- Maintenance or increased spending on more cyclical durable goods by consumers
- Consumers’ speed and willingness to spend down savings and/or take on additional debt
- Inflation psychology on whether higher prices stimulate demand or hinder it.
Positioning for Uncertainty
Given that it is still early in this economic upturn, we suggest a fully invested position in the markets that is at least consistent with long term strategic weights to risk assets with consideration for a slight overweight to risk assets. And, given the unique aspects of this recovery and the generally richly-priced markets, we believe a more diversified approach and a more flexible attitude toward allocations may be warranted and adjustments may be needed in response to changing fundamentals. Most important is the ability to separate the signals from the noise and lately the noise has been deafening.
Stocks: Touchstone has been advocating a more active approach to investing given that the mid-cycle tends to be more fundamentally driven. We believe a selective, stock selection approach could be more rewarding during this phase. We believe a balanced allocation to equities - Value stocks for their cyclicality and lower valuations combined with quality Growth stocks is an important consideration at present. We think diversification across geographies and size, will allow active managers to cast a wide net in search for opportunity and the flexibility to reposition as conditions warrant.
A shift towards an inflationary environment (should it occur) would definitely suggest entry into a new type of bull market. Some believe that an inflationary environment would support a secular shift to the Value style and smaller cap stocks. Inflation has not historically been a prerequisite for Value or Small cap relative outperformance, though, history would suggest it is helpful.
Bonds: Positioning within fixed income is more difficult, given that low current yields and credit spreads indicate a relatively benign outlook for both inflation and the economy. At the end of May 2021, the yield on the Bloomberg Barclays U.S. Aggregate Bond Index was just 1.5%. If the Fed announces plans to begin tapering its Quantitative Easing Program (QE) in the second half of the year, upward pressure on longer term U.S. Treasury yields could occur. We believe a less than benchmark duration stance and an overweight be on the credit side is important to consider as we see less economic risk given the strength of the consumer and continued global re-opening. Additionally more attractive investment grade yields may be found in security classes outside of the Bloomberg Barclays U.S. Aggregate Bond Index such as Preferred securities.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
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