Looking Ahead: What Follows Unprecedented?

02.24.2021 - Ronald J. Sanchez, Chief Investment Officer

Recent headlines have suggested that the equity market, or parts of it, may be in a bubble. Some pundits have opined that stocks have surpassed their pre-pandemic highs too quickly, raising concerns that investors may be facing increased risk of a sudden downturn. Further, the growing presence of retail investors[1] amidst the seemingly frenzied trading in a handful of stocks in the last few weeks raised the idea of instability reemerging in markets. Given the impressive resiliency of financial markets, investors are likely wondering if we’ve come too far too fast.

During 2020, global equities, fixed income and commodity markets recorded robust returns. In particular, the S&P 500 generated impressive performance, leaving market valuations at lofty levels by yearend. While price-to-earnings (P/E) multiples may be well above historical averages[2], we find ourselves in an historic period that seems to be without precedence—extraordinary levels of deficit spending, negative real interest rates and central bank intervention. Any one of those policy tools would be impactful but combined, they seem to herald a new world order. Previous periods of market euphoria have generally occurred at the latter stages of an economic cycle, however, today, we are “resetting” the global economic cycle.

What Likely Comes Next?

We believe the best is yet to come from an economic standpoint. The post-pandemic recovery will likely occur globally and will continue to be accompanied by stimulative government policy. This backdrop should be supportive for risk assets, as investors will be operating in the “sweet spot” as the combination of reaccelerating global growth and full throttle government policy play out over the next few years. Although markets have effectively pulled forward some returns based on improving economic expectations, they should be supported by a long runway for growth.

We think that there are a number of drivers that will push the economy further along the path of recovery and, ultimately, into strong growth territory over the next few years. We should enjoy a sustained period of above-average global growth relative to the 2% level seen during the Goldilocks economy over the past decade.

Figure 1 illustrates our checklist for the sweet spot—a term we use to define the confluence of factors set to drive financial markets over the next few years, ranging from growth, consumers and corporations to government policy. Our team provides additional insight into each item below.

Figure 1: Checklist for a Sweet Spot

With global economies simultaneously emerging from lockdowns at similar paces, we believe the next few years will be characterized by resynchronized global growth.

Healthy Consumer

Today’s consumer, unlike the period that followed the Global Financial Crisis (GFC), is surprisingly healthy, boasting a high monthly savings rate.[3] In the last year, US consumers have amassed roughly $1.5 trillion in additional savings. That’s nearly 7% of US GDP.[4] Thus, the US consumer’s balance sheet has strengthened, with spending curtailed while both housing and stock markets appreciated. Stimulus payments and increased unemployment assistance helped some consumers maintain some fiscal stability. We believe that there is significant pent-up demand as many people undoubtedly deferred spending decisions until the economy has regained its footing. Also, with the ongoing vaccination rollout, the service portion of the economy, which suffered the brunt of the shutdown, may start to gain ground, leading to reinvigorated hiring.

Well-Positioned Corporations

Since the onset of the pandemic, corporations were forced to respond swiftly to restrictions, lockdowns and other measures imposed by governments. Companies focused on realigning their businesses to the realities of operating in a crisis, including reductions in workforce, capital expenditures and travel expenses. This cost-cutting has led to an increase in operating leverage for many companies, meaning they may be able to generate more income per dollar of revenue due to lower costs.

Supportive monetary and fiscal policies

We see the current policy backdrop to be the most favorable on record. The Fed, via its forward guidance, has committed to maintaining low interest rates for the foreseeable future. Its monetary policy will likely remain accommodative, helping to ensure financial markets continue to function properly. Fiscal policy has been extremely supportive during the pandemic. With Democrats controlling the White House and Congress, such support is likely to continue.

So, What Does This Mean for Equity Valuations?

Multiple expansion[5], in anticipation of an earnings rebound, drove most of 2020’s returns. As shown in Figure 2, the trajectory of earnings has been trending higher (dark blue line) and we believe this trend can continue for several years. Corporate fundamentals seem poised to catch up to markets alongside loose financial conditions. Recently, 80% of reporting companies beat their projected earnings[6], suggesting that expectations remain too low. In fact, market analysts have been revising their S&P 500 earnings estimates upwards, hinting at the potential underappreciation of market upside. With a supportive economic backdrop, earnings growth can drive equity returns.

Figure 2: Multiples Remain Elevated as EPS Expectations Rise

Blended 12 Month Forward Earnings per Share and Price-to-Earnings Ratio

Source: Bloomberg, as of 1/26/2021.

Flows May Support Elevated Multiples

Since the GFC, flows have been one-sided, favoring fixed income which has pressured yields to near-all-time-lows. As shown in Figure 3, over the last decade, nearly $3 trillion flowed into fixed income assets, dwarfing the amount ($170 billion) entering equities. Currently, compared to the compressed yields on risk free assets, i.e., US Treasuries, risk-assets like stocks look attractive. Due to this low hurdle rate, flows have started to come back into equities which would further support an elevated price to earnings multiple.

Figure 3: Since the GFC, Flows into Fixed Income Markets Have Far Outpaced Those into Equities

Cumulative Equity and Fixed Income ETF and Mutual Fund Flows (Trillions, $)

Source: Strategas, as of 12/31/2020.

Some Final Thoughts

While we understand concerns over elevated valuations, today’s financial markets feel like nothing we’ve experienced before. Hence, we wonder if we may be applying “normal” yardsticks to an environment that is far from normal. In fact, through the lens of solid consumer and corporate fundamentals, as well as supportive financial conditions, our team think it’s hard to be bearish on markets while being bullish on economic and earnings growth. This backdrop should continue to support current equity valuations. Last year, markets pulled forward returns alongside an improving outlook; thus, we expect a more modest return profile for the foreseeable future. We favor equities relative to the low returns of fixed income as policy makers remain committed to their stimulative efforts. For the next few years, we believe investors are in a sweet spot.

[1] Source: CNBC, “Trading volume is up from 2020′s breakneck pace as retail investors jump in”; Pisani, Bob, 1/22/2021.

[2] 22.5x compared to a 10-year average of 16x. Bloomberg, as of 2/16/21. 20-year period since 2000.

[3] Source: Bloomberg, as of 12/31/2020. For the 10-year period ending 12/31/2020, the average US personal savings rate as a percentage of disposable income was 8.3% vs 17.8% between March 2020 and December 2020.

[4] Source: Bloomberg, as of 2/22/2021.US 2019 GDP shown.

[5] Multiple expansion occurs when investors are willing pay a higher price per dollar of earnings than the company generates measured through a rising price-to-earnings ratio.

[6] Source: Bloomberg, as of 2/22/2021.

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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