Is the Excitement Justified?
The close of the first quarter marks the one-year anniversary of the outbreak of the coronavirus pandemic and ensuing Great Lockdown, putting a capstone on a tumultuous period in history. Spring has brought optimism that the distribution and adoption of effective vaccines will advance the date at which the economy can be fully reopened again – perhaps by early summer. Expectations are running high for a strong start to a post-pandemic world. Consensus forecasts predict the economy to grow by more than 7% in inflation-adjusted terms in 2021, with the second quarter perhaps ushering in the best period of economic growth in this generation.
Though the National Bureau of Economic Research has still not officially called an end to the recession that started a year ago, it is remarkable how quickly investor psychology has cycled from despair to excitement 1. A sharp rise in the value of Bitcoin and other volatile cryptocurrencies, a surge in the number of Special Purpose Acquisition Companies (SPACs, which are designed to take private companies public in a shorter time than the more traditional IPO process2), as well as the emergence of meme stocks3, such as GameStop, have led some to question whether the euphoria and speculative excess that often characterize major stock market tops had arrived. Are we experiencing justifiable excitement, or irrational euphoria?
The gains made by the stock market over the last year have indeed been impressive. In fact, the 75% rise in the S&P 500 index from the market low in March last year is the largest one-year return since World War II. Bond yields have also swiftly priced in a brighter economic outlook, tripling since last year, with the 10-year Treasury bond yield rising from 0.5% to 1.7% by the end of the first quarter. The pace at which long-term bond yields rose during the first quarter of this year led to the worst quarter for the Bloomberg Barclays Aggregate Bond index since 1981 with bonds selling off by more than 3% as inflation expectations picked up.
Despite these dramatic moves, our discipline still confirms that the typical precondition for an imminent and sustained bear market in stocks is not yet present. Stocks do not look extremely overpriced relative to bonds despite the extraordinary market and economic recovery from the coronavirus crash based on our criteria. Long-term interest rates have risen, but so have corporate earnings growth expectations. With nominal GDP approaching 10% this year, consensus forecasts predict a greater than 25% growth in operating earnings growth for the S&P 500 index. The yield curve has steepened dramatically too, which suggests robust economic activity and rising inflation expectations ahead. Therefore, we remain near the top end of our maximum ranges in stocks and near the minimum of our ranges in fixed income across our strategies. We recommend that any cash over and above two years’ worth of spending needs (net of portfolio yield) be averaged into capital markets over six months.
If the long-awaited rotation from fixed income to stocks has started, the first quarter also saw a serious glimpse at a change in leadership driving the continued stock market gains. Cyclical sectors in the stock market, such as Energy, Financials and Industrials benefited the most, while Technology, Healthcare and defensive sectors lagged, leading to Value outperforming Growth stocks for the first time in several years. This has brought some relief to those who have been subjectively and prematurely calling for the dawn of a new Value bull market in recent years. Yet, despite the gathering momentum, our discipline confirms that it is still too early to conclude objectively that a new, sustained period of Value relative strength has begun. When it does, there will likely be a long period of outperformance from which to benefit. Over the years, we have demonstrated a repeatable way of exploiting the cycle between Growth vs. Value outperformance, and we will remain patient before changing our long-standing bias towards Growth, which has served our strategies well for several years4.
Our process called for three shifts in emphasis in policy during the quarter in the areas exposed to public markets.
Changes in Policy: Public Markets
- Bought and sold the U.S. Energy sector: In early January, our sector model identified U.S. Energy as an opportunity given the sector’s drastic underperformance amid the coronavirus pandemic as the economy was ground to a halt. With the vaccine rollout and the economy opening, the sector rebounded very sharply. We normally anticipate that sector opportunities take a year or more to unfold, but by mid-March, the sector had hit our return target for this position. This led us to take profits with over 20% relative outperformance compared to the broader U.S. market.
- Eliminated Gold bullion: In late January, we eliminated our remaining position in Gold as our momentum model signaled there was now a better opportunity in U.S. Large Cap equities. While the precious metal may well still generate a positive absolute return over the next few years given the tailwinds of fiscal and monetary policy largesse, fiat currency debasement and rising inflation, our model signaled that over the next 12 – 18 months, stocks would outperform the precious metal as a result of the strong underlying economic and corporate profits growth environment ahead. We first established a position in gold bullion in April 2020 for both defensive and offensive reasons. The decision to emphasize gold over fixed income for defense last year added value; the decision to continue to hold gold over stocks did not.
- Increased our exposure to Emerging Market stocks: Our model identified continued strength in Emerging Markets, so we increased our exposure at the end of the quarter to our maximum overweight. Emerging market stocks appear to be breaking out after a multi-year cycle of underperformance with investors rewarding their cheap valuations in a sustained way.
We are excited about how our private capital managers are navigating the current environment. As we mentioned in this year’s Capital Markets Forecast5, the income and capital growth that private capital investments can deliver above their public market equivalents will be crucial to meeting investment goals over the coming cycle. Allocations to these long-term strategies require an appreciation of their unique risks and must be selected in a disciplined way.
Our managers continue to find the post-pandemic environment a fruitful place to deploy capital. Within Private Real Assets, valuations on properties remain more attractive and yields on debt remain elevated. Our real estate manager Harbert, which will be closing its fund VII in April, has now purchased six properties since last August at an average 15% discount to pre-coronavirus levels. Within Private Debt, Monroe, our senior debt manager whose fund IV will be closing in June, is originating loans at 100 bps above where it was pre-coronavirus with stronger covenants in place.
Peachtree Hotel Group’s distressed fund, an opportunistic investment we recommended at the height of the coronavirus pandemic, is continuing to execute on its thesis. The fund now owns debt or equity on more than 100 hotels at significant discounts to value and replacement costs. However, the speed at which the economy has recovered has lowered the potential for the worst-case scenario in the hotel industry. This should point to a lower overall multiple on invested capital, but higher rate of return due to a quicker investment period. Peachtree Hotel Group has already began returning capital to investors.
Another intriguing trend we are seeing in the private markets is the blurring of the lines between traditional investing and impact investing. This is evident in our venture manager, Panoramic (formerly known as BIP Capital). Three investments in fund IV are companies founded by minorities or women. One of those women-led companies, Acivilate, looks to reduce recidivism, which is the tendency for a person convicted of a crime to reoffend. Another example is a recent investment in fund V of our buyout manager J.F. Lehman, ENTACT, a leader in environmental remediation services. We are seeing several managers position themselves to take advantage of the $100 trillion opportunity required for the global economy to move away from its dependency on carbon emissions to a more sustainable alternative.
While our assessment of appropriate private capital strategies continues to be primarily driven by their raw risk-adjusted return potential, private markets have long been the tip of the spear in addressing the opportunity that arises from the need for capital to fund changes in long-term societal priorities.
Fiscal and Monetary Policy: Overstimulation?
Before turning to the outlook, it is worth considering the potential consequences of the extraordinary policy response to the pandemic. Whereas in 2008/2009 the policy response to the Global Financial Crisis was seen as “too little, too late”, which set the stage for a long, grinding, but anemic recovery, policymakers appear to be doing the opposite in 2020/2021 in response to the coronavirus pandemic. Their bet now appears to be “go big or go home” to ignite a quick and robust recovery to bring unemployment down quickly.
Despite optimism about the accelerating pace of effective COVID-19 vaccinations in the U.S. and the possibility of re-opening the economy fully by early summer, the extraordinary fiscal and monetary policy stimulus aimed at bringing relief to the economy showed no signs of ending. The new Democratic administration passed a $1.9 trillion front-end loaded fiscal stimulus package, the American Rescue Plan (ARP), and is already announcing its plans for an additional $4 trillion to be spent on infrastructure6. One needs to go back to World War II to see fiscal deficits rise this quickly. After the ARP was passed in March 2021, the federal budget deficit was estimated to exceed 20% of GDP7 .
The Federal Reserve has helped finance this wartime-like response by allowing its balance sheet to rise by nearly 90% since last year to roughly 35% of GDP. This has caused the money supply to grow at an annualized rate of more than 25%. The Fed has reinforced its intention not to raise short-term interest rates until it sees, rather than forecasts, much lower levels of unemployment, underscoring the view that it seems to be more focused on one part of its dual mandate, full employment, by tolerating higher-than-average inflation in the coming months if need be.
Obviously, policymakers cannot continue to feed the economy this candy diet indefinitely. Investors over the next few quarters will begin to focus on when the spinach will arrive. The current administration has already signaled that it intends to increase taxes by $3 trillion in 2022. The tentative proposed changes for 2022 and beyond that have been floated include:
- a partial repeal of the corporate tax cut passed in the 2017 Tax Cuts and Jobs Act, increasing it back to 28% for C-corporations from today’s 21%;
- a rise in top personal tax rates from 37.6% to 39.6% and a narrowing of tax brackets;
- an increase in capital gains rates from 20% up to 43% for high income earners;
- an increase in Social Security taxes on high income earners;
- a lowering of the lifetime unified gifting credit from today’s $11.7 million per person to $5 million per person;
- an increase in the top estate tax from 40% to 45% and
- a potential loss in the basis step-up for those who inherit appreciated assets.
These proposals are likely to be watered down as any bill must be passed by a process of reconciliation between the houses of Congress, especially given the Democratic party’s relatively-thin majority in the Senate. This bears closely watching in the coming months as any tax increases in 2022 will be enacted immediately, while some of the spending packages passed this year may still take several years to unfold. Fiscal policy could go from being a boost to a drag to the economy overnight.
Regardless, the remaining months of 2021 are a once-in-a-generation opportunity to revisit financial plans to shield wealth from the inevitable rise in taxes from today’s extraordinarily low rates. We will continue to be alert to the opportunity of harvesting tax losses to protect future gains if stock markets become more volatile.
In our latest market commentary8, we show that after such a stellar year of stock market returns, it would not be surprising to see a challenging grind through the summer and early fall, before stock markets resume their ascent. The two greatest risks to the outlook relate to the potential for policy mistakes. The first is that significant tax increases proposed for 2022 force earnings expectations to be marked down aggressively. The second is that inflation expectations become so unanchored that the Federal Reserve is forced to focus more on the second part of its dual mandate, price stability, and is forced to tighten monetary policy more quickly than is currently anticipated. How the competing inflationary forces of policy largesse and supply chain bottlenecks play out against deflationary impulses of productivity gains expected from the rapid assimilation of new technologies during the pandemic will be key.
As always, we will lean on our unemotional model-driven process that has guided our decision making successfully over several market cycles caused by such policy mistakes. For now, it is signaling that the excitement we are seeing is justified.
We are very grateful for the trust and confidence you place in our team and process. Thank you. Please do not hesitate to call if we can answer any question you may have.
1 This is yet another example of one of our Balentine’s Investment Cardinals: “Capital markets lead the economy, not the other way around.” See https://balentine.com/vistage/ to request a full list of these cardinals.
2 In fact, global Mergers and Acquisitions Activity reached its highest level since 1981 during the first quarter.
3 A meme stock is a stock that has seen an increase in trading volume and price, not because of the reassessment of the company’s fundamentals and performance, but rather because of hype on social media.
4 See “Wall Street’s Greatest Rivalry: Growth Versus Value” on the Insights tab at www.balentine.com for details.
5 See “Balentine’s 2021 Capital Markets Forecast” on the Insights tab at www.balentine.com for details
6 As discussed in previous quarterly letters, we have been anticipating this for some time and have positioned our strategies in private capital to benefit accordingly.
7 According to Strategas Research Partners.
8 See “Market Update, April 08 2021” on the Markets Publications tab at www.balentine.com.
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