As we embark on what we refer to as the “vaccine-induced, new business cycle” investors should prepare for changes in economic growth, interest rates and stock market leadership. In recent weeks we have witnessed significant changes in market dynamics that could form the beginning of longer-term trends. The recent market pullback and the changes within it may be the markets way of “showing its hand” in terms of future secular changes and wise investors should pay close attention to these movements.
Economic Recovery
The vaccines coupled with the extraordinary Fed and US Treasury stimulus is likely to create an unprecedented economic recovery with recent annual GDP growth estimates north of 6% – a historic liftoff! When one combines the significant household savings rate, along with pent up demand for travel and leisure activities it is easy for us to envision an economic recovery that will be akin to a post-war economic boom. Most investors may not be old enough to have ever witnessed a recovery of this magnitude or understand how it is already likely re-shaping financial markets.
Interest Rates, Inflation and Bond Prices
One of the fundamentals of economics is that significant monetary stimulus leads to stronger economic growth and if that growth is stronger than normal (maybe due to a vaccine) the possibility of inflation becomes a reality. Inflation – which hasn’t been seen since Ronald Reagan’s first presidential term in 1982 – is simply the ability for companies to increase prices, due to overwhelming demand for their products or services. In recent weeks and months, we have seen several signs of inflation making its way into the economy with the price of raw materials as just one example. The Federal Reserve may be telegraphing that they will hold interest rates “lower for longer” until the economy is on firm footing, but investors have already raced past them by pushing interest rates up in anticipation of stronger growth and inflation. This recent rise in interest rates – a ten-year treasury jumping from sub 1% to over 1.5% – looks to us like a longer-term trend which will likely have corrections along the way. The Fed will eventually have to change their tune on continued liquidity and “lower for longer” if they want to prevent the economy from overheating which is not good for the long-term stability of markets. We must recall the famous words of Goldilocks when it comes to the economy and markets – “not too hot or cold, but just right.” For bond investors it’s a great time to be reminded that bond funds could be in for big trouble with continued rising rates. Individual bonds – which is mainly our focus – have maturity dates that mark a return of your principal. However, bond funds do not have maturity dates so prices decline as rates rise with no promise of a return of original capital until rates fall back to previous levels – which may take many years.
It’s a Market of Stocks – Not Just a Stock Market
The economic boom that lies ahead is beginning to reshape stock market leadership and wise investors should pay close attention. The onset of strong growth, mild inflationary pressure and higher interest rates favors a different group of companies than what most investors have become accustom, or should we say comfortable with. A look at most global indexes shows that technology stocks represent a historic percentage as measured by market value – a sign that investors have been relying on this sector to provide consistent, above-average earnings through the last 13 years of slower-than-normal, if not at times anemic, economic growth. However, stronger economies favor companies that by their nature become more profitable when the overall economy accelerates – think industrials, energy, financials, consumer discretionary and raw material sectors. Interestingly, these sectors are trading at reasonably inexpensive valuations making them even more attractive.
The recent market correction was way overdue but is very telling about how the market has begun to reshape itself. The biggest declines in recent weeks have been targeted specifically in technology and telecommunication stocks and the smaller the stock the harder it fell. During the same period the more economically sensitive sectors, as mentioned above, declined very little and the energy sector actually rose. These “old” economy stocks are coming back to life and we think these sectors have just begun a multi-year rally that may take many investors by surprise. If this scenario plays out, as it has in past cycles, expect investors to eventually reduce their “new” economy tech for more “old” economy exposure. Tech and telecom companies are still attractive to our team and may be even more so at current prices – but don’t forget to be exposed to these more economically sensitive companies that have been awoken after years of slumber.
We are excited about the new “vaccine-induced business cycle” and are grateful that the world is becoming more vaccinated by the day. We are also aware that there are risks in this world that are unknown. Therefore, we will continue to manage your portfolio’s risk though our Active Risk Management process. This is a combination of adjusting your portfolio’s allocations to stocks depending on markets condition, increasing or decreasing sector exposure, as well as the implementation of carefully placed stop loss orders.
We hope this update finds you and your family well and if you have experienced any significant changes in your finances or have questions about our strategy please feel free to reach out to us.
All of us on the team thank you for your continued vote of confidence in our work!
Your Main Street Research Team