All Boxes Checked, but With a Caveat
One does not need be hard pressed to find reasons why stocks are up this year (the S&P is 12% higher in the first four months of 2021)1. Last week's glut of economic and corporate data showcases the incredible progress the economy has made in a relatively short amount of time. The fundamental backdrop continues to check all the boxes for a durable bull market, and investors have taken notice. With conditions rapidly improving, expectations and the bar to exceed them keep rising, and the pendulum of emotions is swinging towards optimism. We'd offer the following perspective on four broad categories that tend to drive investment returns over time, along with one caveat.
1. Strong economic growth? Check
- Boosted by two rounds of stimulus payments and the ongoing progress in vaccinations, first-quarter GDP grew 6.4% on an annualized basis, up from 4.3% in the fourth quarter. Consumer spending, which accounts for about 70% of the U.S. economy, surged 10.7% as consumers spent a portion of their stimulus checks from the two COVID-19 relief bills and saved the rest.
- The U.S. consumer was not the only one pulling the weight. Business investment rose 9.9%, and government expenditures increased 6.3%, with state and local spending adding to growth for the first time since the pandemic began. A reduction in inventories, along with a decline in exports as other countries struggled with new restrictions to curb the virus, subtracted some from GDP.
- Following the strong first-quarter growth, economic activity is now only 1% below its peak and on track to fully return to the pre-pandemic levels this quarter, an outcome that was considered almost impossible just six months ago2. With the personal savings rate jumping to 27.6% of disposable income from 13.9%, and with job growth picking up, American households appear well positioned to keep spending elevated, which will likely provide the fuel for even faster economic growth in the second quarter. We expect spending to gradually shift towards services as the economy fully reopens, which will provide the much-needed relief to the industries that have been heavily impacted by social restrictions.
GDP on track to reclaim its pre-pandemic peak
The graph shows U.S. Real GDP which is on track to reclaim its pre-pandemic peak.
2. Rising earnings? Check
- Based on a little more than half of the S&P 500 companies that have reported earnings so far, 87% are beating estimates by a historically elevated 24% rate. Index earnings are on track to grow 40% in the first quarter and 30% for the full year3. Among last week's highlights were the impressive results from the largest five companies of the index (Apple, Microsoft, Amazon, Facebook and Alphabet) which continue to benefit from digitalization trends and more people spending more time at home. Earnings for cyclical companies are also surprising to the upside by a wide margin, even though certain industries are being affected by supply-chain bottlenecks. Despite the broadly positive results, companies that are beating estimates have not necessarily been rewarded, as the average share-price reaction has been muted.
- Rising corporate earnings is a key underpinning of rising stock prices, and we feel this is especially the case currently. With valuations elevated compared with historical standards, earnings alone will likely have to carry the weight of driving investment returns. As seen in the graph below, since the middle of June last year, the price-to-earnings ratio has held steady (+0.6%), while forward earnings have risen 32%, pushing the S&P 500 33% higher3. Based on the outlook for 8% - 10% nominal GDP growth this year, revenue and earnings are poised to continue to grow at a fast clip2. However, valuations are unlikely to expand further, in our view, and could normalize some, especially if long-term bond yields resume their upward trend, which we expect.
Rising earnings drive stocks higher
The graph shows the change in valuation using the price-to-earnings multiple and the change in forward earnings for the S&P 500. Recent gains have been exclusively driven by rising earnings.
3. Easy monetary policy? Check
- The Fed stuck to its dovish tune last week even as it acknowledged that economic activity and employment have strengthened. In his press conference, Chair Powell offered no hints that policymakers are considering slowing the pace of asset purchases ($120 billion per month), let alone thinking about raising interest rates.
- Under the Fed's updated policy framework that now focuses on average inflation targeting and a broad and inclusive definition of employment gains, policymakers are not likely to act preemptively based on economic projections, but will rather wait for data to confirm the substantial progress made, and this could take time. As seen in the graph below, despite the recent job gains, employment remains well below its pre-pandemic peak and below past periods of labor-market stress. Eventually, we expect that improving conditions will prompt the Fed to start pairing back its bond purchases likely near the end of year, which would be the first step in a patient approach toward normalization.
Employment gains do not yet meet the Fed's definition of substantial progress
The graph shows declines in total employment from peak levels. The current decline remains sizable despite the sizable recent employment gains.
4. Stimulative fiscal policy? Check
- The U.S. continues to lead all other major economies in fiscal-policy support, with direct spending between 2020 and 2021 slightly exceeding 25% of GDP. President Biden unveiled his American Families Plan last Wednesday, a $1.8 trillion program focused on child care, education and paid-leave programs. The additional spending is expected to be paid for with proposed tax hikes on upper-income workers (identified as households making over $1 million per year). It is important to note that this is a proposal only. The final bill would need to be voted on and approved by both houses of Congress, and it could be changed significantly through that process before, and if, it does become law.
- Together with the American Jobs Plan that was announced earlier this month and focuses on infrastructure, the proposal would add modestly to the sizable fiscal stimulus that has been a critical factor in accelerating the recovery. However, the higher taxes proposed could be a catalyst for short-term market volatility. We think that the initial proposals for a 28% corporate tax rate or a 39.6% capital gains rate are likely to be tempered as the negotiation process plays out in Washington.
Caveat? Growth rates might start peaking sometime this quarter
- Naturally as the cycle matures and, in our view, the market transitions from the early recovery phase to mid-cycle, the pace of improvement in economic and corporate fundamentals will slow. Past peaks in the leading economic index, which is comprised of various indicators that tend to lead economic activity, have been followed by lackluster equity-market returns three- and six-months forward. This dynamic is possible in the coming months as lofty expectations might become increasingly difficult to exceed, with the market possibly going through a period of adjustment or consolidation.
- However, investors can gain some confidence in that the expected downshift in economic and earnings growth rates will not mark the end of the cycle, but rather the transition to a more normal economy and a steady state, in our view. The reopening is still ahead (especially outside the U.S.), further employment gains are expected as the labor-market slack is gradually eliminated, and the outlook for personal consumption is strong, all of which suggest that the economic expansion is far from over.
- The boxes in the bull-market checklist are all checked, but we would caution investors against becoming complacent and expecting that the recent strong returns and low volatility will continue indefinitely. Maintaining a long-term perspective, seeking quality investments, and managing risk through diversification should remain in focus as the pace of blistering economic and earnings growth slows.
Angelo Kourkafas, CFA
Sources: 1. Bloomberg, 2. Edward Jones estimates, 3. FactSet
Weekly market stats
|Dow Jones Industrial Average||33,875||-0.5%||10.7%|
|S&P 500 Index||4,181||0.0%||11.3%|
|MSCI EAFE *||2,268.51||-0.8%||5.6%|
|10-yr Treasury Yield||1.63%||0.1%||0.7%|
Source: FactSet, 4/30/2021. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results. * Source: Morningstar, 05/02/2021.
The Week Ahead
Important economic data being released next week include construction spending, the PMI index, and Domestic Auto Sales.