The roll-out of vaccines and ongoing central bank stimulus fueled optimism and drove equity prices higher during the quarter but also spurred concerns over inflation, pushing U.S. Treasury yields up during the first three months of the year. A $1.9 trillion stimulus package was signed into law, and an additional $2-plus trillion infrastructure proposal lies in the wings.
The S&P 500 Index hit an intra-day record high going into quarter-end and is in “overvalued” territory by a number of valuation metrics, reflecting robust earnings expectations. Overseas markets generally outperformed the U.S. in local terms, but a strengthening U.S. dollar eroded much of the relative gains. The U.S. Treasury 10-year yield closed the quarter at 1.74%, above the S&P 500 dividend yield (+1.5%) for the first time since mid-2019.
Employment gains, consumer spending and confidence, and housing were among the bright spots during the quarter. And on April 1 the ISM manufacturing print (64.7) was the highest since 1983 (a reading over 55 signals “exceptional growth”). Fourth quarter real GDP was revised up to 4.3%, bringing the 2020 figure to -3.5%. A survey of economists by The Wall Street Journal revealed that the average 2021 forecast was boosted to 6%, which would be the fastest pace since 1983. In further good news, the Conference Board’s U.S. consumer confidence index hit a one-year high in March and posted the largest one-month gain in 18 years.
As for housing, the S&P CoreLogic Case-Shiller National Home Price Index, which measures average home prices in major cities, gained just over 11% y-o-y as of Jan. 31, its highest annual rate since 2006. The surge in housing prices has been fueled by low mortgage rates and record low inventory.
The recently passed stimulus package represents roughly 10% of U.S. GDP; with last year’s stimulus, the total is about $5 trillion or 25% of U.S. GDP. The recent package included $1,400 checks to qualified individuals, an extension of unemployment insurance, and aid to state and local governments. The Congressional Budget Office projects that the federal budget deficit will reach $2.3 trillion in 2021, just over 10% of GDP and the second highest level since 1945, exceeded only by last year’s figure. In the 2020 fiscal year, which ended Sept. 30, the deficit hit a record $3 trillion. Note also that the CBO’s 2021 projection does not include the recent $2 trillion stimulus package.
At its March meeting, the FOMC increased its GDP projection for 2021 from 4.2% to 6.5% (falling to 2.2% in 2023), and its median projection for year-end unemployment fell to 4.5%. However, expectations for PCE core inflation remain muted (2.2% in 2021; 2.0% in 2022). The Fed funds rate was kept on hold at close to 0%, and asset purchases are slated to continue. And, importantly, expectations for rate hikes remain on the distant horizon. The Fed’s statement that “the ongoing public health crisis continues to weigh on economic activity, employment, and inflation and poses considerable risks to the economic outlook” indicated that it is in no rush to raise rates or taper its asset purchases and re-confirmed the view that is willing to let inflation run above its long-term target of 2%. It also acknowledges that full employment will take time to achieve.
While market participants worry that rapid economic growth combined with prospects for increased Treasury supply to fund a growing deficit will lead to additional inflation, the numbers have yet to reflect that concern. As of February, headline CPI was 1.7% y-o-y and core CPI was 1.3% y-o-y in spite of higher energy and food prices. Some expect that any rise in inflation will be short-lived. The recent stimulus package is a one-time injection that is not expected to fuel long-term inflation; likewise, pent-up demand will likely have a short-term effect on price gains but not necessarily a protracted impact.
Finally, secular changes including technology innovation and shifting demographics continue to temper inflationary pressures. As the Fed has repeatedly made clear, it is willing to accept inflation that runs above 2% in order to reach a longer-term average of its 2% target.
Looking Beyond the Pandemic
What a difference a vaccine makes! Pent-up demand for restaurants, movies, travel, and shopping are expected to unleash consumer spending and support a robust economic recovery in 2021. Stock markets appear to be priced for this scenario. With that, rising rates and simmering concerns over inflation are clouds on the horizon. So far, the Fed is unwavering in its commitment to remain accommodative until it meets its full employment and inflation objectives. The 2021 path of the economy, the pandemic, and the markets is likely to provide some twists and turns, and while the start has been bright, Callan continues to advise adherence to a disciplined investment process that includes a well-defined long-term asset allocation policy and, if applicable, to understand the risks undertaken to improve expected investment returns.
