“I am at war ’twixt will and will not”
- Isabella in Shakespeare’s Measure for Measure, Act II, Scene ii
The title suggests the agony of indecision. This installment of ongoing comment on the pandemic, the recovery, and markets examines how each of these is powerfully pulled in contrasting directions.
More than a year into pandemic, remarkably effective vaccines developed at unprecedented speed are now being administered in the US at the rate of over 13 million doses per week. As a large and growing portion of the population receives vaccines and as more have been infected and recovered, new cases and deaths have plummeted. Weekly average new cases peaked in early January and declined 79% through 3/21. Average deaths peaked in late January and then declined 71% through 3/23. But since those recent lows, weekly average new cases have risen 24% through 4/1 and deaths have flattened. Given accelerating vaccine roll-out, how can this be? Some experts guess it’s the effect of widening spread of several more easily transmitted virus variants. Others attribute the rise in cases to precaution fatigue and some premature dropping of our guard. We don’t know yet. But for either reason (or both), how the pandemic may play out over the next several weeks is now even more uncertain. Moreover, Europe has been much slower than the US in vaccine administration and is currently experiencing a significant surge in new cases.
Since indications are the vaccines are somewhat less effective against variants yet still quite useful, most expect this will end with the pandemic being reduced to much less disruptive endemic status. Tools for ending the pandemic are in hand, but now there is suddenly increased uncertainty about the path it may take to get there and whether there may be some level of resurgence of COVID-19 first.
The economy contracted 3.5% last year even as the economy grew 8% in the third quarter and an estimated 4.3% in the fourth. Anticipation of an opening of the economy relatively soon, along with massive monetary and fiscal stimulus already in place (and more of each expected) result in widespread expectation of strong economic growth in 2021. Unemployment peaked at 10.2% last July and fell to 6.0% in March. Most expect unemployment to drop below 5% later this year. Despite year over year money supply (M2) growth at between 23% and 26% each month since last June – inflation has so far remained tame in general price levels even though it has been manifest in residential housing and stock prices.
Many think the recent partisan $1.9T stimulus bill may be over-stimulus, eventually leading to inflation and a need for the Fed to tighten. And close on the heels of the last give-away comes talk of much, much more and perhaps too soon, as some are beginning to fear this porridge may too soon become “too hot”. If a rude discovery is made that free money isn’t free, that may not sit well with either the economy or markets.
With respect to markets, from panic low levels a year ago, interest rates have climbed fast enough of late to cause some concern, but the 10-year Treasury yield ended the quarter just under 1.75%, so rates remain quite low by historical standards. When interest rates rise, bond prices fall, and the total return of the US bond market (the Bloomberg Barclays US Aggregate Index) was -3.37% in the first quarter. For some time, we’ve noted the lack of valuation appeal in longer-dated bonds and that hasn’t materially changed in our view.
The blended index of global stocks vaulted 58.6% from 3/31/20 which was near pandemic market lows, and 5.5% of that was added this past quarter. The S&P 500 Index returned 56.35% in the past year and 6.17% this year to date. Relatively cheap stocks (“Value” stocks) struggled compared to some of the largest, most popular stocks last year through August, but have since fared quite well, including in the first quarter. The Russell 3000 Value Index outperformed the S&P 500 Index by over 2% in the past twelve months and by over 5% this year to date.
Earnings are expected to climb 25% this year for US stocks, and 33% for European stocks, both reflecting expectations for wider vaccinations leading to normalization, pent-up demand, and trillions in monetary and fiscal stimulus. Now comes in the $2.1T new infrastructure package a proposed increase of the corporate tax rate from 21% to 28%. If enacted, expectations for 25% after tax earnings growth this year under stable 21% corporate tax rates shrink to 13.9% after-tax earnings growth if corporate tax rates rise to 28% (other things being equal). That’s not bad growth in a year, but it’s a far cry from the exceptional recovery of 25% growth, and in relative terms, it makes current investment in Europe that much more interesting.
We don’t know how this proposal will play out or when it may become effective if passed, and that’s the point – this too increases uncertainty, and for markets, uncertainty equals risk. We have the ramped up administration of highly effective vaccines vs. an upturn in new COVID-19 cases; we see economic recovery fueled by rising demand and substantial liquidity vs. rising inflation concerns and possibly higher interest rates; and we witness massive fiscal stimulus flooring the economy’s accelerator vs. potentially slamming the brakes in the form of corporate and other tax increases. Lastly, we see on the one hand a very expensive stock market and many, many signs of market speculative excess, yet we also see plenty of stocks that remain reasonably priced and which still appear to offer good investment opportunity.
With the pandemic, the economy, and markets each poised ’twixt such powerful influences for good and for ill, the most likely outcome is volatility. As ever, the best preparation for turbulence is a custom asset allocation that is not more aggressive than necessary for your preference and circumstances, regular and disciplined rebalancing to that allocation, very broad diversification, and holding an extra margin of safety through investments that are materially cheaper than the overall market. Unprecedented times imply, by definition, unpredictable times. We don’t try to avoid the inevitable storms that arise from time to time by seeking to predict the unpredictable. But we can trim the sails and through rebalancing, lean against the wind.