US Economy on a Firm Footing
US Economics and COVID
The US economy seems to be on a firm footing with declines in jobless filings, stability in retail sales, and gains in industrial production. On the unemployment front the payroll gains seemed more subdued than expected. The labor supply is probably constrained by the generous unemployment benefits and not as many people looking for a job as the unemployment rate implies. The housing sector could provide additional economic growth support with strong demand looking sustainable for a long time. Low mortgage rates, pandemic induced shift in preferences and millennials postponing home ownership prior to pandemic – all these factors should support buying intentions. With homebuilders facing capacity constraints the supply-demand imbalance should persist and push real estate prices up. One would expect housing price dynamic to influence inflation albeit indirectly (housing prices are not part of official inflation calculation).
Increasing inflation is well broadcasted with Producer Price Index (PPI) rising 0.6% last month, and 6.2% in the past year. Price increases are also noticeable on the consumer side, as the Consumer Price Index (CPI) added 0.8% in April and 4.2% for the 12 months. The April CPI report was a huge upside surprise, but one of little lasting significance according to Goldman Sachs. The spike was driven by a mix of temporary shortages, supply chain disruptions, and reopening rebounds in travel prices. These forces should not produce a long-lasting effect beyond this year. While it is possible that fiscal support, pent-up savings, and easy financial conditions could persistently push demand well above potential GDP, Goldman doesn’t see that materializing since the starting point (pandemic through) is so low and growth is likely to slow down next year with expiring pandemic unemployment benefits and the fiscal support turning negative with higher taxes. That being said, the inflation annual estimates beyond this year are being revised upwards, although within the range of 2% - 3%. The Fed is comfortable with such a range but watching the situation closely with some officials voicing support for removing elements of monetary accommodation.
The US has become the engine of recovery in the global economy this year. Not only has the US shown resilience during the second wave of the pandemic, but the economic recovery is amplified by fiscal boost and extensive vaccination program. By contrast, China’s remarkable recovery last year has faded faster than anticipated according to JP Morgan. The key activity data for April suggest that while the export sector has remained strong, domestic demand has downshifted sharply. JP Morgan now sees US GDP reaching 1.3%-pts above its pre-pandemic trend by 4Q21 compared to China merely tracking its trend.
With the US and China diverging, Western Europe could become an example of what to expect from the rest of the world. The region seems to be recovering after the second wave and the activity is picking up in May with vaccinations ramping up and lockdown measures fading. According to JP Morgan, the Euro area and UK are experiencing broad-based acceleration in both goods and – importantly - services in May. While Western Europe may be a guide, it is important to recognize that the pandemic remains a headwind to growth elsewhere (especially in Asia). Nevertheless, the global GDP is expected to grow around 6% in 2021 – a very healthy reading after a 3.6% contraction in 2020.
Stock Market and Portfolio Management
With 50% of population over 18 years old fully vaccinated in the US, the rolled-out stimulus and personal savings being unleashed, economic growth is expected to be robust in the midst of re-opening economy. On top of this, the first quarter earnings season demonstrated that S&P 500 earnings for the year could go above $200 a share, with the early year estimates of $175. Moreover, Value stocks had the largest revisions up. All these factors contribute to broader market leadership in 2021 (smaller companies outperforming across all size groups, see chart below).
Large vs. Small and Growth vs. Value 2020 YTD (As of 05/25/2021):
Source: Signet FM
Factor Performance (Top 2 quintiles of Large Cap Universe vs. SP 500):
Source: Signet FM
Recently we made changes to some of our actively managed equity portfolios. While we maintain our barbell approach, large growers in our portfolios are of GARP nature, the part of Large Growers cohort outperforming their expensive peers in the rising long-term interest rates environment (yield curve’s slope is getting steeper). We pair them up with well-run “Back to Normal” companies with great re-evaluation potential. From the sector perspective Financials still look attractive. Consumer Discretionary should benefit from strong consumption. We still believe in IT, see potential in Industrials and Communication Services. Inflation has become a larger concern with prices jumping in April, so Commodities/Materials and REITs might provide a natural hedge. Overall, while inflation is growing from low levels, it is usually beneficial to stocks since companies tend to pass the higher input prices to end consumers. On the defensive front we are staying neutral towards Healthcare. We stay less attracted to Consumer Staples and Utilities.
Equal vs. Market Weighted 1 Yr. Return Spread (Source - Signet FM): through April 2021
Source: Signet FM
Valuation spreads have come down but still have room to shrink (see chart below), so we see a potential in Value continuing with the mean reversion move started in October 2020. We keep emphasizing Medium Cap and Small Caps at the moment, since we are in the middle of economic recovery.
Valuation Spreads: through April 2021
Source: Signet FM
The information and opinions included in this document are for background purposes only, are not intended to be full or complete, and should not be viewed as an indication of future results. The information sources used in this letter are: WSJ.com, Jeremy Siegel, PhD (Jeremysiegel.com), Goldman Sachs, JP Morgan, Empirical Research Partners, Value Line, Ned Davis Research, First Trust, Citi research and Nuveen.