Developments over the Past Month:
- Thus far, 2021 has continued the inflation theme in the market. Value continues to outpace growth, small caps have performed well, and bond yields reflated.
- 10Yr Treasury yields have marched higher (0.93% on 12/31/2020), though took a breather in April, continuing to drive daily movements in the market, and closed the month around the 1.63% level.
- As far as “reasons” the 10-year yield is increasing – the introductions of President Biden’s Build Back Better infrastructure program of nearly $4 trillion in spending over the coming years. That, combined with the continued acceleration of vaccine distribution, is pushing growth and inflation expectations ever higher.
- 5YR Breakevens (market estimated inflation over the next five years) is 2.40%, well above the Fed’s desired 2% threshold – remember, Powell said he’s let this run hot for a bit, i.e., above 2%. Ultimately, the yield curve is pricing in higher inflation expectations. But, we believe that the market is pricing in a normalization of rates, as the U.S. is the only country still below its Pre-COVID 10Yr interest rate level.
- The Fed promised that rates would remain in the 0% – 0.25% range through 2023, with the goal of stoking inflation to moderately exceed 2% for some time. Though, the market yields are now pricing in an increase towards the end of 2022.
- President Biden introduced both the first and second part of his infrastructure plan. The first, the “Build Back Better” plan, for (mostly) physical infrastructure is supposed to be primarily paid for via corporate tax increases. The second part, called the “American Families Plan”, is a social agenda that was presented last week and will aim to be paid for by an increase in personal taxes (personal, capital gains, dividends, and potentially estate taxes).
- Between both the physical and social infrastructure plans, Biden is aiming to spend $4 trillion over 8-10 years while raising $3 trillion in taxes. Biden’s plan will propose raising the corporate tax rate from 21% to 28%, raising the minimum tax on US multinational income overseas from 10% to 21%, and imposing a 15% minimum book tax on companies that make capital investments (often termed the “Amazon tax”).
- Economic data is improving but the gains have softened from the initial V-shaped bounce. Optimism thrives on vaccine developments – Manufacturing and Services PMIs continues to be very strong (highest since 1984).
- Since the start of last year, investors have poured more than $130 billion into SPACs, “blank-check companies” traded on an exchange with the goal of merging with a private company to bring it public. The market has seen more companies publicly list their company at valuations over $1B and with zero revenues than what we saw in 2000. In January, 88% of SPACs traded above their $10 NAV, now many trade well below. SPACs pulled back 11% in March, which now totals a decline of almost 25% from the February highs. Given this, you have seen many SPACs pull back on raising funds during April.
- From our perspective, earnings season for Q1 2021 has been excellent so far. With about 40% of S&P 500 companies reporting earnings during the last week of April, the overall S&P 500 earnings growth rate jumped to 46.3% from 33.9% for the first quarter. All eleven sectors saw earnings growth strengthen, with energy growth flipping positive. From a top-line perspective and all but the Real Estate sector saw improvements.
- Last year S&P 500 operating earnings = $165. Bottoms-up for 2020 = $135 (was as low as $125 in June). 2021 = $187.
- S&P 500 fwd. P/E is at 22x. CAPE Ratio is 35x. EAFE is 18x forward P/E, while EM is at 16x. R1V us 18x v. R1G at 31x.
Key Client Themes – May 2021
- President Biden outlined the biggest expansion of the federal government matched with the largest tax increase since 1968. Biden senses the post-COVID era is a once-in-a-generation opportunity to massively restructure US fiscal, monetary, and social policy. This is a big experiment.
- We have expected bond yields to reflate as the pandemic improves and economic activity begins to normalize. The spread on the 2s and 10s has historically expanded as wide as 300 bps (~150bps as of April month-end)
- Thanks to continued vaccine developments, there is light at the end of the tunnel, and markets are pricing in a recovery in 2021 propelled by low interest rates. Still, the best fiscal stimulus the economy can have is reopening the economy.
- This is not a normal economic cycle, which are caused by financial excesses. This may help explain the stealth recovery in asset prices (along with the Fed flooding the markets with liquidity).
- Should a successful vaccine allow for the resumption of normal economic activity, our expectation is that rates will continue to rise, and market leadership will shift away from Tech Growth into more downtrodden components of the market.
- Longer-term, we believe valuations and bond yields will eventually matter, and both will lower expected returns for balanced portfolios.
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