Capital Market Outlook (February 8, 2021)


  • Macro Strategy—The unprecedented growth in the money supply and the fiscal deficit since March 2020 have naturally raised concerns about the outlook for inflation and financial stability. History shows that periods of above-normal money growth have been associated with periods of above-normal inflation. Fortunately, history also shows that inflation can be tamed by slowing money-supply growth, although the economic pain associated with reining it in can be significant and varies proportionately with how entrenched high inflation expectations become, as the world learned in the early 1980s.
  • Global Market View—The two faces of America are confusing and a generator of investor uncertainty—one face depicts problems and despair; the other highlights what is right with America. All in all, it's this bundle of dynamics that supports America's economic expansion and underpins the current bull market in U.S. equities in anticipation of better-than-expected growth and upside earnings surprises as the year progresses.
  • Thought of the Week—Stock-market bears have roared louder more recently as positive sentiment has teetered on the line of overly optimistic, and a recent spike in volatility led by speculative trading has led to some uncertainty. Still, near-term sentiment risk appears more balanced against the backdrop of reasonable relative valuations, rising economic activity and a positive earnings outlook for 2021.
  • Portfolio Considerations—Positive earnings estimate revisions and upside surprises expected into 2022 should help equity valuations moderate; meanwhile, as yields back up, we expect this to be a pivotal year for portfolio rotation as years of fund flows favoring Fixed Income do not suggest equities are over-owned.

Deficits, the Money Supply and Inflation

The ongoing creation of money and fiscal deficits to cushion the U.S. economy from the effect of shutdowns and other pandemic effects are an order of magnitude greater than any policy response since World War II (WWII). While helpful for the time being, the current surge in government debt and money printing has raised concerns about the longer-term consequences of this massive government spending binge.

During WWII, deficits of roughly 25% of gross domestic product (GDP) were necessary to transform a peacetime economy into a war production machine that eventually prevailed.

The current pandemic has triggered an exceptional fiscal response of comparable magnitude. Also as it did during WWII, the Federal Reserve (Fed) has kept interest rates near zero and purchased a lot of the government debt to finance the big deficits. In fact, the Fed, with its quantitative easing policy, has essentially been purchasing the entire issuance of U.S. government debt, which is the source of the extreme money creation seen in Exhibit 1.

Exhibit 1: Money-supply Growth Now Similar To World War II.

*=Estimate. **M2=a calculation of the money supply that includes all elements of M1 (a narrow measure of the money supply that includes physical currency, demand deposits, traveler's checks, and other checkable deposits) as well as "near money." Sources: Bureau of Labor Statistics; Federal Reserve Board. Data as of February 2, 2021. Past performance is no guarantee of future results.

Prior to 2020, the episodes of the most extreme money growth in the 20th century were during WWI, WWII and the great inflation of the 1970s. During the period of massive deficits and money creation in WWII, money-supply growth (blue line) exceeded three standard deviations above its 120-year average, as shown in Exhibit 1. The other two highly inflationary episodes, WWI and the 1970s, saw money growth between one and two standard deviations above normal. The WWII spike in money-supply growth has been almost matched over the past year when money growth was just shy of three standard deviations above its average of the past 120 years.

Exhibit 1 also shows the deviation of inflation (red line) from trend, and that the three episodes of excessive money growth prior to 2020 also saw inflation rise by more than two standard deviations above trend. While money-supply growth tends to lead inflation by a couple of years, as shown in Exhibit 1 and as documented by Milton Friedman and Anna Schwartz in their Monetary History of the United States, 1867-1960, the lead is not always the same. For example, during WWI, the inflation response was bigger and more coincident with the money-supply surge compared to the WWII and the 1970s inflation flare-ups. Thus, while investors are becoming more concerned about the inflation outlook given the clear message from the history of rapid money growth, it's difficult to forecast the timing and magnitude of the coming inflation. For one thing, as Friedman and Schwartz showed in their book, the lags in the response of GDP and inflation to bursts of money-supply growth are "long and variable."

One main reason for the lack of a precise relationship between money growth and inflation, both in terms of timing and magnitude, is the multiple roles that money plays: a medium of exchange, a source of liquidity in a portfolio, and an asset that varies in attractiveness compared to other forms of wealth. If money was purely a medium of exchange, the inflation response would be quicker and bigger than, say, when money is primarily being held for liquidity and wealth preservation purposes.

At the macro level, we can detect when these alternative motivations are dominating money demand by looking at the velocity of money (Exhibit 2).The velocity of money is the ratio of GDP to the money supply. If GDP is $20 trillion and the money supply is $10 trillion, the velocity of money is 2. When people hold money mainly for transactions rather than hoarding it as an asset, velocity is higher (faster turnover on average). When people hold a lot of the money supply for precautionary reasons, money turnover is slower. Also, when interest rates are low, people generally hold more money and fewer non-money interest-bearing assets like bonds, reducing the velocity of money. In the extreme case when rates are near zero and people are scared, velocity is extremely low, as in the proverbial liquidity trap described by Keynes in his classic work on the Great Depression.

Exhibit 2: Changes In The Velocity Of Money Affect Inflation.

Indeed, another reason for low velocity is a high saving rate. As the U.S. banking system collapsed in 1932, velocity reached its lowest level of the past 120 years. People were hording money as the economy ground to a halt. Declining prices, or deflation, caused the real value of money to rise by annualized double-digit rates in the years leading up to 1933, further encouraging people to hoard money. As shown in Exhibit 2, velocity began to recover from its all-time low in 1932 as the economy began to grow but relapsed in the 1940s not least because of the effects of the war on saving. Similar to today, when the pandemic has forced abnormally high saving rates, by the end of WWII, many Americans had record savings because they couldn't buy new cars, for example, while the carmakers were producing tanks and planes, helping to explain the extreme low levels of velocity in 1946 and 2020.

Thus, the faster, bigger response of inflation to the surge in money-supply growth during WWI compared to the lagged, more proportionate response in WWII (Exhibit 1), probably owes something to the much lower velocity of money in the 1940s, when lingering caution from the Depression and massive saving during the war slowed the circulation of money. This suggests that the almost record-low level of velocity today should continue to mitigate some of the inflationary effects of the big money-supply surge in 2020.

Still, it's hard to escape the conclusion that inflation is going to rise above trend over the next few years, in our view. In addition to the massive money-supply growth, the forced saving during the pandemic is likely to be unleashed, speeding up the velocity of money just as the forced saving during WWII spurred the consumption boom that fueled the U.S. economy in the 1950s. It took a few years for the high inflation of the late 1940s and early 1950s to subside after the war.

As shown in Exhibit 1, the Fed had to rein in the money supply after the war before inflation returned to trend. To do that, the Fed had to assert its independence from the Treasury and fiscal deficits by reaching the Treasury-Federal Reserve Accord in March 1951. Currently, the Fed is bound to monetize government debt as in the 19421951 period. A key to avoiding inflationary instability in the future will likely be a similar agreement to that in 1951, separating monetary and fiscal policy by restoring the Fed's independence.

Portfolio Positioning in Janus-like America

"Janus-like: named after the Roman god depicted with two faces looking in opposite directions, meaning, in this case, having contrasting aspects or characteristics"

We have noticed a growing ambivalence among investors struggling to wrap their heads around a soaring stock market on the one hand juxtaposed against a global healthcare crisis, wild swings in the U.S. stock market due to speculative betting, and mounting structural challenges to America, ranging from widening income inequality to the ballooning federal budget deficit.

One common theme: that the political and social fabric of the country remains fragile given all the political angst of the past few months, and the fact that the pandemic has exposed glaring inequalities across the U.S.

The latter point is particularly relevant, considering that some 34 million Americans lived in poverty in 2019, a rate of 10.5%. Some 27.5 million people have no health insurance, while 37 million don't have a dental plan—this, in a heightened era of hygiene. Roughly 21 million Americans don't have access to the internet, including 9.4 million students aged 3 to 18. And speaking of high school students, every day in America, some 1,400 students drop out of school, denying the U.S. labor market a future productive input. A soaring stock market? That means nothing to 75% of the U.S. households that live paycheck-topaycheck. Some 7 million Americans don't even have a checking account, disproportionately people of color. Women, meanwhile, continue to suffer from a gender pay gap, with women earning roughly $0.82 for every dollar a man was paid in 2018, according to the Census Bureau. The gap for Latino and black women ($0.54 and $0.62, respectively), and single mothers, is even wider.

All of the above is one face of America—and it isn't pretty. It's also risky, since social fault lines have a way of becoming political fault lines—think of the rising tide of populism and de-globalization over the past few years, both catalyzed by social-cum-political pressures.

However, the other face of America is far more appealing and agreeable to investors, and centers on the underlying strength and competitiveness of the U.S. economy. Despite all the chatter about China being the only major country in the world to grow last year, the U.S. economy remains the largest and most competitive wealth-generating system on planet Earth. With just 4.5% of the world's population, the U.S. generates more than 20% of world output. No other nation comes close, with China's nominal GDP of $15.2 trillion in 2020 a distant second to America's $20.8 trillion, according to the International Money Fund.

In addition, despite all the media angst about America's shrinking manufacturing base, America still accounted for roughly 20% of world manufacturing output last year, a share equivalent to America's slice of the global manufacturing pie in 1980, according to the United Nations. In other words, the U.S. continues to manufacture plenty of goods, including automobiles and airplanes. Capital goods are among the largest and strongest categories of U.S. exports. And speaking of U.S. exportsthey are booming. What the U.S. typically exports in a month—$185 billion in goods and services in November 2020—is greater than what most nations export in a year.

Meanwhile, American workers are among the most productive in the world. U.S. firms are among the most innovative, with the latest rankings from the Boston Consulting Group (BCG) showing that of the top 10 innovative companies in the world, six were U.S. firms. Corporate America is also a global brands leader, with the latest rankings from Interbrand marketing consultancy indicating that eight out of the top 10 global brands in the world were American.

In addition to the above, the U.S. has emerged as an energy juggernaut over the past few years. According to the U.S. Energy Information Administration, America's energy costs are among the lowest in the world, granting a huge competitive advantage to U.S. firms relative to their foreign competitors. Thanks to super cheap energy costs in the U.S., America remains a magnet for foreign direct investment inflows. And thanks to our universities and higher-education infrastructure, which is second to none on a global scale, America also remains a magnet for the world's best and brightest students. No other country in the world attracts as much brain power each year as America.

The U.S. also leads the world in a host of other areas, including technology capabilities, financial market sophistication, labor market efficiency, business innovation, corporate transparency, spending on research and development, and a myriad of other variables of wealth, in our view.

In the end, it's not just one factor that drives U.S. economic growth and competitiveness—it's a unique and dynamic bundle of factors that separate America from the rest of the world. It is this bundle that supports America's economic expansion and underpins the current bull market in U.S. equities in anticipation of better-than-expected growth and upside earnings surprises as the year progresses.

Exhibit 3: Two-faced America.

  • Poverty rate at 10.5%
  • Gender pay gap
  • Growing uninsured and unbanked population
  • Students without internet access
  • Over 1,000 school drop outs a day
  • Global innovation leader
  • Top global manufacturer
  • Largest GDP in world
  • Global brand leader
  • Top energy producer

Investing in Janus-like America

The bottom line—the two faces of America are confusing and a generator of investor uncertainty—one face depicts problems and despair; the other highlights what is right with America.

So what's an investor to do in this situation? We continue to favor U.S. Large-cap Equities, notably cyclicals based on reaccelerating growth in the U.S. and overseas; given the dramatic build-out of the global digital economy over the past year, we favor Information Technology over the long term. Owing to the pandemic, the lines between healthcare and Technology (health-tech) are becoming blurred, offering investment opportunities. We are neutral on International Developed market equities and the Emerging Markets in general but believe strategic portfolio positioning should play off each nation's strength: i.e,, luxury brands and goods (France/Italy); solar and wind energy (Denmark/Nordic nations); capital goods (Germany); technology (South Korea/Taiwan/China) and robots (Japan). Consider investing in what a country enjoys a competitive advantage.

On a thematic basis, our investment bias and portfolio positioning pivot around disruptive technologies, as well as cybersecurity, renewable infrastructure and platform economies.

Near-term Sentiment Risk Balanced with Medium-term Upside in Earnings

As we near almost a year into this pandemic, it is hard not to reflect on the remarkable current run in the equity market. The S&P 500 is now up 74% on a total return basis since the March lows, as ultra-accommodative monetary policy and unprecedented fiscal stimulus helped to light the fire beneath the rally. And in recent months, vaccine prospects and renewed hopes for another round of fiscal stimulus have led to greater investor optimism and an improvement in market breadth, with roughly 90% of S&P 500 stocks trading above their 200-day moving average.

Stock-market bears have roared louder, however, as positive sentiment has teetered the line of overly optimistic and a recent spike in volatility led by speculative trading has led to some uncertainty. Fund manager cash allocation levels have fallen to 3.9% on average, sending a bearish "sell signal," according to BofA Global Research, and absolute equity valuations appear extended. Some market pundits have compared today to the dot-com era following a surge in initial public offering (IPO) valuations. 2020 saw five of the top 10 U.S. trading debuts on record for companies that went public and raised more than $1 billion,4 and January of this year saw more U.S. companies go public than any other month in the last 20 years.5 Still, near-term sentiment risk appears more balanced against the backdrop of reasonable relative valuations, rising economic activity and a positive earnings outlook for 2021.

The current equity risk premium at 3.4% continues to signal the relative attractiveness of equities to fixed income. That's a considerably stronger picture compared to the late 1990s and early 2000s, when the risk premium turned negative, a sign that investors had taken on too much risk. Even further, the economic outlook in the dot-com era looked far different from today, with a Fed that was tightening rates, an inverted yield curve, and real GDP running above potential. Economists continue to revise their economic growth forecasts up for 2021 with economic data pointing toward a strong recovery. And from an earnings perspective, estimates for 2021 have improved since March 2020, with earnings for the year expected to be up 24% (Exhibit 4). Expectations could move even higher as the economy continues to recover and as more of the population is vaccinated, allowing for states to ease shutdown restrictions.

Ultimately, what remains core to our bull market thesis for the year ahead is our expectation for corporate profits to surprise to the upside and the strengthening of the economic recovery as vaccine distribution helps to unleash consumer demand. Some near-term consolidation and volatility may be expected, but we would consider these opportunities to add to risk assets like equities.

Exhibit 4: S&P 500 Earnings Growth Expected To Improve.