- We expect fiscal and monetary policy to remain highly supportive of accelerating growth in the US economy. As economic reopening progresses, relative performance patterns may be influenced by the trajectories of policy, inflation, and real interest rates.
- The post-World War II shift to a peacetime economy, which catalyzed a cyclical rebound of growth and inflation, may be the closest historical analog to the upcoming post-COVID era where vaccination and reopening gain steam over the course of 2021 and 2022.
- In a rapidly growing economy with rising inflation, assets with exposure to high nominal growth rates, including value stocks and commodities, may hold up well, whereas bonds could struggle.
- While technology and other factors have kept inflation in check, we believe greater policy experimentation and "peak globalization" trends will eventually cause long-term inflation to rise faster than expected.
Rising growth and inflation expectations boosted riskier asset prices to additional gains during Q1, marking a remarkable one-year performance rebound since the bottom of the pandemic sell-off in March 2020. US small- and mid-cap equities, REITs, and commodities led the way during Q1. Rising bond yields caused fixed income returns to struggle, with more economically sensitive high-yield corporate bonds holding up best.
Riskier asset prices and bond yields continued to rise amid a progressing global recovery, the approval of a $1.9 trillion US fiscal package, a broader rollout of COVID-19 vaccines, and expectations for an eventual full economic reopening. We expect fiscal and monetary policy to remain highly supportive of an acceleration in US nominal growth, with elevated valuations and rising inflation representing challenges to asset markets.
Markets remain in a reflationary recovery dynamic. As economic reopening progresses, relative performance patterns may be influenced by the trajectories of policy, inflation, and real interest rates. More accommodative monetary and fiscal policies could generate inflationary pressure, whereas a move toward policy normalization could negatively impact financial conditions. We expect the potential for elevated volatility in 2021.
See our interactive chart presentation for an in-depth analysis.
Economy/macro backdrop: Global business cycle in a multi-speed recovery
The US and most major economies are progressing toward the mid-cycle phase of expansion, with varied levels of activity based on vaccine rollouts and reopening progress. While China's expansion is maturing in its post-pandemic period, US activity is poised to accelerate amid economic reopening and fiscal stimulus. Many other large economies, particularly developing countries, have slower vaccination and recovery trends.
The post-World War II shift to a peacetime economy, which catalyzed a cyclical rebound of growth and inflation, may be the closest historical analog to the upcoming post-COVID era where vaccination and reopening gain steam over the course of 2021 and 2022. Assets with exposure to high nominal growth rates, including value stocks and commodities, may hold up well, whereas bonds could struggle.
After 2020's steep decline in corporate earnings, investors expect profits to rebound strongly and exceed pre-pandemic levels before the end of 2021. Vaccine-related optimism helped generate higher earnings estimates for the third consecutive quarter, led by cyclical sectors that suffered the biggest 2020 losses. Earnings appear likely to experience a significantly faster recovery compared with past recessions.
The US Treasury-bond yield curve steepened significantly as longer yields rose and the Federal Reserve indicated patience with its accommodative posture anchoring short-term rates near zero for an extended time. Central banks around the world continued QE programs that collectively have added more than $8 trillion to their balance sheets since last year, providing a powerful liquidity tailwind for financial markets.
Surveys of manufacturing purchasing managers and small businesses reveal the highest price increases and inflationary pressures in more than a decade. Near-term market inflation expectations are significantly higher than pre-pandemic levels but also indicate a belief that inflation pressures will be transitory and diminish in the years to come. However, with core inflation still muted, the Fed expressed a tolerance for sustained, above-target inflation in order to make up for past misses, in accord with its average inflation targeting (AIT) framework. Labor markets have recovered substantially from their early pandemic lows, but unemployment remains well above pre-pandemic levels. The Fed is likely to remain accommodative as it seeks broader and more inclusive employment gains.
After decades of rapid technological change and policies that concentrated economic gains in the upper tiers, income and wealth inequality reached century-high levels. Political trends are shifting toward policy changes aimed at reducing inequality, directionally similar to the postwar, "Great Compression" era, including broad-based public investment, a more progressive tax regime, and support for low- and middle-income workers.
With Democrats signaling the introduction of several trillion dollars of multi-year fiscal legislation during 2021, the shape and magnitude of the changes will depend on politics in a narrowly divided Congress. Survey data generally suggests there is public support for infrastructure spending and aid for domestic manufacturing and low- to middle-income workers. The 2 parties pointedly disagree about levels of taxes and social spending.
The $1.9 trillion emergency fiscal package enacted in March may push the US government budget deficit above last year's level, making it the highest peacetime deficit in history (relative to the size of the economy). President Biden announced another plan in late March aimed at a pro-growth fiscal mix, adding high-multiplier spending on infrastructure and other areas while raising lower-multiplier taxes on corporations.
The dramatic worldwide rise in public and private debt in recent decades reflects monetary and fiscal policymakers' proclivity to use low interest rates and government support in an attempt to boost growth rates. While technology and other factors have kept inflation in check, we believe greater policy experimentation and "peak globalization" trends will eventually cause long-term inflation to rise faster than expected.
Asset markets: Value sectors led equity rally, bond prices declined
US equities posted strong Q1 results amid continued leadership from small caps along with significant outperformance by value stocks, including the financials and energy sectors. Non-US equities also added to gains but leadership shifted to Europe over emerging markets. While more cyclical equity and bond sectors led over the past year, safer and more interest-rate sensitive assets such as gold and Treasury bonds lagged.
After 2 straight years of valuation-driven stock rallies, US stock valuations sat at historically elevated levels. A strong recovery in corporate earnings may be critical to providing fundamental support for additional gains. Historically, stock valuations were highest during periods of modest inflation between 1% and 3%, implying that a period of sustained high inflation might be challenging for valuation multiples. Valuations for non-US equities also remained elevated, but at still relatively attractive levels compared to US stocks.
Trailing earnings growth remained in negative territory on a year-over-year basis, but it sharply inflected upward over the past quarter for all major regions. Forward expectations exhibit hope that earnings will continue to rebound meaningfully over the next 12 months, with double-digit growth rates anticipated in all regions, led by emerging markets.
US 10-year Treasury yields jumped more than 80 basis points during Q1, continuing their recovery from record low levels during the 2020 recession. Rising inflation expectations and real yields drove the increase in nominal yields, representing expectations for a recovery in both real growth and higher inflation. The real cost of borrowing remained negative, while inflation expectations rose to their highest level since 2013.
The business cycle can be a critical determinant of asset performance over the intermediate term. Stocks have consistently performed better earlier in the cycle, whereas bonds tend to outperform during recession. While we believe a business cycle approach to actively managed asset allocation can add value, portfolio returns are expected to even out over the long term (more than 10 years), regardless of the starting point of the cycle phase.