Economic Outlook – May 2021
In this month's Economic Outlook, Chief Investment Officer Greg Sweeney gives perspectives on Federal Reserve policies, expectations for interest rates and inflation, and what's going on in national and global markets.
Greg Sweeney
Underlying fundamentals of the economy and corporate earnings appear positioned to deliver on the rosy forecasts for the year. The stock market seems to support these prospects for growth, with the S&P 500 trading at 31 times the last 12 months’ earnings. This price-to-earnings ratio is high relative to past averages. Since the stock market is considered forward-looking, perhaps this elevated P/E is justified. Experts forecast U.S. economic growth in the range of 6% for 2021. If that prediction is realized, it will be the country’s best economic growth in 40 years. Sure, it comes with costs. At the top of the list are enormous government spending and never-before-seen levels of government debt.

The increase in personal income in March was the highest on record back to 1946, as the third phase of pandemic stimulus checks were sent out. Some of the money was spent, and some made it into savings. It is important to remember that fiscal stimulus takes about nine months to fully make its way into the economy, suggesting the U.S. is seeing the effects from the first stimulus package, delivered around the middle of last year. This also implies the economy should be full of good news for the rest of the year as the second and third stimulus injections make their way through the system. Are there any potential hurdles on the horizon? Sure. Near the top of the list would be tax increases, prospective Federal Reserve policy changes and the imbalance between employers’ need for workers and the willingness of workers to re-enter the job market.

More than a decade ago and in response to the 2007-2008 global financial crisis, the Federal Reserve started a program called quantitative easing (QE 1) with the idea of pushing interest rates lower and injecting money into the economy at the same time. Shortly after that came QE 2, Operation Twist (QE 2.5), and then QE 3. Commentators at the time started dropping the numbers and began to call the whole thing “QE Infinity.” So far, that moniker has been correct. The Federal Reserve is still purchasing $120 billion in U.S. Treasury and mortgage-backed bonds each month. Through all of this, the Fed failed to get much traction pushing inflation rates higher. The decade of low inflation in the wake of the QE programs perplexed the Fed. Sure, QE created a lot of asset price inflation (pushing bonds, stock and real estate prices higher), but not much in the way of consumer price inflation measured by the consumer price index (CPI). We think much of the money targeted at QE programs never left the financial system. With the consumer generating about two-thirds of U.S. gross domestic product, any money going into the economy would need to end up in consumers’ hands to get inflation moving higher. Fast-forward to the last 12 months with the CARES Act, Paycheck Protection Program (PPP), stimulus checks and government spending plans, and we see money actually reaching consumers who will spend it – maybe not right away, but they will spend it. This recipe has a much higher probability of pushing inflation higher.

Prior to 2008, an investor who wanted 5% interest income could choose from an expansive array of opportunities in safe bond investments. Today, the options are just a puddle of some of the worst junk bonds, with high expected default rates that produce those types of yields. This is the world of bonds after a decade of Federal Reserve intervention.

As investors reach for yield and returns, we are starting to see signs of too much money in the economy – with no place to go. Examples are everywhere: blank-check special purpose acquisition companies (SPACs) that have no business plans … digital images called non-fungible tokens (NFTs) selling for hundreds, and even hundreds of thousands of dollars… Dogecoin, a crypto currency that started as a way to mock the crypto market, now worth $50 billion … and a sandwich shop in New Jersey with $35,000 in sales over the last two years combined with a stock market cap over $100 million (Hometown International ticker HWIN). Back in 1996 Alan Greenspan called this type of environment “irrational exuberance.” It wasn’t until four years later that the tech stock bubble popped.

There is not a day that goes by that doesn’t include a question from someone asking where the market is going. The only honest response anyone can provide to that question is, “I don’t know.” We know about long-term average market returns. We can talk about our economic and market expectations. We know how to evaluate one investment option against another. Forecasting where the market is going has only two potential outcomes: wrong or lucky – and if it is lucky, it will only happen once.

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