Dramatic acceleration in the rollout of vaccinations and a significant decline in U.S. COVID cases and hospitalizations during the first quarter of this year, has put the U.S. economy on course for re-opening and a strong growth ahead.
A very large, by any measure, economic stimulus package of $1.9 trillion, on top of $900 billion passed in December, and continued monetary support from the Federal Reserve have further cleared the path for near-term economic growth. In fact, expectations for the U.S. economic growth in 2021 have been steadily climbing since the beginning of this year to currently over 6%.
Recovery in jobs and pent-up consumer demand, on top of the stimulus and excess savings rate during last year, provide a strong support for solid economic growth near-term, while a multi-trillion infrastructure bill, if passed, is supposed to provide an additional boost to the economy beyond this year.
The equity markets have responded positively to these trends, but the performance was uneven. While the U.S. stock market appeared to have steadily and calmly gained 6% during the first quarter, underneath the surface, the big drama of great rotation has played out with dramatic volatility in individual securities and big daily swings between growth and value stocks.
Broader economic recovery and rising interest rates have allowed Value stocks to gain the upper hand reversing some of their underperformance in 2020. While Growth stocks underperformed, they remain pricier vs. historic levels compared with Value, which leaves some additional room for Value to run in the near-term.
International Equity markets have lagged U.S. markets during Q1, as many countries continue to lag the U.S. in vaccinations, COVID case reduction, and economic recovery. This could prove to be a longer-term opportunity, as countries eventually get this pandemic under control, and valuations, especially in some emerging markets, remain more attractive.
Bonds and Gold were the weakest performers during the quarter due to rising interest rates and the strengthening U.S. dollar.
With most of the pandemic challenges of 2020 starting to appear in the rear-view mirror and the brightening near-term outlook, there are still plenty of things we are watching closely:
- Inflation. Growing concerns about inflation fueled by easy monetary policy and rapidly expanding fiscal spending could put further upward pressure on interest rates. This would further erode already measly real returns in the bond market. Gold, on the other hand, could benefit reversing recent weakness.
- Valuations. Equity valuations are at high levels by historic standards, and while these have been justified by low level of interest rates, if recent increase in longer-term interest rates persists, we could see some compression in equity market valuation. While a stock market correction is possible, there are other paths to lower valuation. If stocks simply do not go up as much as earnings in the near term, that would also lower valuation on stocks. Of course, negative real yields on short-term debt and plentiful liquidity sloshing around continue to favor stocks as the best way to beat inflation longer-term.
- Taxes. Both corporate and personal tax rates are expected to go higher under the current Administration. Higher corporate taxes would pressure after-tax profit margins and therefore corporate earnings, while higher personal taxes could negatively affect consumer spending. Both are potential headwinds to economic and corporate earnings growth.