The incoming economic data over the last two months is firmly corroborating our 2021 US GDP forecast of 6.8%. While it is human nature to extrapolate existing trends, history tells us that economic growth and the scope for economic surprise tend to be mean reverting, and we believe quarterly growth will peak sometime in 2021 and wane into the later part of the year and 2022.
To illustrate, one reliable indicator of growth is the ISM manufacturing PMI which has likely formed a cyclical top in March at 64.7 (a multi-decade record) and has since eased to 60.7 in April, with all subcomponents (new orders, production, employment) coming down.
There is understandably much attention on the fiscal spending proposed by the White House in the form of the American Job’s Plan (proposed at USD2.3 trillion) and the American Families Plan
(proposed at USD1.8 trillion), which will no doubt play a key role in buttressing risk asset prices.
This spending is spread out over eight to ten years, however, and is offset by a series of significant tax increases.
Even accounting for the upcoming fiscal spending packages, if we zoom out to take a strategic perspective, the overall picture is that the net fiscal impulse in 2022 and 2033 will fall on a relative basis, resulting in a fiscal drag.
As US growth is due to peak ahead, what will be the impact on markets?
One area of implication is inflationary fears and its effects on markets. While inflation fears are likely to overshoot over the near term due to base effects and as growth reaches a crescendo, we believe that an easing in economic growth after will conversely help alleviate fears of an inflation crisis.
The fears of hyper-inflation due to post-GFC unconventional monetary policy that we see today are not new. In fact, the alarming inflation headlines today are reminiscent of 2011-2012, during which many felt certain the unprecedented monetary easing by the Fed was bound to result in excessive inflationary prices, until reality proved otherwise when core inflation hit a 50-year low in 2013.
A thoughtful assessment of the situation today leads us to believe that this is again likely an inflation scare, not a crisis, and we expect inflation to rise gradually ahead but not in an uncontrollable fashion.
One reason is that temporary forces in play today such as low inventories and long delivery times due to the pandemic are expected to resolve.
In addition, the disappointing non-farm payroll report miss last week (226k reported versus 1 million expected) indicates that some time is required to absorb the slack in the labour market, before inflationary pressures can rise significantly.
Even as commodities prices can continue to rise due to growing demand from the global economic recovery and infrastructure renewal, as well as relatively inelastic supply over a near-term horizon, during the last commodity bull run in early 2000s, core inflation levels did not rise above trend in a sustainable way.
A post-growth peak alleviation of inflationary fears, which subsequently caps the rise in bond yields, is a pattern that we tend to see in previous cycles. A sharp rise in bond yields has driven the recent turbulence in long duration assets, such as investment grade bonds, and high growth stocks in the technology sector, and this could ease ahead as the scope for a further significant spike in bond yields over the near-term seems limited to us.
Against this backdrop, as we begin to transition into a mid-cycle stage of the economic cycle, earnings growth will play an increasingly key role in driving equity upside, and given this, we continue to favorably view marquee blue-chip tech stocks with solid earnings prospects. That said, as the economic re-opening intensifies, we see higher uncertainty over those very high-growth tech names that do not have stable earnings profiles and have benefitted from the work-from-home narrative due to the pandemic.
Looking ahead, even as we maintain a positive outlook for markets against a healthy backdrop for earnings and economic growth with abundant liquidity, our conviction is rightly lower as the risk-reward has become less attractive given higher risk asset prices.
Given that valuations indicators, such as the high price-to-earnings ratios and equity-to-bond ratio are near cycle highs, there is a case to be made that buoyant equity markets have already made significant progress in discounting the economic recovery. While we also expect the rotation to cyclicals to have more legs as growth continue to improve, most of the easy gains in this rotation is behind us and it is important in our view for investors to be more selective in their bottom-up individual stock selection.
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Version: July 2020