Economic Flash: Non-Inflationary Growth Is the Goal

subway view

March 2021

US Economy: Not in recession.

Recent economic data have met or exceeded expectations, including retail sales (+5.3%) and durable goods orders (+3.4%). Notably, personal income jumped 9.5% in Jan. due to $600 stimulus checks and enhanced unemployment benefits. More stimulus with broad support for individuals, local governments, and vaccine distribution is likely by mid-March.

US Stocks: New leadership?

While equities were broadly positive in Feb., what was interesting were the areas that saw the strongest performance as investors questioned whether companies that led the markets in 2020 would continue to in the reopening. Value sectors, including energy (+22%) and financials (+11%), appeared to separate themselves by outperforming growth stocks in the last few weeks.

Foreign Stocks: Rising tide.

While emerging markets posted modest returns in Feb., developed foreign markets continued to perform roughly in line with US stocks with post-Covid reopening the driving force. Somewhat surprisingly, Spain (+5%), France (+5%), Italy (+6%) were each top-performing markets despite a slower vaccination rate.

Fixed Income: Rate scare abates.

US interest rates rose sharply in Feb. unsettling financial markets globally. The 10-year Treasury yield has risen roughly 1 percentage point this year, to 1.5%, with much of the climb in Feb. TIPS yields followed Treasury yields higher in the latest surge, suggesting that investors are pricing in less accommodative Fed policy sooner than expected.

Real Assets: Great expectations.

Optimism about economic reopening continues to drive commodity prices higher. While precious metals prices remain weak, several major categories have seen robust returns year-to-date, including energy (+24%), industrial metals (+14%) and soft commodities such as cotton, sugar, coffee (+11%). Meanwhile, other real assets have seen very modest appreciation.

Alternatives: Managed futures lead.

Managed futures strategies took the lead year-to-date in the liquid alternatives space, as trend followers benefitted from anticipating rising interest rates and the rebound in commodities. Hedge funds recovered in February with support from higher level of mergers and acquisitions in the last few months and the ongoing rebound in equity markets.

Equities Total Return

U.S. Large Cap 2.8% 1.7% 31.3%
U.S. Small Cap 6.2% 11.6% 51.0%
U.S. Growth 0.2% (0.2%) 45.2%
U.S. Value 6.3% 5.7% 23.3%
Int’l Developed 2.2% 1.2% 22.5%
Emerging Markets 0.8% 3.9% 36.0%

Fixed Income Total Return

U.S. Agg. Bond (1.4%) (2.2%) 1.4%
TIPS (1.6%) (1.3%) 5.8%
U.S. High Yield 0.3% 0.7% 8.6%
Int’l Developed (2.5%) (3.9%) 4.1%
Emerging Markets (1.6%) (1.9%) 5.9%
Intermediate Munis (1.1%) (0.6%) 1.7%
Munis Broad Mkt (1.6%) (1.0%) 1.0%

Non-Traditional Assets Total Return

Commodities 6.5% 9.3% 20.3%
REITs 2.7% 2.6% 3.4%
Infrastructure 0.8% (1.4%) 1.1%
Hedge Funds
Absolute Return 0.8% 0.6% 3.7%
Overall HF Market 1.9% 1.7% 9.8%
Managed Futures 5.2% 3.9% 7.9%

Economic Indicators

FEB-21 AUG-20 FEB-20
Equity Volatility 28.0 26.4 40.1
Implied Inflation 2.2% 1.8% 1.4%
Gold Spot $/OZ $1734 $1968 $1586
Oil ($/BBL) $66 $45 $51
U.S. Dollar Index 112.0 116.0 117.7

Glossary of Indices

Our Take

US economic recovery in 2021 will continue to be driven by the Covid-19 vaccination rate, which is rising (albeit unevenly) after early stumbles. With this backdrop, we are not surprised that US interest rates have started to rise significantly, having expected them to steadily climb throughout 2021. That said, the pace of rising rates has been a little surprising and a reminder that a diversified portfolio must include income sources that are not as vulnerable to higher rates.

Investors are rightly concerned about rising interest rates for several reasons. First, given the runup in stocks and other risk assets in the past year, a sharp upward move in interest rates could lead to a repricing in the equities markets. Unprecedented monetary and fiscal stimulus has led investors to rationalize today’s above-average market valuations, and should interest rates head back up decidedly, it is intuitive to think stock market values could fall.

We do expect rates to continue to rise, but not wildly. Following the quick move up, it appears interest rates have stabilized in the early part of March. Given ongoing bond repurchases by the Fed and lower interest rates abroad, we could simply see rates return to the average for the past 10 years.

Second, the prospect of inflation is front and center. At this point, inflation forecasts remain generally tepid and market measures, such as the relative TIPS yield referenced earlier, do not suggest a near-term spike. Excess capacity and a labor market that hasn’t fully repaired are factors keeping inflation constrained. While near-term inflation might be more of a speed bump than a mountain, current and anticipated government spending does point to a more inflationary environment at some point. Consequently, as is the case for rising interest rates, we recommend portfolio positioning that can protect against inflation.

What We’re Doing

We continue to recommend bigger equity positions at the expense of fixed income. Our base case remains that equities will be supported by ongoing, tremendous fiscal and monetary stimulus, with cyclical sectors sensitive to economic reopening garnering most investor interest. We are also evaluating our real assets allocation to make sure we have the right combination of exposures should inflation accelerate more quickly. Additionally, we are focused on sourcing alternative investments to improve both the risk and return characteristics of portfolios.