Fire Capital Market Update - 1Q 2021

TURN THE PAGE

At the forefront of our outlook, the global economic recovery appears to have taken root on the back of historic monetary and fiscal stimulus. The two largest economies, both the U.S. and China, are showing signs that this year will exhibit robust growth.

Despite protracted COVID-19 related restrictions, the manufacturing and service sectors for both countries are expanding at levels not seen in several years prior to the pandemic.  As a result, gains in cyclical sectors and smaller capitalization companies of the broad equity market have begun to unfold.

Outside of the U.S. we continue to favor emerging markets in the Asia region.  Over the last several years we have marveled at the growth and success of consumer-focused companies as China’s middle class expands. We believe multiple fundamental catalysts are present for even further innovation to capitalize on this trend. Namely, a large technical workforce and robust internal financial markets are positioned to provide the sophisticated capital & labor necessary to enable economic gains that endure into the future. As vaccines have slowly begun to be distributed worldwide, businesses are in preparation for more pent-up demand. The U.S. consumer is getting another shot in the arm (no pun intended) with Congress recently passing an additional $900B in relief stimulus. With a fresh round of checks being deposited, the savings rate in the U.S. may surge as it did in mid-2020. This also bodes well for future discretionary spending.  If the months immediately following the first round of stimulus are any indication, consumer spending may again exceed pre-pandemic levels.

Meanwhile, the transition to Work From Home (WFH) has already led to productivity increases not seen in over a decade. Firms in nearly every industry are confronted with this transformation in working culture.  As a result, we’re seeing an increase in technological capital spending as employers are revamping tools to meet the flexible working environments of the future. As the largest and most direct benefactors of the WFH movement, the Technology sector has led all others since the rebound began – sending indices to multiple new highs along the way. Typically, capital spending precedes a rise in earnings, and we have already noted positive revisions to earnings expectations as we head into the first earnings season of the new year.

As it happens every January, we pause to consider what the upcoming year has in store.  For many of us, the arrival of this new year has been much anticipated with hope and optimism that we may soon emerge from our homes and social distancing regimens. Perhaps, 2021 has not quite begun as we had imagined but despite the challenges that remain, we believe that the underpinnings for future sustained growth are abound.

Reflecting this positive perspective for growth, equity valuations in the U.S. have become relatively expensive once again. P/E multiples at current levels have not been seen since the early 2000’s. Accordingly, reported earnings and guidance for the future will be a major focus for at least the first half of the year. Those firms who are best able to navigate near-term pitfalls and leverage the tailwinds for future growth will justify their valuations.  Overall, we see this as a stock pickers market.  Beyond rising earnings expectations, clear contributors are accommodative financial conditions provided by expansive monetary and fiscal policy.

To that end, the result of the Georgia Senate run-off gives way to a blue wave to usher in the Biden administration.  With this as a tailwind, primary agenda items for the first half of his term are likely to be centered around the ability to expand fiscal policy. While details are still scarce, Biden has previously proposed $1.3 trillion in infrastructure spending over the next 10 years.

Any new infrastructure bill is likely to build from last summer’s Moving Forward Act, a $1.5 trillion bill introduced in the House of Representatives that includes a variety of new spending for surface transportation, rural broadband, aviation, and climate-related initiatives.

A comprehensive infrastructure package such as this will likely at least be partially offset by tax increases.  Proposed changes include: top individual rate up to 39.6%, corporate rate up to 25%, cap gains and dividend rate up to 25-28%.

While we wait to see how the Biden administration’s policies take shape, the Federal Reserve (Fed) has been well underway navigating the dynamic economic environment. As outlined in our blog series, the Fed has a dual mandate to deliver maximum employment while maintaining price stability.

As mentioned, the employment recovery has been, and will likely continue, to be wavy for the seeable future. After four consecutive months of improvement, the unemployment rate increased in December 2020. While still concerning, most of this contraction was confined to the hospitality sector. As COVID-19 vaccines make their way through the population, we expect that many of these jobs will be restored. Importantly, employment in other areas of the economy improved while labor wages remained in check. This reflects a push-pull relationship between an increase in the demand for workers as the economy grows, and the more flexible arrangements WFH provides as people continue to migrate to lower cost of living geographies. Maintaining tame labor costs is important because it is the primary driver in the Fed’s second mandate – keeping inflation expectations under control.

The factors contributing to an increase in inflation expectations are complex, but labor costs are a core component. Inflation has been kept stubbornly low in developed economies over the last decade in large part because workers competed for jobs that could be performed in lower wage regimes such as China. A component of Biden’s "Build Back Better" program proposes to increase wages through progressive labor policies such as increased union power and higher minimum wage.  As wages are ordinarily a function of supply and demand, a recent decline in the labor participation rate provides slack in the near-term as we wait to see how those policy initiatives may be implemented.

Another core element of the inflation puzzle is money supply. The Fed has committed to continue asset purchases through at least the balance of 2021 even as we observed the money supply explode in 2020. Indeed, expectations for rising inflation may already be upon us as treasury yields spiked with the transition of the Senate in anticipation of the aforementioned potential Biden policy action(s) aided by a Democratic Senate majority.

As a result, a key risk to this expansion story would be if the Fed was forced to raise interest rates to cool inflation before the unemployment rate has sufficiently recovered. Given current unemployment is double pre-pandemic levels, it may take multiple years to fully recover. If the Fed were to raise interest rates too soon, current equity multiples may not be sustainable.

Additionally, with the current budget deficit already greater than GDP (with more spending likely on the way), servicing the national debt would make for a precarious situation to say the least. This is something we will be watching closely and have already positioned client portfolios to navigate accordingly.

Undoubtedly, we are excited about the opportunities ahead of us. It is time to turn the page on another year and move forward with great enthusiasm. While challenges remain, the ingredients for future growth are present for both developed and emerging markets alike. Citizens of the world have largely embraced more flexible working conditions and productivity has benefited. Upon reflection, we find solace that better times are ahead, and our resiliency shall be rewarded. In such moments may we be reminded of the words of the former U.S. Senate Chaplain, Peter Marshall,

“A different world cannot be built by indifferent people. May we think of freedom, not as the right to do as we please, but as the opportunity to do what is right.”

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