Why Markets Have So Much Trouble Pricing The U.S. Recovery
It's not quite “man bites dog,” but the headline will still be a shocker when it lands amid other dry economic news: U.S. OUTPACES CHINA GROWTH THIS YEAR! There are more than nine unpredictable months ahead, but leading forecasters predict America will bounce back from last year’s lockdowns with nearly 8% growth in 2021, while Beijing has committed to just above 6%. China certainly contained the pandemic sooner and suffered less, but rich and mature economies aren’t supposed to outpace dynamic upstarts.
CHINA AND U.S. ANNUAL GDP (Y/Y %)
Source: Bloomberg. As of March 12, 2021. Note: For 2021, official Chinese estimate and U.S. market estimates.
This may help explain the market confusion about the strength and durability of the current recovery. Typically sober bond investors seem to believe in the boom, worrying about overheating as the surge of cash hits American households, while genetically optimistic stock investors are suddenly concerned that their discounted cash flows are about to vanish.
Both groups are probably wrong. Prices will likely rise as demand recovers and supply chains work through bottlenecks, but excess capacity and a wounded labor force should keep inflation in check. Meanwhile, if the familiar headwinds from “secular stagnation” winnow out the weaker players, there will be plenty of opportunity for companies that can adapt to technological change and post-pandemic preferences.
The current rosy outlook is a testament to America’s economic resilience, the Fed’s swift response, and a mere $5 trillion in combined fiscal stimulus. Who says you can’t throw money at a problem? In the last few weeks, data on personal spending, new home sales, and factory orders have all landed above expectations. Accelerating vaccinations and reopening schools offer a tantalizing picture of an American summer boom.
Will the speed of the recovery trigger overheating as wildly fluctuating yields suggest? Probably not.
Recall, the U.S. economy entered last year huffing and puffing into the end of the longest expansion on record. Even after a sizable 2017 tax cut and generous Fed support, the U.S. struggled to deliver growth above 2.2% in 2019. Meanwhile, there has been no change in either rising savings of “baby boomers” or continuing competition from developing countries to keep rates and wages low.
“Typically sober bond investors seem to believe in the boom, worrying about overheating as the surge of cash hits American households, while genetically optimistic stock investors are suddenly concerned that their discounted cash flows are about to vanish.”
Then, there are the lingering scars to the labor force. While unemployment registers officially at 6.2%, Treasury Secretary Janet Yellen is quick to point out that large numbers of misclassified or discouraged workers probably puts the actual rate closer to 10%.
If inflation is not a concern, a careful investor will naturally wonder if the patient can really bounce back stronger than before following what was after all a near-death experience last March. Many an emerging market has suffered a sudden stop in capital flows and rallied strongly after painful adjustment. But can the world’s deepest and richest financial markets deliver the best growth rate since 1984 after a recession that was deeper than what followed the global financial crisis?
Yes, but that doesn’t mean markets will continue rewarding undifferentiated classes of stocks. Initially, last year, investors swarmed into the COVID-beneficiary tech stocks while punishing COVID-vulnerable travel and leisure. Then there was the catch up for value, commodities, and post-lockdown plays. With the equal-weighted S&P 500 outperforming the market cap-weighted index since last fall, broad risk markets have recovered.
There is still opportunity, but now it gets tricky. Whatever the final GDP number this year, it will be much lower next year and the year after that. Even if President Joe Biden secures a big infrastructure and investment package, the fiscal support for the economy will be dwindling. Meanwhile, the new ‘normal’ will present new patterns for travel, urban commuting and shopping habits and new technologies will continue to reshape the competitive landscape.
With the S&P 500’s price-to-earnings ratio hovering in the low 20s, and bond yields looking competitive with dividend yields, investors can’t just buy the market—or even sectors from here. They will need to differentiate among firms that can deliver returns. There will be winners and losers across the economy, but it will take some close study to identify those that have built resilient business models and those that haven’t.
10YR YIELD AND S&P 500
Source: Bloomberg. As of March 12, 2021.
There are plenty of potential risks ahead. For all the good news on the pandemic, fresh outbreaks are still possible. For all the positive economic data and ratings upgrades, it’s hard to imagine that we will emerge without more corporate defaults. Even without surprises, there will be volatility as investors digest a year that has delivered such macroeconomic extremes. Still, a hard look at the past and the present suggests a future that is neither too hot nor too cold for companies that are resilient enough to thrive in post-pandemic times.