It was eighteen months ago now that we first starting hearing about a growing flu pandemic in the Chinese province of Wuhan.  Back then, with the stock market at all-time highs and the economy humming along, few were paying attention to this situation in an isolated place so far away.  A month later, after cases starting multiplying in South Korea, Italy, Britain and then the west coast of the U.S., investors started paying attention.  Economic shutdowns across the globe put the problem front and centre, resulting in the fastest 30% decline in the stock market on record and then the worst economic collapse since the 1930s, though self-imposed this time around.  I recall fielding calls from friends, some of whom I had known for decades and who had never asked me any questions about the stock market, wondering if they should be getting out of the market rather than watching their retirement plans deteriorate further.  While I suggested that such periods of panic are always better times to try to ‘stay the course’ and look for buying opportunities, I clearly under-estimated and could never have envisioned a situation where the stock market would blow through all-time highs in such a short period of time, especially if I was told at that time that the virus would still have parts of the economy shut down eighteen months later!

The game changer for markets in March of 2000 was the action of the U.S. Federal Reserve, in conjunction with most other global central banks to throw the full weight of their support to financial markets.  Not only did they basically cut interest rates to zero, they injected further massive ‘financial liquidity’ into the markets by increasing their Quantitative Easing program under which they were buying treasury and mortgage securities of US$120 billion per month, inflating their balance sheet from under US$4 trillion to over US$8 trillion in the process.  They did everything they could to support financial markets outside of going out and buying stocks themselves.  This backdrop of support emboldened investors to begin taking more risk.  Confined to their homes and without many typical outlets such as sports and entertainment, retail investors also jumped in, armed with stimulus cheques issued by governments, who themselves were inclined to forget about debt worries in the short term and focus on keeping money in the system.  The first wave of beneficiaries of this wave of buying were the growth stocks, since their longer-term earnings estimates were not being discounted back at much lower interest rates, thereby creating higher valuations.  The big technology companies were clearly the biggest winners in this re-rating and they backed up this confidence with earnings growth during the pandemic closure that exceeded both their own expectations as well as the results from almost all other goods and services businesses, which were mostly shut down.  Apple, Amazon, Alphabet, Facebook, Microsoft, Netflix and Shopify lead that group.  The other beneficiaries of this increased risk taking were the ‘stay at home’ stocks that fit the new reality of remote work and leisure and an accelerated move to online activities.  New names such as Zoom, Peloton, Docusign and DoorDash all fit that profile and rallied sharply despite being far from profitable, in the traditional sense.  While stocks were rallying, so were bonds with the massive liquidity injections from central banks and lack of any inflationary pressures.  The benchmark 10-year U.S. treasury bond dropped from almost 2% in early 2020 to a low of under 0.5% in August.  Other risk assets also rallied, with cryptocurrencies such as Bitcoin rising from under US$10,000 to over US$30,000 in 2020, drawing money away from the traditional store of value, gold, in the process.

That situation went on for the first six months of the bull market, but then the narrative changed dramatically in early November when Pfizer, and then Moderna, announced in short order they had each achieved over 90% effectiveness in preventing Covid-19 with their new mRNA vaccines.  While trials were still early and limited to somewhat smaller samples, stock market investors were not waiting around for the final results.  The pandemic was done with, the global economy was going to re-open and recover, and the stock market needed to begin to reflect that new reality.  For the subsequent seven months the cyclical sectors of the stock market, which had thus far lagged in the recovery, suddenly took the lead.  Financials, Energy, Industrials and Basic Materials sectors all rallied sharply while the big tech stocks effectively ‘flatlined’ for a period of time despite continuing to report blowout earnings growth.  The fly in the ointment for the growth stocks was the sudden firming of interest rates, as the 10-year Treasury yield rallied from 0.50% to a high of 1.75% earlier this year.  This ‘normalization’ of interest rates became a huge tailwind for bank stocks and also presaged some higher inflationary expectations that benefitted cyclical/value sector of the market.  This was a complete reversal from the first six months of the advance.  While it wasn’t apparent strictly from looking at major averages such as the S&P500, the rotation was much more apparent in the small cap and value indices.  From early November 2020 to the end of May 2021, the Russell2000 small cap index rose over 50% while the ‘growth oriented’ Nasdaq Index gained under 20%.  Of course, maybe this is all just suggesting that expectations are too high ‘overall’ when a gain of 20% in six months is judged as inferior!

Fast forward to June and July this year and the situation has once again reversed.  Growth stocks have outrun their value stock counterparts sharply over the past two months, much as they had for most of the past ten years.  The impetus this time around seems to be doubts about the sustainability of the current high level of economic growth as well as the impact of the powerful Delta variant on the (unvaccinated) population.  The bond market mirrored these worries as U.S. Treasury yields have retracted from their mid-May peak of 1.75% to as low as 1.18%.  While this is still well above the cycle low of less than 0.5%, it is paradoxical to see such a pullback in yields with economic growth running over 8% in the past two quarters and inflation at a 14-year high.  Clearly investors are buying into the rhetoric of the U.S. Fed that these inflation issues will be ‘transitory’.   Our view continues to be that inflation will remain persistently high for longer than investors expect right now.  Supply chain problems, tighter end markets, material shortages, rising consumer inflationary expectations and lengthening delivery times all suggest price pressures remain.  But the good news for investors is that this pricing power for corporations is allowing them to keep profit margins higher for longer, as is being demonstrated in the substantial earnings ‘beats’ we have seen in the past month.  In the end, while the ‘cyclical/value’ trade has taken a rest in the past two months, we think there is far too much economic stimulus in the system to see any significant pullback in economic growth and we are a long way from the end of this new cycle, which only started a year ago.  This higher economic growth support higher profits and therefore help stock valuations.  The chart below shows how massive both the monetary stimulus (blue line showing money supply growth) has been as well as the fiscal support (red line showing federal government budget deficit as percentage of GDP).   Both measures are at multi-decade highs and provide huge economic tailwinds.

US Monetary and Fiscal Policies

While the immediate response has been a surge in growth, at some point, all of this stimulus will necessitate an interest rate response to control inflation as well as some measures to deal with record debt levels.  But for the next few quarters we believe that investors will be more focused on the strength of this recovery.  We are seeing a global spread of this recovery as vaccination rates rise.  Separate surveys of European businesses recorded the strongest increase in activity for more than two decades, suggesting the continent is set for the kind of growth already being experienced by the U.S.  Surveys in Australia, India and other parts of Asia, however, suggested the pace of global economic recovery continues to depend on the course of the pandemic.  The data indicate that the U.S. expansion is entering a new, more measured, phase. Economists surveyed by The Wall Street Journal estimate the U.S. economy grew at a seasonally adjusted annual rate of 9.1% in the second quarter, which would be the second fastest pace since 1983, topped only by last summer’s rapid rebound from the pandemic-related shutdown.  While this will slow further in the back half of 2021 and into 2022, we think that the growth risks are on the upside.  Demand remains strong and the only impediment in the short term are driven by supply side issues.  The global supply problems that accompanied a rapid surge in demand earlier this year have yet to be resolved.  The major risk, in our view, is that continued price increases for labor, raw materials and transportation threaten to keep inflation elevated longer than central bankers are counting on right now.  That would then necessitate an interest rate response which would send ‘shudders’ through the stock market, much as they did during the infamous ‘Taper Tantrum’ back in 2013.

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