The past year has been a novel experience on a global scale. The pandemic has caused the tragic loss of lives and livelihoods, as well as fast-paced innovation as individuals and institutions rapidly adapted with new approaches and technology. But the unique nature of the crisis also represents a case study in causality—or cause and effect.
A causal relationship, where one event contributes to the occurrence of another, can sometimes be direct: If I flip the switch, the light turns on. But real-life relationships are rarely this clear, and effects are far more often uncertain, ambiguous, and debatable. If I stay up late studying for the test, will I be more prepared and earn a better score? Or will my performance suffer from a lack of sleep? Parents and students will rarely agree.
Strange conditions created by the COVID-19 crisis provide many examples of causality. The emergence of the threat (cause) led to a rapid, global economic shutdown (effect). A lack of outlets for physical interaction led to the rise of virtual experiences. And an inability to spend on travel and leisure caused spikes in demand for some kinds of physical goods. Now, as vaccination progress accelerates and our attention shifts to the economic and market implications of the global reopening, we face a new slate of causes and effects with massive implications that are also highly complex and far more ambiguous.
- Will the large and experimental stimulus programs and policies used during the crisis serve as an effective bridge across the crisis that prevents permanent damage, or will it only exacerbate the next recession through soaring levels of debt and deficits?
- Will pent-up demand (willingness to spend) and strong consumer balance sheets (ability to spend) drive a rapid recovery in earnings and jobs–or will it push the economy toward problematic inflation?
This edition of Investment Strategy will delve into these topics and the range of outcomes they could represent.
Market Recap—First Quarter 2021
Propelled by an accelerating vaccine rollout and a fresh jolt of fiscal stimulus, the reopening rally continued in the first quarter amid growing optimism—with the most robust recovery witnessed among last year’s hardest-hit corners of the markets.
U.S. stocks led the way with a return of 6.2 percent for the S&P 500 Index. Energy was the best-performing sector within the S&P Index, with a return of nearly 31 percent for the quarter, as oil prices rose alongside higher demand expectations for the months ahead. Financials also performed well as bank capital restrictions imposed during the crisis were eased and a steeper yield curve boosted prospects for profitability.
In a stark reversal from investors’ preference last year for larger companies believed more resilient to pandemic shocks, small-cap stocks posted the strongest performance for the quarter—particularly value-oriented companies more tightly linked to levels of economic activity. Small-cap value (as measured by the Russell 2000 Value Index) showed returns of more than 21 percent during the first quarter and a staggering 97 percent over the past 12 months.
International stocks finished the quarter behind U.S. equities. With the dollar strengthening amid a brightening outlook for U.S. growth conditions, international returns for U.S. investors were somewhat muted, as shown in Figure One. Europe posted strong gains, in part due to enhanced stimulus measures from the European Central Bank, and Emerging Markets stocks continued to benefit from the global inventory restocking cycle.
Figure One: Asset Class Performance—First Quarter of 2021
Asset class returns are represented by the following indexes: Russell 3000 Index (U.S. stocks), Russell 2000 (small-cap stocks), MSCI All-Country World ex-U.S. Index (international stocks), Bloomberg Barclays U.S. Aggregate Bond Index (U.S. bonds), and Dow Jones U.S. Real Estate Index (real estate).
The sharply rising tide of economic optimism had the opposite effect on bond prices during the first quarter of 2021. The Bloomberg Barclays U.S. Aggregate Bond Index fell 3.4 percent during the quarter, representing the worst quarter since 1981 for core investment grade U.S. bonds. Bond price declines were driven by Treasury yields that moved sharply higher during the quarter. Even so, yields remain at the low end of their historical range. Investors in search of income maintained a strong appetite for credit, causing already narrow credit spreads to tighten further during the quarter.
Direct and Indirect Effects
The coronavirus remains the key driver of the trajectory of the economy and markets. Here, the causality relationship is pretty direct: Continuing progress against the virus supports growth, while bad virus news could cause setbacks.
Although the U.S. vaccination program has been quite successful, with well more than 200 million doses administered, progress has been far slower elsewhere, as shown in Figure Two. This is largely due to vaccine supply problems that will eventually be solved. But given the highly interconnected nature of the global economy, uneven global progress risks a continued drag on growth. And because each new infection (regardless of location) offers this relentless virus another chance at successful mutation, the threat will persist until vaccination success is global.
Figure Two: Percent of People Fully Vaccinated by Country (as of April 20, 2021)
Sources: Our World in Data; The New York Times COVID-19 Vaccination Tracker
Other events that have occurred during the crisis have far more complex and indirect relationships. These include the effects of policies enacted to fight the crisis and business and consumer behavioral changes, such as spending and saving patterns.
Aggressive policy action began early in the crisis and only accelerated from there. The U.S. Federal Reserve acted in swifter-than-expected fashion by cutting its fed funds target rate to zero on March 15, 2020, alongside the launch of a $700 billion bond-buying program dusted off from its financial crisis playbook. What followed was an alphabet soup of programs aimed at restoring market liquidity, maintaining confidence, encouraging banks to lend, and, for the first time ever, supporting businesses and corporations through direct lending. These programs caused the Fed’s balance sheet to swell from $3.9 trillion in March 2020 to $6.6 trillion by the end of last year.
Deficit spending, the other major policy lever was also rapidly and forcefully pulled, culminating in the $1.9 trillion American Rescue Plan Act passed in March. So far, these programs tally to a $6 trillion cash infusion into the U.S. economy—and that’s before another potential trillion-dollar stimulus jolt from the proposed infrastructure package currently under discussion in Washington.
These stimulus programs represent a flood of liquidity into markets, which is to say, money that must go somewhere. With little competition posed by historically low interest rates, it is no surprise that money has poured into financial assets and the housing market, boosting prices, elevating valuations, and dampening volatility. This powerful influence of liquidity on financial assets forms the basis of one of the most influential investment mantras of the modern era: Don’t fight the Fed.
Our view is that the policy tailwind is likely to persist for some time. Although we could see a slowdown in its bond-buying program that could place further upward pressure on longer-term interest rates, the Fed has made clear its intention to be patient with its hard-hitting policy stance while the labor market heals. While the price of financial assets and corporate earnings expectations have recovered to pre-crisis levels, Figure Three illustrates the significant ground yet to cover—roughly nine million jobs—before the labor market is fully healed.
Figure Three: U.S. Employment Deficit
Sources: Bureau of Labor Statistics; Bloomberg; FRED (St. Louis Fed)
Impact of Debt and Deficits
The goals of the policy actions described were to bridge the economy across the pandemic, prevent permanent scarring, and return growth to its pre-pandemic trajectory. If policymakers have learned anything from history, it is the dangers of slow or inadequate crisis response. However, stimulus at this scale is unprecedented and experimental, thereby magnifying the risks of policy error if something were to go wrong. In 2021, the amount of U.S. government debt is expected to exceed the size of the economy—or gross domestic product (GDP)—for the first time since World War II.
This degree of deficit spending naturally raises concerns over our ability to manage a ballooning debt burden. To date, the impact of soaring debt levels has been muted, as the exceptionally low interest rate environment has lessened the impact on debt servicing costs. However, if rates were to rise, servicing the public debt would consume a greater share of government resources, risking harm to America’s competitiveness on the global stage.
While we do not believe the current growth rate of public debt within the U.S. is sustainable, examples suggest that dangerous outcomes such, as sharply rising interest rates, are not a foregone conclusion. Similar policies enacted amid the financial crisis failed to spur runaway inflation or rising rates as feared at the time. As shown in Figure Four, Japan provides another case study, as its public debt has nearly doubled as a percentage of GDP over the past decade, while the yield on its 10-year government bonds remains near zero—far lower than the U.S. 10-year Treasury.
Figure Four: Government Debt as a Percent of GDP and Interest Rates
Sources: International Monetary Fund; Bloomberg; yields as of 4.12.2021
A final fiscal consideration is the impact on tax rates. The infrastructure package currently being discussed has the potential to provide economic support over a longer time horizon, improve productive capacity, and broaden the jobs recovery. It also raises risks of higher corporate tax rates that could harm profits for companies whose stock prices are already richly valued relative to earnings.
Reopening Fuels High Expectations
A combination of factors, including the acceleration of vaccines, aggressive stimulus, pent-up demand, strong consumer spending power, and growing confidence sets the stage for a period of outsized growth. During its March meeting of the Fed’s Open Market Committee (FOMC), participants projected a range of GDP growth for 2021 between 5 and 7.3 percent, with some forecasters across the investment community calling for even higher growth levels. As shown in Figure Five below, GDP growth at these levels would dwarf those seen in the leadup to the late ’90s technology boom and may even surpass levels last seen in the 1980s.
Figure Five: U.S. Real GDP Growth (1970 – 2020)
Percent change in annual real GDP and percent change in annual PCE (chain-type) price index.
Sources: Federal Reserve Bank of St. Louis, Federal Reserve Summary of Economic Projections.
An interesting aspect of the growth story is how this most unusual recession could affect behaviors on the other side. Often, consumers’ enthusiasm and ability to spend are dampened amid a recession, as household balance sheets are weakened, and banks are more reluctant to lend. This reticence can slow the trajectory of economic recovery. But this time is quite different; those households spared from job losses or direct financial impacts from the pandemic may have seen little change to their income, even as their energy costs and mortgage rates declined.
While some of this spending capacity made its way into Pelotons and backyard gardens, much went into savings accounts and reducing credit card balances. Meanwhile, investment portfolios rallied, and as shown in Figure Six, a combination of strong demand and plummeting supply caused home prices to appreciate at the fastest rate since the 2006 leadup to the housing bubble.
Figure Six: U.S. Housing Price Change (2000- January 2021)
Sources: Bloomberg; S&P CoreLogic Case-Shiller National Home Price Index
U.S. consumers now possess an estimated $3 trillion in excess savings, compared to pre-pandemic levels, representing an unprecedented capacity to spend. And the University of Michigan Index of Consumer Sentiment touched a one-year high in March, suggesting that they also have a willingness to spend. The potential energy supplied by a strong and willing consumer may propel the economy forward as the reopening continues.
A global pandemic is probably among the most deflationary events imaginable, as chronicled by stark images of idle factories, empty office towers and stadiums, and airport tarmacs converted into long-term parking for jets. But a natural result of the growth expectations and stimulus policy described above is rising inflation anxiety. Inflation is the heat produced by the economic engine, and moderate and stable inflation is evidence of a healthy economy. But in contrast to the past few decades of economic policy within the U.S., the conversation has turned from the risks of too little inflation to those of too much.
We think about inflation across two dimensions: time and type. Will inflation be short term (or transitory) or form a longer-term trend? And where is it likely to occur—within the prices of goods, the level of wages, or within asset prices?
Over the next year, we expect to see pockets of inflation as the economy reopens. This could take the form of rising prices for gasoline, event tickets, lumber, and goods, as well as wage hikes. Restarting a system as complex as the global economy will be bumpy, and supply and demand mismatches and supply chain disruptions are likely to occur. Over the longer term, however, we expect these effects to work through the system and inflation to return to more normal levels. Because it is more closely linked to stimulus policy, the asset price inflation we have witnessed could linger depending upon how long the Fed maintains its highly growth-oriented, accommodative stance.
Separating Cause from Effect
The conditions described above paint a very complex picture, and any attempt to diagram relationships with lines and arrows quickly resembles the chalkboard of a football locker room. Without a doubt, many economics PhDs will be minted on the study of the unique economic impact of the virus, as well as the short- and long-term effects of policy and behavioral reactions to it.
In the post-pandemic era, our best advice is also our mantra: The biggest driver of good outcomes is proper asset allocation. The time to consider changes is from a position of strength rather than being forced to react in times of stress. With stock indexes at all-time highs, now is the time for investors to meet with their financial advisors to evaluate and tweak their plans, if needed. And given the wild market swings we’ve seen, it is possible that asset weights have gotten out of whack, creating over- or under-exposures easily fixed by rebalancing portfolios.
 Cheng, Jeffrey; Powell, Tyler; Skidmore, Dave; Wessel, David, “What’s the Fed Doing in Response to the COVID-19 Crisis? What More Could It Do?,” brookings.edu, 2021
 Davidson, Kate, “U.S. Debt Is Set to Exceed Size of the Economy Next Year, a First Since World War II,” The Wall Street Journal, 2020
 Kennedy, Simon, “Consumers Saved $2.9 Trillion During the Pandemic. Their Money Will Drive the Global Recovery,” Bloomberg.com, 2021