The 1984 versus 2021 analogy, a popular topic these days, is an interesting one on a broad basis. We confine our discussion to similarities related to the forward-looking economy and the implications for inflation and markets. Suffice it to say, no one has seen this configuration of a recovery—characterized simultaneously by extraordinary fiscal stimulus, Modern Monetary Theory in action and the potential for consumer “revenge” spending—which we believe will, together, produce economic growth rates last seen in 1984 (Exhibit 1). The current U.S. administration’s “Build Back Better” message of economic revitalization takes a different approach than the 1984 “Morning in America” campaign ad, but as this writer sees it, the intent is much the same: to bolster consumer confidence and animal spirits.
This description of current economic conditions may be U.S.-focused, but many of the fiscal, consumer and central bank conditions hold across other regions, as well. Furthermore, the impact of U.S. policy will likely be felt far beyond American shores.
The U.S. recovery is robust and could reach levels not seen in decades
A broad-based recovery is underway in China
The 2021-22 economic outlook
Not since the 1984 recovery from the double-dip recessions of the early 1980s has the outlook for annual economic growth been this robust. Consensus expectations for U.S. and global real GDP growth in 2021 center around 5.7% and 5.6% respectively, but United States quarterly real growth estimates run as high as 9%–11% in either the first, second, third or a combination of quarters. The magnitude of the U.S. stimulus thus far stands at 29% of GDP, yet it is only one leg supporting the growth outlook. This staggering number does not even include the two-part (physical and human) $3.8 trillion infrastructure proposal, with even more government spending potentially to come.
Excess consumer savings in the United States of over $2 trillion—or about 10% of GDP (Exhibit 3)—together with the spending power of Europe and the rest of the world, create additional support for strong growth expectations. Consumer spending will likely take on “revenge” or “spend it all now while you can” characteristics that would be in keeping with pre-global financial crisis (GFC) U.S. spending habits. A colleague has pointed out another example of post-existential threat spending—in the aftermath of World War II.
Liftoff! In the United States, over $2 trillion of excess spending potential had piled up by year-end
Excess savings in Europe could reverse as confidence returns
Inflation expectations might be a bit low in the United States and likely in the rest of the world, too
What this type of hypergrowth, which has not been seen for over 35 years, could do for wages, commodities and housing prices (or owners-equivalent rent) is hard to calibrate. We anticipate a moderate rise in inflation expectations and somewhat more persistent inflation—beyond just a transient “base effect”—induced rise in prices over the next couple of quarters. Here’s why:
Inflation is an important focus of the Federal Reserve’s (Fed’s) policy. The Fed’s September announcement of a new flexible average inflation target allows for inflation to run above the long-run 2% target over shorter time periods, as the goal is now to achieve an average 2% long-run rate of inflation.
The Fed and the current U.S. administration are both advancing a rising wage and employment agenda for the bottom quartile of the income spectrum, which will likely result in a continuation of loose fiscal and monetary policy. We have doubts the labor participation rate will rise smoothly to meet labor demand as the economy rebounds; that could put additional upward pressure on wages. Additionally, fiscal policy, which has traditionally been counter-cyclical, may this time run well into the expansion, putting meaningful upward pressure on inflation and interest rates (Exhibit 5).
At this stage in the recovery, expansionary fiscal policies could pressure inflation and interest rates upward
Supply constraints from semiconductors and energy will likely contribute, on the margin, to inflationary pressures, and the cost of services is already rising as demand percolates. That said, the disinflationary pressures from technological innovation and productivity dynamics are not going away, and should counter some of the cyclical and pandemic-related inflationary forces.
Consistent with our view that inflation expectations could see a moderate uptick and price increases could be less short-lived than some may anticipate, we are allocating to longer- as well as some shorter-dated TIPS, and have an allocation to broad commodities as well as gold for those mandates that allow it. This allocation has room to grow depending on whether expectations for growth—both global and especially emerging markets—are met. Supply issues have not been an important driver of commodity prices over the past several years, but with OPEC+ cooperation, production constraints by U.S. energy producers and the potential for higher food prices, we may get a faint version of a commodity super cycle—a multi-year period in which commodities trade above their long-term price trends.
The outlook for near-term equity upside is looking more limited
We believe much, but not all, of the 2021 economic rebound has already been discounted in U.S. and global equity prices. Cyclical and value stocks should outperform modestly over the next few quarters, driven by the potential for earnings beats based on revenue and modest pricing power surprises in service sectors, as well as by companies with operating leverage. Additional support for cyclical sectors should be provided by the resumption by banks of dividends and buybacks, and for energy companies by a rise in oil prices. We do not expect the 17% outperformance of U.S. value over U.S. growth seen in the last two quarters to continue at the same magnitude, but we believe value outperformance has more room to run. Therefore, we retain our overall value tilt within U.S. and European markets for now.
Growth and technology stocks everywhere appear on the expensive side of their trading histories. Depending on the speed and magnitude of rate increases, growth and tech stocks should participate in, but not lead, markets, at least over the next two hypergrowth quarters of 2021 (Exhibit 6). We find it increasingly hard to identify pockets of material undervaluation globally. Those markets with the most leverage to global growth, such as Japan, European value and emerging markets, have driven most of our overweights and/or first-quarter additions to equity risk.
The rise of interest rates represents a material challenge to what the market is willing to pay for each percentage point of revenue growth
China, as mentioned above, is on a post-pandemic policy course and has already begun to pull back on the stimulus reins, albeit with less force than in the overreaction of 2018. The country should continue to be a major driver of global growth, even at its lower stated goal of 6%-plus growth. Nonetheless, the aggregate growth differential between emerging markets and developed markets is unlikely to provide the high level of rewards for risk-taking that emerging market (EM) investing has offered in the past. That said, inflows into EM equities have risen consistently over the past 27 weeks. Our portfolios maintain their EM overweight versus the MSCI ACWI benchmark, consistent with the global GDP growth surge over the course of 2021–2022, and in line with our Long-Term Capital Market Assumptions for superior EM returns over the next 10–15 years or two business cycles.
Summary of our outlook and portfolio positioning
The global economy looks ready to surge at a multiple of long-term trend growth rates, and should continue that above trend-line growth over the course of 2021 and 2022. Our portfolios are overweight equity risk, reflecting a growth optimism—tempered by estimates that much of that optimism has been discounted over the past year. Our expectations are for mid-single-digit returns for the balance of the year. We believe our allocations to U.S. and European value, Japan and emerging markets should capture the best part of the financial markets’ response to the extraordinary conditions put in place by central bank policies and fiscal stimulus, combined with pent-up demand and, as indicated by TIPS breakevens, an above-trend-line growth inflation premium that is somewhat above current inflation expectations.
There are plenty of risks to consider, ranging from new waves of coronavirus variants to speculative activity within the SPAC/IPO market to overall retail investor enthusiasm. There are also signs of excess liquidity that can be seen in the prices of digital art and housing. We are aware of and watching these risks, though at this time we are not calling for broader concern. We remain comfortable with our overall pro-risk positioning against the backdrop of a global economic recovery and continued support from fiscal and monetary policymakers.