As we look out over the balance of 2021 and the next few years, economic growth assumptions seem reasonable. COVID stimulus so far has been used to support short-term objectives of maintaining consumer spending and bailing out badly damaged sectors and businesses that have suffered a near death blow from virus-induced disruptions. Even with more than 10 million unemployed and cities boarded up, negative headlines have not slowed the markets’ march.
Is it the market’s time to shine? Possibly, but it’s important to consider these 5 things that could help or hurt an economic recovery.
#1 – Help – Market expectations are high from serial rounds of COVID stimulus
Investors have come to expect full Fed support to keep markets moving in a positive direction and have perceived little risk that gains could falter. Speculative investor behavior underscores the idea that investing looks easy as they have gotten used to what seems like a never-ending series of new market highs.
Yet the storyboard has changed dramatically with the Fed likely to be supportive, but on the sidelines until they need to start to withdraw accommodation, as interest rates and inflation rise. Near-term inflation is not as big a concern as many pundits think, with entrenched deflation still present throughout the global economic ecosystem.
For the moment, it looks like smooth sailing with market expectations still anchored by the euphoria of more government support.
#2 – Help – Robust infrastructure plan
There are trillions of dollars of proposed fiscal infrastructure spending that could lift economic activity to levels not seen in decades. We think the infrastructure plan could set the stage for a new long cycle bull market that could provide stunning returns once the bear market dust clears.
#3 – Hurt – Proposed tax increases
A significant risk factor to economic recovery and the bull market is proposed tax increases. While the intended purpose of tax increases is to fund infrastructure spending, tax policy is largely being driven by the politics of wealth redistribution.
The problem with tax increases is that they can offset the positive economic growth effects of infrastructure spending. It’s like priming a pump with water, which gets the water flowing strong, and then pouring sand into the pump, effectively clogging it up, stalling water flow or, in this case, economic growth.
#4 – Hurt – Rampant Fed and government spending
The Fed and government have spent tens of trillions to keep the economy afloat during and after the 2008 Financial Crisis. With the COVID crisis they will be forced to spend tens of trillions more to keep the economy alive. Rampant spending will likely drive the U.S. budget deficit dangerously close to 30 trillion dollars within the next couple of years.
#5 – Hurt – Rising Interest Rates
Rising interest rates pose another huge risk factor to the economy and markets as the cost to finance the ballooning debt starts to increase. If rates do rise to 3.0% or higher on the 10-year treasury, the cost to fund the deficit will drive a virtual increase in the level of debt that may well become unsustainable. Current monetary and fiscal policy is like a grand Ponzi scheme that works until people won’t let you borrow any more money to pay the carrying cost for what you already borrowed.
Which sectors and stocks are important to consider right now?
In the near term, the reflation trade, value stocks, and the sectors closely aligned with economic recovery should be a great place to invest. Many of the traditional value sectors – energy, financials, industrials, and materials – that have been underperforming for years recorded strong performance in Q1.
Smaller companies and value-based stocks tend to perform best in a robust economy. Many value stocks are still trading at reasonable prices with trailing price-to-earnings ratios less than half of their large-cap growth counterparts.
It’s been a very long drought for value and dividend investors who have seen return stagnate for a decade as Fed monetary policy pushed tech and momentum stocks to overvalued extremes. The extreme valuation levels is a reason investors should keep an eye on changing risk factors.
The high-flying tech trade reminds me of the Dot.com bubble right before prices started to fall hard, bringing value back in line with reality. These major price adjustment events usually catch investors by surprise and can torpedo retirement plans.
What steps can investors take now to stay on track with their financial plan?
While investing may continue to look easy for a while longer, we have learned the hard way that investing is never easy. The most important path to investing success is to preserve your capital by taking small losses in bear market cycles.
Limiting losses may be more important this time around because losses may be larger than historical norms suggest. We have had unprecedented monetary policy and government support of markets for more than a decade and rationalizing the excesses may be very painful.
By avoiding large losses that markets can deal out when the risk is finally realized an investor would be well-positioned to take advantage of the next bull market trend.
Photo by Anna Nekrashevich from Pexels
Disclosures
The views presented are those of Don Schreiber, Jr. and Matt Schreiber and should not be construed as investment advice.
Investing involves risk, including the loss of principal. Neither diversification, risk managed, passive or active management, or any combination of management can guarantee a profit or protect against a loss.
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