Economic growth, inflation, earnings — defining the 2021 markets

If you think (insert market dynamic here*) is over, think again. It has only just begun.

*reflation/rising inflation
*rising interest rates
*a steeper yield curve
*the economic re-opening
*the manufacturing boom
*the jobs recovery
*consumer pent-up demand
*revenge/envy spending
*the bull market
…

As my team and I were discussing the markets and our model portfolio over the last few weeks, one question that kept coming up was, “Did we just get a year’s worth of market movement in a quarter? If so, then what’s left? And if not, then where do we go from here?” By this, we point to the rapid rise in U.S. Treasury yields (and Canadian yields for that matter), the gains in oil and other commodity prices, and equity market returns. In short, we concluded that no, the year hasn’t been front-ended. In fact, we suggest that while the speed of the market movement was faster than we anticipated, things have progressed directionally, as expected. Markets are merely responding to the improving economic and earnings environment that we laid out in our “2021 outlook – the rapid reopen.”

Equity markets performed well through the first quarter, extending the gains made since the market lows of March last year. The S&P 500 Index gained 6.2% in U.S. dollar terms (4.9% CAD), including dividends. Gains were prevalent across most major equity indices with the MSCI EAFE Index up 3.6% in U.S. dollar terms (2.32% CAD) and the MSCI Emerging Markets Index returning 2.3% USD (1.1% CAD), both including dividends.

Our expectation of Canadian equity outperformance against U.S. equities for 2021 appears to have materialized through the first quarter as the S&P/TSX Composite Index gained 8.1%, including dividends. In our 2021 outlook, we highlighted the financials and energy sectors as two sources of potential, given an expected rebound in oil prices (energy) alongside a steeper yield curve (financials). Energy and financials were the second and third-best performing sectors over the quarter, gaining 18.8% and 12.7% respectively, only bested by health care, which gained 37.8%.

Perhaps the biggest surprise to the market was the increase in bond yields. The U.S. 10-year Treasury yield started the year at 0.91% and very quickly rose by 83 basis points to end the quarter at 1.74%. The rise in yields was right in line with our full year 2021 view. We had held the out-of-consensus view that yields would move higher than the market expected; however, we didn’t expect them to move so quickly. The move in U.S. Treasury yields was met by similar movements in Canadian bond yields. The 10-year Government of Canada bond yield gained 88 basis points to finish the quarter at 1.56%. Bond yields rose across several categories. As a result, the FTSE Canadian Universe Bond Index, the benchmark for Canadian bonds, fell 5% during the quarter.

U.S. Treasury curve
March 31 vs 1 month and 6 months prior

Back to the initial question though: “Where do we go from here?” We outline our views in three themes that we believe will define the economic and market environment through the remainder of 2021:

• Economic growth is set to surge — surprises to economic growth will skew to the upside.
• Higher inflation is the new norm — yields will continue to follow.
• Equity market gains will transition from multiple expansion to earnings growth.

Economic growth is set to surge

While countries around the world continue to face new waves of COVID-19 contagion, and lockdowns as a result, we point to some of the recent economic data, which has surprised to the upside, emanating out of the United States for what a full reopen may look like. Last week, for example, the Institute for Supply Management’s Manufacturing Purchasing Managers’ Index (ISM PMI) jumped to 64.7, a level not seen since 1983 (a level above 50 indicates expansion). Additionally, the U.S. Non-farm Payrolls report showed 916,000 jobs were created in the month of March (with an additional 156,000 from revisions to the prior two months), the strongest job gains since last August.

U.S. Nonfarm Payrolls report Monthly, from March 2020

Some economies, like the United States, have only just started to open up, while others (much of Europe and Canada) remain economically restrained. For example, the combined population of California, Illinois, Massachusetts, and New York is approximately 78.5 million people. These are states that had some of the more stringent lockdowns and are poised to reopen. The recent data, however, would support our thesis from last year that the COVID-19 pandemic is more likely a disruptive even rather than a destructive event. As lockdowns lift, and in line with our rapid reopen thesis, we suggest that the data we’re seeing foretell a surge in economic activity to come.

Higher inflation is the new norm

Our out-of-consensus base case at the start of the year was for inflation, as measured by the U.S. Consumer Price Index (CPI), to accelerate to above 2.5% on a year-over-year basis. We believe January’s 1.4% CPI is the low level for the year. Our inflation model forecasts sustained higher inflation through 2021, with only some moderation in early 2022. The upside risks to inflation remain higher wages (as the travel and hospitality sectors rush to add back staff), continued commodity price pressure (not limited to oil), and higher producer prices.

Evidence of higher inflation is already making its way through the economic data — the ISM PMI Report on Business Prices Index has surged to 85.6, the highest level since 2008. Lumber, one of the biggest costs in home-building after land and labour, has never been more expensive and is more than twice the typical price for this time of year. Crude oil, a starting point for paint, plastics, flooring, etc., has shot up more than 80% since October. Copper, which carries water and electricity, costs about a third more than it did in the autumn. Given the low levels of business inventories combined with the backlog of orders and potential release of pent-up demand, the direction for inflation is most likely higher, not lower.

ISM Manufacturing Prices Paid Index vs CPI YOY 
Last 20 years

Higher inflation expectations have led the U.S. 10-year yield to rise above our full-year target of 1.5% before the end of the first quarter. Our out-of-consensus view of inflation led to a similar out-of-consensus view for yields. As the surge in yields has met our initial target, we’ve revised our expectations to 2.0%, with risk to the upside through the remainder of the year. This will continue to pose challenges for fixed-income investors when it comes to long-duration bonds.

Equity market gains will transition from multiple expansion to earnings growth

The optimistic economic outlook leads us to our favourable view towards equity markets. Our research suggests that in an environment characterized by accelerating growth and accelerating inflation, major equity markets tend to perform well — in particular, those that are cyclically oriented or have higher exposure to commodities (e.g., emerging markets, Canada).

Over the past year, equity market returns have largely been driven by valuation, or price-to-earnings (P/E), expansion. This is typical of an equity market recovery following a recessionary bear market. This period is typically characterized by stellar equity gains as the market starts to price in a recovery. For those investors who are concerned with the current market valuation, we suggest that higher equity valuation in the context of higher forthcoming earnings growth (today’s scenario) is less of a concern than higher valuation and low earnings growth (the 2000 tech wreck scenario). The driver of performance tends to shift to earnings growth and is usually marked by a peak in valuation. We should point out, however, that in earnings-driven environments, market returns tend to be positive yet average to below-average. Therefore, investors would be well served to discount the outsized equity market gains over the past year and return to average expectations. However, we believe that the risk is to the upside.

Year-over-year change in S&P 500 Index earnings per share vs Change in trailing P/E multiple Last 50 years

As we head into first quarter earnings results, we’ll be watching closely and paying attention to full-year guidance. Our expectation, given the recent economic data, is that earnings risks are to the upside through 2021 and will be the driver of continued market gains.

Capital Markets Strategy model portfolio positioning

We remain very comfortable with our model portfolio positioning since the start of the year and, as such, are keeping the asset allocation static for Q2. We remain slightly overweight equities at 65% while underweight in fixed income at 35% (relative to a 60/40 benchmark).

Fixed-income positioning — no changes from last quarter

• 35% weight — underweight (-5%)
  
• 20% Global Core Fixed Income (government/credit)
• 15% high-yield corporate bonds

Fixed-income returns are likely to face continued headwinds of rising longer-term bond yields. While we don’t expect the U.S Federal Reserve to start raising rates this year, and perhaps next, higher inflation and greater confidence in the economic recovery are likely to continue to put upward pressure on yields.

We favour high-yield bonds, as the asset class tends to be positively correlated with rising 10-year Treasury yields while maintaining a 20% defensive posture in core bonds, however, with an emphasis on shorter duration.

Equity views and positioning — no changes from last quarter

• 65% weight — overweight (+5%)
  
• 15% Canadian equities
• 25% U.S. equities
• 15% international equities
• 10% emerging market equities

Our view towards equities continues to be positive for the coming 12 months on accelerating earnings growth. Equities are fully valued, perhaps over-valued; however, in the context of much stronger earnings growth, we believe valuation is likely to ease over the coming year, which is typical following equity returns driven by multiple expansions.

Our Growth/Inflation Momentum Matrix would suggest that emerging market equities, Canadian equities (the S&P/TSX Composite Index), and commodities tend to do well in an accelerating growth and accelerating inflationary environment. These are areas that we’ve increased exposure to in the prior two quarters.

***

Lastly, I’ll leave you with these thoughts …

My son and I have been looking for new mountain bikes. Apparently, there’s little to no inventory in Toronto for mountain bikes. Luckily, I put a deposit down on one back in January for when new inventory comes in. My son decided on one a little later and called the same bike shop to put a deposit down. He was told by the store manager that every bike coming in has been sold. This is before a single bike has arrived in the store. And the shop doesn’t know when they will get more inventory. We called almost every bike shop within an hour’s drive of Toronto and were told the same thing.

I bring this up as an example of how tight inventories are, how deep the manufacturing backlog is, and what a wave of consumption driven by excess savings and pent-up demand might look like through 2021.

Insert market dynamic here …