Chief Investment Officer | Johnson Financial Group
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy to provide consistent, actionable investment solutions for our clients.
6 minute read time
Many have written about the excitement surrounding the men and women’s college basketball tournament, March Madness, as an early indication of the economy’s reopening, including us. As the tournament makes its way to the Final Four and then national championships, I can’t help but think about an analogy for the economy and markets.
While the headline numbers for economic growth indicate a successful recovery, we know that the story is much more nuanced than those numbers suggest. And the same is true for markets. While the major stock indexes are making new highs, the churn below the surface has been unprecedented as stock investors move between technology winners and companies benefitting from the economy’s reopening. To help clarify what’s happening we’ve developed our own brackets.
We knew coming into 2021 that economic growth would accelerate for two reasons. Last November we received news about the approval of the first vaccines for the COVID-19 virus, and in December we saw a $900 billion stimulus package passed that provided additional help to individuals and businesses that were most negatively affected by the pandemic’s closing of certain segments of the economy.
Since then, we’ve seen another stimulus bill passed for $1.9 trillion. Combined, these two bills alone are over 5% of the country’s annual economic output! While the more recent bill included a number of items that won’t be entirely spent in 2021, the impact on consumer spending will be significant.
We know this because we already began to see an uptick in February from the December stimulus plan as consumption rose by 6.3% over the prior year. The chart below shows the Chase consumer card spending tracker, which indicates how dramatic the rise was relative to spending when the pandemic began. As a result, economic growth will win, and continue to accelerate, likely beyond the current consensus of 6.5%.
On another front, yesterday, the Biden Administration released details of their next spending and tax plan. While this will receive a lot of attention and pushback from Republicans in Congress, it would only add to the complexity of the stimulus story in 2021—not disrupt the general direction. We’ll break this down next week.
Of course, all this stimulus, i.e., government spending, has investors concerned about the potential impact on interest rates and inflation. Recall that part of a bond’s interest rate is tied to the level of inflation as investors require a return in excess of the amount that prices will rise over time (inflation). For example, if inflation is expected to rise by an average of 2% over the next 10 years, then the interest rate on a 10-year bond should be 2% plus the amount an investor wants to get paid for having money tied up for that long. While never a perfect relationship, over time the figures make sense.
However, today, the yield on a 10-year Treasury is near 1.7%, which means that “real” rates are actually negative for Treasuries. This is due to the low level of interest rates globally, downward pressure from the Fed and a number of other issues that will make a good commentary in coming weeks. We don’t see interest rates moving dramatically higher, though, due to these same forces continuing.
The point is that higher inflation leads to higher interest rates. The economy’s restart will certainly produce inflation as bottlenecks in the supply chain for goods and services push prices higher with greater demand. As an example, the days of $80 airfares are likely behind us because demand for air travel is rising while a good portion of the airline fleet is still mothballed. In the near-term, this kind of thing means that inflation will win over interest rates and this has implications for how we invest bond portfolios.
Beyond inflation, two other reasons investors need to be compensated for taking risk in bond portfolios are credit and maturity risk. While some may question the idea of government bonds being of the highest credit quality (most likely to be paid back) due to the sizable increase in deficit spending, these bonds are still the yardstick used to measure credit risk.
When you purchase a corporate bond from say Apple, which has over $150 billion in cash on the balance sheet, versus Delta Airlines, for which cash has been reduced due to the pandemic, you feel better about the credit risk with Apple and so get paid less interest. There are many companies whose businesses have benefitted from the pandemic, revenues are up or expenses are down, or both, and so taking some, the right, credit risk makes sense.
But using longer maturities today does not make sense. As already mentioned, interest rates are already low, and real rates on longer dated bonds are negative. So credit wins.
Finally, let’s look at the competition in stocks. Last year, the stock market recovery was led by large technology companies who were benefitting from their businesses’ growth during the pandemic. For example, Apple’s gaming, music and device business, Amazon’s cloud and consumer sales business, Netflix’ streaming services and so on.
Stock prices for these and other “pandemic winners” also benefited from investors shoveling cash in their direction, something called momentum. When stock prices rise because more people are buying stocks simply because of their rising prices, that is momentum at work.
However, as we learned about vaccines and began to think about the economic recovery coming out of the pandemic in 2021, we saw cyclical companies’ stocks start to outperform. As an example, in the last three months, stocks in the energy, industrial and materials sectors are up 17.3%, 6.6% and 7.5% while technology stocks are up only 1.8%. Clearly cyclical stocks, those benefitting most from an economic recovery, are winning now. And because the consensus for economic growth is probably still a couple of percentage points away from where we’ll end the year, there is perhaps some room for these stocks to continue to move higher.
We’re left with economic growth and cyclical stocks in our championship. And given the economy’s restart, the government’s determination to throw everything they can at jumpstarting the recovery, we think this is the right conclusion.
This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Johnson Wealth Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE