Economic Commentary – Q1 2021

Quarter in Review

• Equity markets are rallying as the economy begins the process of normalizing after the unprecedented shutdowns of 2020.
• Loose monetary policy has now been assisted by massive fiscal policy to provide a boost to all segments of the economy.
• Some of Maple’s picks did not work as well this quarter, but that should be expected. We invest for the long term, not one quarter, and we believe in the merits of our selections.

Commentary

Equity markets turned in solid returns again this quarter as the U.S. made significant progress with the vaccination effort. Now that most local restrictions on economic activity have either already been lifted or will be soon, more businesses will be hiring and returning to a post-pandemic normal. The new fiscal stimulus of $1.9T also gave investors reason to cheer since it provides the consumer, state/local government, and small business sectors with the means to spend, and the spending will be spread out over many months.

Bond yields rose significantly during the quarter and once again the action was predominantly in five year and longer maturities. We view this development favorably since yields should no longer reflect the emergency-like conditions of 2020 now that a clear path forward for economic recovery is in sight. Bond yields are rising for all the right reasons — economic activity is improving, fiscal policy is taking the baton from monetary policy, and financial conditions are supportive for a broad-based recovery.

In terms of an economic outlook, rarely has there been greater certainty. Above-trend growth is the widespread expectation for 2021 due to the recent new stimulus and also the tremendous pent-up demand for all manner of goods and services. If even just some of the new infrastructure proposals from the Biden administration are implemented, the robust growth could stick around longer. The 13+ point jump in the Conference Board’s monthly index of consumer confidence reflects this optimistic outlook. On March 30, this index rose to its highest reading in a year, no doubt in reaction to the swift vaccination progress and the fiscal stimulus which has started to hit bank accounts. Higher vaccination rates in the second quarter should lead to further gains in consumer spending as the home-bound venture out once again.

Another fairly certain outcome is for higher inflation that will be reflected in these next few months’ data for which there is an obvious explanation: base effects. Many prices of products and services plunged last year — think oil and auto insurance — due to the pandemic and the sudden shut-down of the economy. As those large price cuts fall out of the year-ago comparisons, the year-over-year figures will appear large (the “base”), but a longer term look will reveal no big increase. Anticipation of this jump in inflation is widespread but the tendency to extrapolate recent data, combined with the sheer size of the latest economic relief package, has caused many to raise alarm over the rising inflation, even though it hasn’t even appeared yet! We do not anticipate the trend to persist and expect it to be transitory, much like Fed Chairman Powell expressed in his recent appearance in Congress.

Inflation will require more than a few one-time price hikes in order to become a sustained trend, and the supply bottlenecks now evident due to the pandemic should soon give way to more normal supply-demand patterns. Much of the financial media claim a 1970s-style inflation will soon develop since it makes for a good headline, but it should be remembered how many seminal events were required for that episode to occur: the end of the gold standard, high war-time spending, wage and price controls, expensive “New Deal” social spending, and the oil crisis, to name just a few. All of these occurred before globalization and the myriad innovations that make today’s economy much more dynamic compared to the ‘60s and ‘70s.

Not only did it take a lot to create the inflation of that era, but a glance at the countries experiencing rapid inflation today is also instructive — Venezuela, Zimbabwe, Sudan, and Lebanon lead the way. None of these countries features the deep trade relationships or robust markets for goods and services of the developed world. And let’s not forget the Amazon effect, which provides price transparency for consumers and continues to drive prices lower for many goods and a growing number of services. For these and other reasons too dense for this piece, we do not expect a run-away inflation problem in the U.S. any time soon.

With so much positive change anticipated by the markets, it is important to ascertain what is factored into market prices while at the same time considering what risks may lead to different outcomes from the expectations of market participants. On the fixed income side, many corporate management teams are expressing a commitment to debt reduction, so we are encouraged that debt metrics will start to improve as revenue returns to normal for many. Similarly, the federal stimulus will allow municipal budgets to come into line while also enabling some capital spending. Bond ratings could benefit from both of these trends, whether from the avoidance of downgrades or from upgrades due to better results. Just last week, Moody’s upgraded the State of Connecticut’s bond rating for the first time in twenty years, something that probably would not have occurred absent the federal stimulus. However, absolute yields as well as the yield spreads for the corporate and securitized sectors are still quite low so we do not believe it is prudent to take on much credit risk in this environment.

On the equity side, the somewhat narrow rally of 2020 has become a more broad-based one. Energy, for example, performed well after two rough years, while information technology took a breather and lagged the broad market. Cyclically exposed sectors of the market outperformed secular growth in general. We expect these kinds of short term relative performance gaps to emerge from time to time but we invest with a longer term view and do not rotate in and out of holdings for short term gain or seek to exploit short term fads.

One curious side effect from the pandemic is the notion that some investors have had more time on their hands and a greater inclination to trade on so-called “advice’ from various on-line sources. Much of this advice seems to be what we would term faddish in nature, or fashionable ideas on products, services, or companies that may or may not have much investment merit. Rest assured we are not swayed by such fashions as we prefer to leave the speculative ideas to others.

Final thoughts: There is much change afoot in Washington. As always, not all of the proposals will come to fruition, particularly those that require tax increases or further deficit spending. But thanks to the inoculation effort, the country is able to focus once again on “bread and butter” issues, some of which may result in new growth opportunities for companies and industries. After such a difficult year due to the health crisis, it is exciting to see a scientific break-through allowing a return to normal, and hopefully some of the new techniques can be applied to more types of transmissible diseases. Perhaps the exuberance in financial markets has been expecting this all along.