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In this episode Richard Calhoun, CEO of Laidlaw Wealth Management, discusses the factors supporting the current market advance and handicaps three major risk factors, the significance of improved market breadth following the November election and how U.S. market sectors and overseas markets have fared so far in 2021, the concepts around Modern Monetary Theory and how they apply to current U.S. economic policy, and the need for significant infrastructure spending to support long-term U.S. growth prospects.
The topics discussed in this episode are: How to handicap the risks to the current market advance?, How should we view the market’s greater breadth and how are different sectors and geographic markets performing year to date? Should Modern Monetary Theory be viewed as a risk or a benefit?, and What is to be gained from a substantial infrastructure investment program and what companies would benefit?
Please tune in for more timely insights.
Hello and welcome to another episode of “A Brighter Future.” I’m Rick Calhoun, CEO of Laidlaw Wealth Management, and I am joined again by David Garrity, Chief Market Strategist for Laidlaw & Co.
David, I know you were disappointed to miss out on skiing due to rain over the holidays, but I saw you were back on the slopes last weekend.
Rick, while the conditions this past weekend were far improved, the weather was frigid with sub-zero wind chill as winds gusted over 30mph. We enjoyed the skiing, but called it early as we were chilled to the bone. Never have I heard happier cheers at the arrival of hot chocolate and other warm beverages than this past weekend.
I took the opportunity to tell our boys of Jack London’s short story, “To Build A Fire,” of how a newcomer to the Yukon Gold Rush decided to venture forth with his dog into -75 degree Fahrenheit weather to join up with a band of prospectors. Needless to say, the story doesn’t end well for the man, but husky being more adapted to the environment survives.
While retelling the story was meant to impart a respect for the cold and its dangers, a similar warning may be offered to current day prospectors in the financial markets where conditions have likewise gone to potentially dangerous extremes.
David, we saw equities add to their solid nine-month gains last week, with major indexes reaching fresh all-time highs as Joe Biden was sworn-in as the 46th president of the United States. The recent two-and-half-month stretch from Election Day to the inauguration marks the strongest post-election performance since 1932, with the S&P 500 returning +14%.
For comparison, the second-best election-inauguration gains took place in 1960-1961 when Kennedy assumed power, with the S&P 500 gaining +9%. In addition, the discovery and rollout of effective vaccines have raised hope that restrictions will gradually be lifted, accelerating the economic recovery and return to normalcy.
So, David we have rising corporate profits, easy Fed policy, and loose financial conditions – a powerful combination for rising equity markets and then if you add in that these conditions, historically, occur in the early and mid-cycle phases, rather than the end of a bull market and it looks like we are set up for 2021 to be a good year.
Rick, all the conditions you mention are indeed supportive of positive market returns, but there are clear signs of excess that should caution investors to book profits as there are made and not be complacent in the view that gains will continue to compound as they have off the March 2020 lows.
Just to recap, the four pillars of recovery remain intact, namely, 1) Historic Fed stimulus, 2) Massive Federal stimulus, 3) Vaccine optimism and 4) No Double-Dip Recession. The fifth pillar discussed previously, Divided Government, went by the wayside earlier this month with the Democrats winning control of the U.S. Senate. However, investors should note that there are three leading candidates that pose a risk to further market progress, namely, 1) Possible Tax increase, 2) Stimulus Disappointment and 3) Vaccine Disappointment.
As to the likelihood of each risk materializing, we take Janet Yellen’s comments during her Senate confirmation hearing that the 2017 tax cut would not be reversed until the economy fully recovers as providing sufficient reassurance on the first point. Relative to stimulus disappointment, we think this hinges on whether the filibuster is removed as part of the new Senate rules. Leaving the filibuster in place promises to hamstring the Biden administration’s ability to move quickly forward with its $1.9 trillion fiscal stimulus plan. On the question of vaccine distribution, there are clear indications from countries across the world that vaccination efforts are being hampered by supply chain issues limiting availability as well as moves by providers such as Pfizer to price by dose, not vial, in order to maximize profit. Separately, news that Merck is ceasing vaccine development efforts may diminish future increases in supply, but there are expectations that Johnson & Johnson will shortly announce the successful conclusion to its vaccine development efforts.
Bottom line, Rick, the market has always traded higher on rumored expectations and then taken profits on the actual news. A great deal of hope is now discounted in the market, something the final outcomes may not support. Last week’s trading around the 2020 4Q results from IBM and Intel certainly gave a clear example of that mindset being very much present in the current market. Accordingly, we advise investors to book profits as they are made and not be so inclined to let their winners run.
David, there has been a lot of media attention to the concept that the S&P 500 Index is being carried to all-time record highs by a small handful of stocks that we all know and whose products and services we use every day some maybe more often during the pandemic.
And while that might have been the case at certain points in the past, over the last five months or so the widening breadth has become much more pronounced. So much so that since late October, the equal-weighted S&P has outperformed the capitalization-weighted S&P by approximately +5%, meaning more companies are participating in the market’s gains.
But it is not just large-capitalization stocks that are moving higher. The Russell 2000 Index, an index tracking stocks of small-cap companies has been setting new record highs over the course of the last six months and has outperformed the SPX by more than +30% since late September.
Can you share with our listeners why having a smaller company index outperforming the larger company index at the same time a wider swath of those big companies are carrying the S&P to new all-time record highs is a meaningful positive when trying to gauge the underlying strength of the stock market.
Rick, last year we had discussed the narrow nature of the market’s advance and how historically this has been indicative of a potential top in the market. Consequently, the fact that we have seen market breadth improve following the November election with a record +41% advance by the small-cap Russell 2000 index since the end of October is clearly encouraging.
The major reason underlying this advance is the expectation that with COVID vaccines being distributed and more aggressive fiscal relief being advanced by the new administration that the prospects of GDP growth accelerating by the economy reopening are improved. So far, S&P 500 sector performance in January bears out the expectations for economic reopening with the Russell 2000 (+9.8%) and the Energy sector (+11.0%) substantially outperforming the S&P 500 index.
|Performance: Year-to-date 2021 – Style, Market Cap & Sector|
|Index||Price Change||vs. S&P 500|
|Smaller Market Capitalization:|
|S&P Health Care||3.7%||1.4%|
|S&P Comm Svcs||2.0%||-0.3%|
|S&P Real Estate||0.4%||-1.9%|
|S&P Consumer Stpls||-3.5%||-5.8%|
Relative to how markets outside the U.S. have started off 2021, it is clear that better ability to manage COVID containment efforts have redounded to the benefit of China, Taiwan and South Korea, but most important for investors to note is that almost all overseas markets with the sole exception of the Eurozone have outperformed the S&P 500 despite the U.S. Dollar weakening only modestly.
|Performance: Year-to-date 2021 – Geographic|
|Index||Price Change||vs. S&P 500|
|– U.S. Dollar Index||-0.1%||-2.3%|
|MSCI South Korea||9.0%||6.8%|
|MSCI Emerging Mkts||8.1%||5.8%|
|MSCI Emerging Mkts ex-China||5.6%||3.4%|
|MSCI Frontier Mkts||4.2%||1.9%|
David, in keeping with a tradition here on “A Brighter Future,” I’d like to spend a few minutes on one of our favorite topics – The Fed.
When the coronavirus pandemic hit last February, the Fed’s balance sheet stood at $3.94 trillion. Today, it’s $7.37 trillion and it is going even higher as the Fed has proclaimed that it will buy at least $80 billion per month of Treasury securities and at least $40 billion per month of agency mortgage-backed securities “…until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
The Fed’s balance sheet today is 35% of GDP, but it is slated to hit 42% of GDP in 2021 based on the trajectory of the stated purchase program.
In addition to the Fed, we now have Janet Yellen who will be our Secretary of Treasury, saying at her nomination hearing that the U.S. needs to “Act Big,” taking advantage of historically low interest rates, to combat the effects of the pandemic and that the economic benefits will outweigh the costs of this relief package.
So, my question, David, is have we accepted that Modern Monetary Theory is our way out of the “hole” created by the pandemic?
As a reminder to our listeners, Modern Monetary Theory essentially says that as long as government spending creates a higher growth rate than it does inflation, any debt or deficits the spending creates really don’t matter. Simply put, MMT abandons the idea that government needs to be able to afford their spending.
Rick, as the practical upshot of fiscal policy over the past 20 years, no matter the political party in power, has been to raise government spending as long as it supported growth in real GDP, we can say that Modern Monetary Theory has been practiced in stealth mode and is now out in the open.
In discussing present fiscal policy, one point to make here is the significant difference between the COVID Depression and the 2008 Financial Crisis. With COVID the global economy was impacted by the exogenous force of the pandemic that forced shutdowns worldwide from which full recovery will depend crucially on effective COVID containment and vaccination efforts, so the need for fiscal and monetary stimulus is clearly to sustain the economy until such time as that occurs.
With the 2008 Financial Crisis, it was the mispricing of risk and an overabundance of overleveraged borrowers that prompted a collapse particularly in the financial services sector the failure of Lehman Brothers and the take-under of Bear Stearns by J.P. Morgan. Then in 2008 it could be said that the recipients of relief were being bailed out from their own errors, that moral hazard had occurred. Not so in 2021.
The advantage to the U.S. applying MMT is that as the issuer of the world’s reserve currency, the ability to finance the related deficits is unimpaired. As real long-term interest rates are negative, the financial markets are giving the U.S. a clear signal that if there were ever a good time to implement further fiscal stimulus that time is now.
David, as we bring this week’s episode to a close, I think our listeners would be interested in your thoughts on an investment theme that President Biden specifically addressed in speech – Infrastructure.
In a speech last week, President Biden said, “It’s time to stop talking about infrastructure and to
finally start building an infrastructure so we can be more competitive.” He added that his plan “would produce millions of good-paying jobs that put Americans to work rebuilding our roads, our bridges, our ports to make them more climate-resilient, to make them faster, cheaper, cleaner to transport American made goods across our country and around the world.”
Both parties have agreed for four years that increased infrastructure is paramount, but intraparty squabbling has blocked a spending plan from being passed through all required channels. So with a Democratic control of Congress and the presidency does it make it more likely that some kind of infrastructure bill will be passed into law? If so, could be some examples of companies/industries poised to benefit from increased infrastructure spending?
Rick, it is true that new administrations proposing bold infrastructure initiatives has become something of a political chestnut in that all say they are in favor of it, but then fail to pass any of the enabling legislation.
While there will be a rapid short-term economic rebound once there is widespread vaccination, even without new fiscal stimulus, the importance of and the need for infrastructure investment comes into focus when one considers the long-term growth prospects for the U.S. economy. A big increase in public investment is beneficial for many reasons. It would help sustain the economy beyond the vaccination bounce; it would help repair our decaying infrastructure; and it could be an important part of a climate strategy.
How should this public investment surge be funded? Actually it does not need to pay for at all. Even before the pandemic the U.S. was an economy awash with more savings than the private sector wanted to invest, so that the government could borrow money very cheaply. In effect, markets have been begging Washington to borrow even more, and it would be good for everyone if Congress obliged and used the money to invest in the future.
Whether the GOP under Senator McConnell will allow this to happen is the main question now. Under the previous administration, McConnell did not want a big infrastructure bill. His objections probably flowed not from concerns that such a bill would not work, but from fear that it would — and in working, would help to legitimize an expanded role for government. Now, if McConnell would not permit infrastructure come to the floor with a Republican in the White House, he will certainly not do so during the Biden administration, which is just another reason why the filibuster needs to be set aside.
Now, assuming the political roadblocks can be removed to passing infrastructure program, the trade for investors can be straight forward in considering the engineering, equipment and materials suppliers that would benefit which with the Biden administration’s “Buy America” program would be names such as Caterpillar (CAT), Fluor (FLR) and Vulcan Materials (VMC).
To touch back to our discussion of MMT, Rick, having greater public spending go towards building back better in terms of infrastructure spending will serve to increase the GDP growth prospects for the U.S. economy not just over the next year, but over the longer term which is more important in providing support for the growth expectations that have been factored into the U.S. financial markets presently.