Q1 2021 Commentary Letter: Turning the Corner

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As Covid-19 is not yet behind us. But the Coronavirus Recession that was caused by Covid-19 ended in Q1 2021, at least in the United States.

As we look ahead, the world economy will be more and more affected by the other pressing global issue of the day: climate change. The focus this week, designated as US Climate Action Week, is the Leaders Summit on Climate hosted by US President Biden. As well as government commitments to ambitious goals, climate activists and investors will be watching governments’ action plans to foster greening of the economy, for example in the US infrastructure proposals now being considered in Congress. Look for commitments from businesses also, including traditional oil and gas businesses. As we discuss later in this note, the renewed spur to action will create important investment opportunities. At RockCreek, we have long been leaders in this space, with ongoing investments across climate related sectors, transitioning to a sustainable and more eco-friendly office in 2016 and being early signatory to the NetZero Asset Managers Initiative.

Back to Covid-19! Thanks for the progress so far goes first to the modern miracle of the invention, production and distribution at scale of safe and effective vaccines. There is a long way still to go — not least in ensuring swift access to vaccines around the globe as well as in harder-to-reach communities in the United States. Worrying side effects, however rare, will likely add to vaccine hesitancy and will curtail the speed with which the world can get adequate vaccine supplies. New infections have been rising again recently in the United States, as well as elsewhere. But in the first quarter of 2021, after a long year of disease and death, it became clear that the virus could be contained, even if not beaten. At the same time, policymakers, particularly in the United States, left no doubt about their determination to keep up extraordinary support for the economy. Swift passage of a further $1.9 trillion spending bill was coupled with continued Fed insistence that monetary policy will remain unchanged until the economy reaches full employment and/or the Fed observes inflation in the data — making monetary tightening a distant prospect. Small wonder that Q1 marked an inflection point for the economy, as Federal Reserve Chair Jerome Powell noted. RockCreek called for “The Coming Boom” in our March 15 letter, before the data for March was in. Now, recovery is confirmed in the numbers — from an increase of nearly a million jobs in March to a nearly forty year high recorded in the Institute of Supply Management’s (ISM) closely watched manufacturing index and a jump in retail sales to above pre-pandemic levels.

Two big questions for investors surfaced in Q1. Will a surge in inflation force the Federal Reserve to tighten sooner than expected, perhaps bringing recovery to an early end? And if, as RockCreek expects, the economic expansion continues apace, will the benefits of faster growth and increasing job opportunities be felt on Wall Street as it will be on Main Street?

Inflation or Growth?

Investors and analysts worried from the beginning of 2021 whether fiscal and monetary policy could revive growth without triggering dangerous inflation. Bond markets had their worst quarter since 1980. Warnings about inflation came from unexpected quarters, including Democrats as well as from more conservative commentators. Some argue that the recent rapid increase in liquidity makes an inflationary period down the road inevitable. It is true that M2 has risen sharply in relation to GDP. But experience — and economics — suggests that this will only trigger an inflationary spiral if companies and individuals try to spend all the money more quickly than output (or imports) can ramp up to meet demand — and that is perhaps unlikely. Rising yields at the longer end could stall recovery — or they may act as a natural speed limit, slowing growth through their impact on interest-rate sensitive sectors of the economy, from housing to net exports, but not reversing the recovery. The Fed appears to be taking the latter view, resisting cries in Q1 from bond investors to embark on yield curve control.

As the quarter unfolded, the data suggested that investors more broadly might be getting more comfortable with President Biden’s argument that it is better to err on doing too much than too little. Strong payroll numbers for March show that companies may be able to build up capacity more quickly than expected. Other indicators are also showing more strength than they did at this time in the aftermath of the Global Financial Crisis (GFC). At the same time, however, millions of Americans are still without jobs. Many businesses, especially small and medium-sized ones that provide lifeblood to neighborhoods, have been shuttered. With growing demand, and financial help, they — or successors to them — may be able to reopen, adding to supply. These factors suggest that there is still room for further output gains, without pushing wages and prices into an uncontrollable upwards spiral.

Inflation fears, however, should not be dismissed. An uptick in prices is likely in coming months. Yields may likely rise further at the long end, and if inflation expectations rise to uncomfortably high levels, financial markets will be calling for the Fed to tighten. So far, the central bank has stuck to its view that it sees room for more jobs and growth before it tightens, which a majority of Fed decision-makers expect to put off through 2023. If above target inflation is sustained, the Fed may eventually bring forward its planned timetable for tightening. But that will only happen against a background of strong growth and declining unemployment. We are in for an extraordinary economic rebound in the United States from what has been an extraordinary downturn. China is also set to grow rapidly this year, and together the world’s two largest economies will pull along the rest of the global economy — now projected by the IMF to grow by 6 percent this year, and close to 4.5 percent in 2022, with Asia outpacing other regions.    

The Disconnect

Last year was notable for many things. One of those was a disconnect between financial markets and the real economy. The pandemic-induced recession hit the US economy with great force a year ago. An early rebound in jobs and output stalled as Covid-19 surged again, and then again, whenever states and localities eased restrictions. But financial markets went from strength to strength, powered by the twin engines of easy monetary policy that promised low rates for longer, and large fiscal stimulus. 

As long as the threat from Covid-19 persisted, schools remained largely closed, travel and vacations were curtailed and many of those who could isolate stayed shut in their homes; the fiscal and monetary boost had limited places to go. But towards the end of the first quarter things began to change. As vaccinations spread and “herd immunity” comes within sight, more of this money was being spent in March. There has been a lot of focus on how consumers may use the government stimulus checks, higher unemployment benefits and — for some — stock market wealth. A jump in spending in 2021, but with some savings left for later, is the most likely outcome. We are already seeing a housing boomlet, helped by low rates as well as increased income. Another important element — especially for the longer-term outlook — will be how companies behave. The past decade has seen under-investment in many sectors. A lasting recovery will require more investment in productive capacity, which in turn will support earnings. In that world, a reverse disconnect between financial markets and the real economy can be avoided.

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