The Coming Boom

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After a dreadful year for most Americans — and others around the world — an economic boom is on the way. This is most obvious for the US. The passage of yet another enormous spending bill this month — the $1.9 trillion American Rescue Act — assures a strong recovery. Growth projections from official sources and market analysts have been revised upwards accordingly. But markets cannot quite decide how much to cheer. Will all that spending bring inflation? Will the Fed decide to push up interest rates sooner and faster than planned? Will investors and companies end up paying for a big expansion of social programs? And will the economy quickly sink back into the “secular stagnation” that has dampened productivity growth, held back household incomes and brought political polarization over the past decade?
First, on Covid-19, where vaccines are changing our world — we hope. Public health officials are still warning of the dangers of the virus. But the speed of vaccinations in the US is now taking some businesses by surprise. And last week, President Biden made it official to hope for a spring opening. If we have enough vaccine for all adults in the US by May — a  mere two months away — as the President promised, then firms that had been expecting to move to a post-Covid-19 normal in the summer or fall need to move more quickly. The challenge will be to encourage people to get the shot — and to decide how to manage when some refuse.

For many of us, last week marked the one-year anniversary of Covid-19. It was on March 11, 2020 that the World Health Organization (WHO) declared the new disease to be a global pandemic. Suddenly, life changed. Schools and offices closed. Millions of Americans lost their jobs. And, frighteningly, hospitals and then morgues began to fill. Financial markets were ahead of the WHO and most governments. Equities had begun to plunge on February 20 — while most of us were still going about our lives normally. Markets also anticipated recovery, turning up after a mere six weeks. Helped in the US — and China — by the growing weight and strength of tech companies, equities continued to soar even as jobless numbers stayed stubbornly high. For months, buoyant stocks were ahead of the economy. Is that now reversing? 
Observations and takeaways for investors:
1. Neither V-shaped, nor L-shaped, nor, perhaps, even K-shaped: the path of the American growth engine 

There has been much debate over the past year about the timing and shape of economic recovery after the Covid-19-induced collapse in output. Set in motion by swift and extraordinary fiscal and monetary actions in the US and elsewhere, the recovery from the Coronavirus Recession has also reflected the path and impact of the disease. The apparently V-shaped rebound stalled out with a late-summer surge in infections. Payrolls dipped again when a third winter surge took hold. Fears grew of a K-shaped recovery, with better-off Americans able to work from home and benefit from rising financial markets while poorer communities suffered. 

The uneven impact of the disease on low-income service workers has certainly been matched by an unequal impact from recession. Black and other minority workers in the US have seen a faster rise in unemployment and, notably, women have lost jobs and incomes, and left the labor force, at a far greater rate than men. The phenomenon is not limited to the US: in Japan, a million women have left the labor force. Education shortfalls have also fallen significantly on girls, with the Malala Fund estimating that 20 million girls in developing countries have left school and may never return to the classroom as a result of the pandemic-induced recession.

The potential long-term costs of these shifts are significant. Recent research shows that they are not inevitable. Policy choices can have an impact, as Antoinette Sayeh, Deputy Managing Director at the IMF noted in her March 5 blog. The UN’s COVID-19 Global Gender Response Tracker shows countries enacted nearly 1,000 policy measures to address challenges related to gender. These include paid leave for women, job protection measures, more flexible work and income/in-kind support for vulnerable households. More generally, the scale of the action in emerging markets lags that in the US and Europe. Despite big announcements, actual net disbursements by the World Bank and other multilaterals have fallen behind the rhetoric and speeches so far.

Looking ahead, a full recovery in US jobs and output will still depend on controlling the virus. But the shape and speed of recovery are now being determined by a decisive policy shift, marked last week by the passage of the latest relief bill, signed by President Biden on March 11. Supported widely in the country although not in Congress, the legislation is almost exactly in line with President’s Biden’s. It involves more reliance on fiscal policy and government spending to boost the economy than at any time since perhaps the Great Depression. 

Apart from its sheer size, the package is noteworthy for its expected impact on income distribution. About 70 percent of its tax benefits will go to low- and middle-income families, earning less than $91,000 a year, according to the Tax Policy Center. In addition to stimulus checks, extra unemployment benefits and money for state and local government, hospitals and schools, the legislation extends support for all families with children through the tax code, including those too poor to pay taxes, and provides extra aid for food and rent. These measures have been criticized for going beyond what was needed to address the pandemic. The Administration is betting that their beneficial impact on many families, including those who have suffered most during the recession, will be good for the economy and the country overall. And, in the face of concerns that the size of the package would lead to excessive debts and deficits and potential inflation, the Administration declared that the risk of too little outweighed that of doing too much.

Economic forecasters have taken note. The Paris-based Organization for Economic Cooperation and Development, OECD, almost doubled its projection for 2021 US growth in its March Outlook, to 6.5 percent. Private analysts mostly agree. Some go even higher — and we think that is plausible, against the backdrop of last year’s collapse. Can the US really grow by as much as 6.5 percent this year? Why not, ask the optimists. The surge of government spending — coupled with direct payments to 90 percent of American families — more than takes care of the demand side. The question is then whether supply can keep up. If not, then look for a widening of the US current account deficit as the US pulls in imports from abroad and helps to power a global recovery.

For investors, the trick will be to gauge which companies and sectors are best placed to take advantage of the coming boom in spending. Last week highlighted the importance of stock and sector selection, especially in US markets. The week started off with a strong rebound in growth and momentum stocks — particularly technology — after a pause in the treasury selloff. Rates moved up towards the end of the week and not surprisingly re-opening stocks, cyclical, value and small cap all rallied accordingly. Rate-sensitive stocks like software are having a hard time of it this year. Energy and financials are the two best performing sectors year to date in the S&P 500 though net exposure in these sectors are still muted looking on a 10-year basis. We expect current energy prices are conducive to faster growth in investments in renewables and in US domestic energy. Investors are cautious with little conviction based on incremental flows into these sectors and other cyclicals. The macro picture however continues to remain supportive to equity markets — especially in the US. 

2. Monetary policy still matters for markets — can central bankers thread the needle?

Central banks are no longer the only game in town. That much is clear. But markets still hang on their words and actions. For years, the Fed has led the way in responding to market tremors, calming investors to maintain the financial stability needed to support economic stability and growth. This month, as bond yields have shot up across major markets, leaders of other central banks — from the ECB’s Christine Lagarde to Japan’s Haruhiko Kuroda — have been quick off the mark to issue reassuring statements and promises of action. The Fed has taken a different tack, so far. 

When asked if he was concerned about the recent rise in longer dated yields, Fed Chair Jerome Powell responded “it was something that was notable and caught my attention. But again, it’s a broad range of financial conditions that we’re looking at, and that’s really the key.” More generally, Powell and his colleagues have chosen to restate rather than change the central bank’s view. They believe that the economy is on track, that recovery has much further to go before unemployment falls as far as they would like, that they do not foresee concerning inflation trends — indeed they welcome signs that inflation is shifting up and maybe beyond the 2 percent target — and that they intend to keep policy rates unchanged, and very low, for some time. This time around, central bankers are more concerned about the unequal distribution of recovery than in previous crises and this is shaping their reactions. Markets are not convinced. Interest rate hikes are priced in from 2022, a whole year sooner than the median projections of FOMC members. 

Rising rates inevitably impact equity markets. But it is important to distinguish between a rise in yields that signals inflation ahead and one that reflects a better economic outlook, that in turn will help company profitability. Some analysts believe that inflation is bound to take off, given the enormous liquidity injections into the economy in the past year and the prospect of continued debts and deficits combined with monetary ease. They compare the big spending to the Vietnam war era spending on “guns and butter” that ushered in 1970s inflation. Others are more doubtful, especially after the latest CPI data came in below expectations. Indeed, there is little evidence so far that generalized price inflation will do more than tick up in line with the Fed’s preference — running a little above target for a period of time. As Peterson Institute fellow and former Fed economist Joe Gagnon suggests, the historical analogy to the Korean war is more apt. Prices rose as the war effort was underway, but inflation expectations did not take off. 

Central bankers will be watching to see that broad inflation expectations remain anchored around the 2 percent target. That is not to say that some markets and sectors will not see prices go up more sharply, at least for a time as supply chain stress is exacerbated as growth takes off. Indeed, we can expect that to happen as the effect of the pandemic on particular sectors wears off this spring, notably perhaps with food prices. 

More likely, the rise in yields is reaffirming that the US economy is on a path to strong growth. Ironically, what is good for Main Street may not be as good for Wall Street as the past decade has been. The Fed — contrary to some market beliefs — does not see its job as maintaining a buoyant stock market. It would worry if rising rates and a steepening yield curve went so far as to threaten recovery, depressing housing and financial wealth and spilling into broader consumption and investment demand. This is where the trillions of dollars of fiscal spending come in. With the government supporting incomes and demand, the central bank may not need to rush in to calm markets. The balance will be a tricky one.

Given Chairman Powell’s disinclination to talk down or take action against rising treasury yields, real and nominal rates in the US have continued their 2021 trend, rising further in March. The 10yr breakeven inflation has risen by nearly 13 bps in March driven by a nine basis point rise in real yields and a 22 bps rise in nominal yields. The mid part of the curve, between two-year and ten-year notes, is the steepest it has been since September 21, 2015. This backup in rates has driven losses in long duration fixed income investments. They would love Fed intervention to bend the curve. But is the 10-year-2-year gap worrisome on a systemic basis for the Fed?

Investors should listen closely to the FOMC decision this week, both for indications of how monetary policymakers view the steepening yield curve and for the latest economic projections from the Fed’s economists. The new dot plot will be of particular interest: will the Fed’s earlier expectations of steady rates through the end of 2023 be affected by the recent divergence of market expectations from this view? 

Rates in other parts of the world, most notably Australia and the Eurozone, have reversed course, with bond markets rallying as their central banks have either taken action or indicated they will take action to prevent a too rapid rise in rates. The ECB pledged to increase substantially the pace of its purchases over the next quarter, while the Reserve Bank of Australia doubled the amount of its purchases in the longer dated part of the curve after the substantial rise in Aussie rates toward the end of February. 

3. Covid-19 still counts: what’s the matter with Europe?

Last year, the US and the UK trailed much of Continental Europe in managing the pandemic. It seemed that in Europe, lessons in public health and patient care were taken to heart after the initial wave of cases in Northern Italy overwhelmed health services. In America and Britain, numerous shifts in public messaging and policy and, in the US, fragmented approaches across the country, resulted in infections and death rates far above global averages.

The tables have now turned. The UK is leading among major advanced countries in vaccinating its population. The US is next. By contrast, the rollout of vaccines in Europe has been slow and contentious after the EU countries agreed to let the European Commission in Brussels take the lead. Only about 7 percent of the adult populations in Germany and France, have received a first dose of vaccine. As lockdown restrictions drag on and the summer tourist season approaches, no wonder that the EU is also marking down growth projections. 

This divergence in outcomes has been most clearly expressed via the currencies of the UK and the Eurozone. Sterling has risen 1.9 percent vs. the USD year to date, while the euro has fallen by 2.2 percent over the same time period. Equities send a more mixed signal with the broader European market, as measured by the Stoxx 600 outpacing the UK FTSE 250 MTD, but lagging YTD (all in USD). Equity investors are trading Europe from a sector rather than a country or regional perspective with Financials, Industrials, and Consumer sectors top contributors across geographies. Lingering issues with the virus on the continent, and continued, but reduced, uncertainty around the prospects for the UK economy, post-Brexit, are keeping European equities below their pre-pandemic peaks. 

While within Europe there remain concerns affecting asset prices, the European market has still participated strongly in the reflation story. MSCI Europe and the FTSE100 have outperformed the S&P 500 over the last four months. Active stock and sector selection in Europe and the US remains critical.

4. Emerging Markets growth and markets follow 

A strong US recovery should help to pull emerging markets out of recession. Commodity exporters will likely continue to benefit from higher prices. But unlike during the Global Financial Crisis, a decade ago, emerging markets (ex-China) will be followers rather than leaders. This time around, the recession hit everywhere. The US and developed countries provided extraordinary levels of support for their citizens during the pandemic, ranging from some 15 to 25 percent or more of GDP. Many emerging markets were also able to loosen monetary and fiscal policy, but to a much lesser extent. Estimates average around 6 percent of GDP for middle-income countries and even less for low-income developing countries. Multilateral programs, such as the World Bank, were seen as anemic. Only China-aid programs continued, although even those slowed down. Looking ahead, the race to vaccination will also factor in to the speed of recovery in emerging countries, many of which — especially in Asia — have outperformed in disease control but may lag the US in access and distribution of virus. “Vaccine diplomacy” is underway with China distributing its vaccine widely — and Russia the same. The US is holding on to extra supplies until all Americans are vaccinated. But as the president’s  Quad summit last week showed, with India, Australia and Japan, the US will be ready to play that card for strategic as well as health reasons. And the Administration believes the health rationale is strong. 

Last week, investors saw a bifurcation in performance between Chinese equities and the rest of emerging markets. The CSI 300 Index finished the week down close to 3 percent in local currency terms. As of Friday, the rest of emerging markets was up close to 2 percent in USD terms (the RMB was largely unchanged). Post-Lunar New Year, Chinese equities have pared back much of the YTD gains, going from a peak of 19 percent on February 6, 2021 to 2 percent this week. Technology-related names in the IT, communication services and consumer discretionary sectors led the correction. It seems that the bond yield driven de-risking is more targeted towards stretched growth and momentum mega cap stocks, rather than broad-based. To this point, median level stocks stayed resilient amidst the recent downturn given their un-stretched valuations.
Historically, Chinese equities cope well with rising bond yields. Data show that on average Chinese equities advance 0.2 percent when bond yields rise (see table below). Looking ahead, we expect Chinese equities to enter range-bound territory, underpinned by solid fundamentals and EPS revisions for the second quarter of this year.
Despite the volatility in markets, emerging markets flows remained strong with inflows for the 24th straight week — the largest ever streak in USD inflow terms (see below).
Within regional equity funds, Asia ex-Japan saw net inflows while EMEA and Latin America saw net outflows for the second consecutive week. Not surprisingly, emerging markets fixed income funds recorded the largest outflow in a year. RockCreek emerging markets portfolios have increased exposure to Indian equities where we see opportunities in the healthcare and financials sectors in mid to large cap names. India’s lower sensitivity to rising global yields and a stronger USD compared to Latin America and EMEA is increasingly attractive. We are keeping a watchful eye on crude oil prices, which, given the recent rally, could derail India’s economic recovery. We are, however, encouraged by India’s growing investment in distributed renewable energy.
RockCreek Update
RockCreek celebrated International Women’s Day this past Monday by releasing a special edition of our weekly letter highlighting the work RockCreek and our partners have done to advance women’s equality. Read the full letter here

RockCreek Founder and CEO Afsaneh Beschloss was named to Barron’s 100 Most Influential Women in U.S. Finance list for the second year in a row. In a year that challenged all businesses, “RockCreek delivered one of its best years, thanks to investments in businesses with environmental, social, and governance mandates.” Read the full story here.

Last Friday marked the first anniversary of RockCreek working remotely. The RockCreek team continues to work seamlessly and efficiently remotely, with more team members choosing to come into the office. We maintain a resilient culture and sense of community with morning coffee sessions, town halls, book clubs, meditation sittings, bicycle rides, hikes and more.

Team RockCreek

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