Beating The Fed’s Forecasts
The implications of all of this for growth, jobs and inflation are extremely difficult to estimate with any precision. There simply is no modern blueprint for how fast the economy could recover from a pandemic as the pandemic winds down. In addition, we have no historical experience of what happens when, over a six-month period, stimulus aimed at lower- and middle-income households, equivalent to over 5% of GDP is dispersed into an economy that is already recovering.
What does seem likely, however, is that economic numbers this year will be even stronger than the Federal Reserve’s March projections. At that time, they envisioned real GDP rising 6.5% year-over-year in the fourth quarter with an unemployment rate averaging 4.5% and consumption deflator inflation projected at 2.2% year-over-year.
If, over the next few months, it becomes apparent that the economy will indeed beat these numbers, markets will likely begin to price in a tapering of bond purchases starting in early 2022 and a first increase in the federal funds rate in early 2023 or even late 2022. This could easily push 10-year Treasury yields above 2% in the months ahead.
Adjusting To Higher Interest Rates
Such a scenario presents challenges for investors in fixed income and equities. On the fixed income side, higher Treasury rates could lead to losses for many long-duration and high-quality bonds as there is limited room for spread compression. One potential exception to this is emerging market debt, although, as always, investors will need to be wary of the many potential regional problems in this space.
On the equity side, this scenario also poses some challenges. Following a 22% drop in S&P500 operating earnings in 2020, analysts expect a 40% rise in 2021 to roughly $172.50. While this is possible in a faster-than-expected recovery, further gains in 2022 could be very limited, given higher interest rates, higher wage costs, slowing economic growth and, potentially, a hit from higher corporate taxes. This makes today’s overall market valuations, at over 22 times forward earnings, look pretty rich, while frothier areas of financial markets remain are particularly vulnerable to higher interest rates.
However, it is also important for investors not to neglect opportunities as we transition to a post-pandemic economy. Even after a rotation towards value and small cap stocks in recent months, relative to history, they still look cheap compared to large-cap growth stocks and should benefit from a very strong economic surge. International stocks also look less expensive than U.S. equities with higher dividend yields and have the potential to outperform once the global pandemic subsides. A higher-than-average dispersion of valuations within the S&P500 points to a potential opportunity for active managers. Finally, longer-term themes such as greater R&D investment in green technology and biotech and the growing importance of China in global fixed income and equity markets could all provide opportunities for better returns in the years ahead.
A double-dose of vaccines and fiscal stimulus should make 2021 a spectacular year for economic recovery. However, high valuations and rising interest rates could also make it a challenging one for investors, underscoring the importance of making adjustments to help portfolios meet the challenges of a fast recovery and the financial landscape of a post-pandemic world.
David Kelly is chief global strategist at JPMorgan Funds.