Explore Our investment Outlook
The speed of the U.S. economic recovery is creating its own challenges and opportunities. Let’s start with inflation, the topic du jour. Our base case is that the rapid increase in inflation is transitory, a product of the dramatic rebound in demand for materials, goods and services at a time when supply chains simply aren’t fully up and running.
Conversely, we also see the comparatively high unemployment rate and the continuation of long-term trends like an aging population, automation, digitization and the “Amazon.com effect” combining to limit inflation over time.
But one of the biggest risks to financial markets is that inflation turns out to be “stickier” than we expect. Another few trillion dollars in federal spending when the Fed is holding interest rates near zero holds the possibility of demand-driven inflation. Or, consider the reports of labor shortages in certain sectors of the economy. If these became more widespread, then presumably employers would start to raise wages in earnest and heighten the threat of persistent wage inflation. Of course, as of this writing, unemployment is still well above pre-COVID levels and it’s hard to see signs of large-scale wage increases.
Another potential complication is the housing shortage across the U.S. With interest rates still low by historical standards, millennials entering their prime home-buying years and the economy emerging from lockdown, there’s tremendous pent-up demand for housing. Very strong demand and limited supply mean we just saw the fastest year-over-year increase in home prices, reaching all-time highs in April.
How tight is supply? Freddie Mac estimates the U.S. needs 3.8 million additional new homes to meet demand. For some perspective, the last time there were 1 million new homes built in the U.S. was before the 2008-2009 financial crisis. What’s more, reported construction labor shortages and record-high lumber prices mean it’s unlikely new home builders will come anywhere close to that number again this year. To be clear, this isn’t the 2007-2008 housing bubble—there are fundamental reasons for the increase, and the credit quality of homebuyers is much higher now than during the runup to the financial crisis.
But the same economic fundamentals creating these risks also present significant opportunities. For example, economically sensitive value stocks look very appealing relative to growth-oriented stocks. Consider a classic cyclical value industry like banks—more economic activity means more loans, more transactions and higher borrower credit quality, all else equal. Add the likelihood of higher interest rates and a steeper yield curve, all of which benefit banks’ net interest income. In short, we believe the economic recovery that’s driving the rotation from growth to value still has plenty of room to run.
Similarly, small-cap stocks look appealing relative to large-cap equities because small-company stocks tend to be more domestically focused and more economically sensitive. Consider that large companies may operate in many geographies, products and markets, making them typically more resilient during a downturn, but relatively less attractive at a time when the U.S. is recovering much faster than the rest of the world.
Finally, in fixed-income markets, we believe municipal bonds, which offer federal and state tax-free income, remain attractive. Munis have performed very well in recent months as investors look ahead to potentially higher taxes under the Biden administration. In addition, the economic rebound helps muni credit quality, while provisions in the proposed infrastructure plan also benefit state and local governments.
Reacting isn’t a good investment policy, and overreacting is even worse. Ideally, investors prepare for and build portfolios to withstand interest rate volatility over time. Similarly, investors who incorporate a diversified, strategic inflation hedge into their long-term asset allocation are likely better off than those reacting to an inflation spike. Add it all up, and we see no reason to move off the core bond position that’s a key part of our long-term, strategic asset allocation.
The speed and success of vaccine rollouts put the U.S. at the forefront of the economic and earnings recovery. As a result, we maintain our underweight to non-U.S. stocks relative to U.S. markets. This reflects our conviction that relative economic growth differentials, among other macroeconomic, valuation and technical/momentum factors favor U.S. equities over non-U.S. equities in the near term.
The fundamental economic drivers favor the U.S., even if only in the short run. We believe in the long-term attractiveness and growth opportunities EM equities present, but the pandemic is still an unfolding crisis in many countries. Beyond this fundamental view, our forecast retains its negative outlook on EM equities in the short term as momentum in currencies, stocks and credits remain strongly in favor of U.S. stocks.
Last quarter, we said we were carefully monitoring this position in anticipation of a potential move toward small versus large. Now, we believe that move is justified. We prefer small-cap stocks over large based on several factors. These include stronger U.S. growth relative to non-U.S. economies (small stocks have greater exposure to domestic growth); still relatively low interest rates (supports future growth); narrow/tight corporate bond spreads (along with interest rates reflect low funding costs); and attractive relative valuations.
Our multi-component forecast registered its highest reading for value stocks in the past 20 years. The continued economic recovery, rising consumer sentiment and indications of higher interest rates all favor sectors like financials, materials and industrials over tech and health care in the near term. It bears repeating that we are not moving completely out of growth in favor of value, but overweighting and underweighting asset classes relative to our long-term, strategic targets.
The rapid economic rebound, higher interest rates and concerns about inflation weigh on bond markets across the developed world. Lower-yielding, more interest-rate sensitive government bonds are less attractive than higher-yielding corporate bonds, which should benefit from the upturn in growth. Even within corporates, however, the recovery’s benefits are uneven, so we argue for a very selective approach. The notable exception is the U.S. municipal bond market, which looks attractive as federal taxes and spending rise.
We’ve been arguing for a year or more against the idea of a single, monolithic market for real estate investment trusts (REITs), advocating investors take a more nuanced view of the sector. That’s never been truer than now, as the economic rebound and return to work and retail after pandemic-induced lockdowns mean the demand picture for residential and commercial space is changing rapidly. So, for now we remain neutral, as the sector is less attractive in relative valuation terms after a big rebound, but we continue to watch this one closely.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
International investing involves special risk considerations, including economic and political conditions, inflation rates and currency fluctuations.
Alternative mutual funds that hold a variety of non-traditional investments also often employ more complex trading strategies than traditional mutual funds. Each of these different alternative asset classes and investment strategies have unique risks making them more suitable for investors with an above average tolerance for risk.
Diversification does not assure a profit nor does it protect against loss of principal.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
Mutual fund investing involves market risk. Investment return and fund share value will fluctuate. It is possible to lose money by investing in mutual funds.
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