Equities finished the week slightly off record highs, as investors continue to balance positive news with near-term challenges. In focus is the $1.9 trillion fiscal-stimulus proposal from the Biden administration and worsening coronavirus news, coupled with the vaccine rollout. Republicans have shown resistance to such a sizable stimulus plan, concerned about the long-term sustainability of the government’s deficit levels. This week will shed some light on company earnings and fundamentals, with over 23% of the S&P 500 releasing results. Housing continues to remain strong as starts and permits are both on the rise, and although there has been a short-term pullback in mortgage refinancing, demand is still elevated due to persistently low rates.
Markets Near New Highs, but Can the Streak Continue?
Equities added 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%1. For comparison, the second-best election-inauguration gains took place in 1960-1961 when Kennedy assumed power, with the S&P 500 gaining 9%1. The discovery and rollout of effective vaccines have raised hope that restrictions will gradually be lifted, accelerating the economic recovery and return to normalcy. At the same time, the $900 billion fiscal stimulus passed in December and prospects of more fiscal relief under the new administration have added fuel to the stock market rally. We offer the following perspectives on the market’s strong performance and our views on what might come next:
1. The new administration’s first policy priorities align with two key market drivers for 2021. We believe that two of the most important drivers of market performance this year will be the pace of vaccinations and size of additional fiscal stimulus. It is not lost on investors, in our view, that the most favorable proposed policy aspects for stocks are front-loaded this year, while the ones that might trigger some indigestion, like corporate tax increases, will likely be postponed until the recovery is on surer footing.
Effective vaccine distribution is a needed catalyst for faster growth – To sustain market gains and realize the expected recovery in corporate earnings, a successful rollout of the vaccines is necessary. Last week, President Biden released details of his coronavirus response plan, emphasizing a ramp-up in testing and including greater use of the Defense Act to help with vaccine production. The plan also seeks to accelerate the rollout of vaccines by providing more funding to local and state officials. From an economic perspective, a potentially accelerated vaccine rollout will allow for a faster return to normal spending habits and benefit hard hit industries like leisure and hospitality, while also acting as a catalyst for further healing of the labor market.
Another booster shot to the economy is likely on the way – Until the recovery gains more momentum, an extension of the fiscal bridge is probably needed. The $900 billion COVID-19 relief bill that was passed in December under the Trump administration provides unemployment benefits until March 14. The Biden administration has proposed another massive fiscal injection worth $1.9 trillion, equivalent to almost 9% of GDP, that would extend unemployment benefits until September. We suspect Biden’s fiscal proposal will be scaled back in the negotiation process over the next several months, but another sizable relief package is likely coming, boosting GDP growth and lifting personal incomes. The U.S. CARES Act pushed personal incomes $2 trillion higher than the pre-crisis levels last year, and incomes remain above the pre-pandemic trend2. Additional direct payments to households and extensions of the unemployment benefits would keep incomes well above trend, supporting consumption.
2. The bull market has further room to run. Rising corporate profits, easy Fed policy, and loose financial conditions are typically a powerful combination for rising equity markets. These conditions have historically occurred in the early- and mid-cycle phases, rather than at the end of a bull market.
Earnings poised to grow – As the budding economic recovery accelerates after a soft patch early in the year, corporate earnings will get a boost from the upturn in the business cycle. U.S. GDP is expected to grow between 4%-5% this year, with the high-end more likely if further fiscal stimulus is passed. Additionally, a 7% decline in the U.S. dollar against major currencies will help revenue growth, and lean corporate structures will allow profit margins to expand. All in all, it seems feasible for corporate earnings to grow more than 20% in 20212. Even though the fourth-quarter earnings season has only just begun (13% of the S&P 500 companies have reported earnings as of 1/22), early results are encouraging, with companies so far reporting earnings 21.5% ahead of expectations3.
The Fed will stay accommodative – The prospects of additional fiscal aid lessen any pressures for the Fed to do more to support the recovery. However, even with the stronger economic rebound we expect, the Fed is likely to stand pat and keep rates near zero for at least the next two years. There will still be significant slack in the economy and labor market by the end of the year, which is why we believe that the Fed will also continue its current pace of bond purchases.
3. Elevated expectations could mean that a period of consolidation lies ahead. The rally has set a high bar for the new administration, and markets have already priced in a healthy improvement in fundamentals, potentially leaving the door open for short-term disappointment. Below are three factors that could dent sentiment in the near term without derailing the recovery, in our view.
The pandemic will continue to drive fundamentals in the months ahead. The new, more contagious COVID-19 strain threatens to keep European lockdowns in place longer than expected. This led to Germany cutting its 2021 GDP forecast to +3% from +4.4%3. Encouragingly, more vaccines could be on the way, with Johnson and Johnson’s trial results expected later this month.
With the inauguration now behind us, investors’ focus will shift to the legislative process and what is actually getting accomplished. To that end, the new administration will face obstacles in the Senate, with Biden’s stimulus plan already having received some pushback. Stocks have historically paused in the first 100 days after a new president is sworn in, with the S&P 500 returning about 1% on average since 1933, though performance has varied widely, reflecting the economic conditions at the time rather than the election results1. Encouragingly, stocks have increased under any political combination, a testament to the nonpartisan nature of the markets. Since 1933, the combination of Democratic president and Congress has resulted in a 9.3% annual return1.
The S&P 500 is trading at almost 23 times this year’s earnings, reflecting a high level of optimism3. We think strong earnings growth this year will help valuations normalize, but at these levels a lot of the good news is already discounted. As last year’s earnings resiliency highlighted, there is still room for positive surprises, but investors will be sensitive to any economic setbacks and policy proposals that affect corporate profits, such as higher corporate taxes.
We believe the market’s winning streak will continue in 2021, but not uninterrupted. A period of consolidation would be healthy and allow the improving earnings and economic fundamentals to catch up with prices. We note that such market corrections are common even during the early stages of the market cycle. Given our positive outlook for economic growth and earnings, we would view any upcoming pullbacks as attractive buying opportunities for investors with a long-time horizon.