1/6/2021: Market Update by Jack Ablin, Chief Investment Officer at Cresset
Here are Cresset’s Five Themes for 2021
- YOLO spending will pressure prices
- The Fed flinches
- Valuation is stretched, but opportunities remain
- Investor optimism could lead to disappointment
- Innovation investing stands the test of time
1. YOLO Spending Will Pressure Prices
The global economy is poised for a 2021 rebound, as COVID vaccinations are dispensed across the world. The pandemic prompted the biggest economic retreat since the Great Depression. But last year’s economy equated to a natural disaster, with the ability to sharply rebound as we get back to business; it will not be a long, drawn-out credit-led recession, from which it takes longer to recover. The recession related to the financial crisis took four years to fully rebound.
Americans saved a record share of their income last year, with disposable income topping $1 trillion despite record job losses. According to a New York Times report, the increase was attributed to job losses concentrated in low-income categories combined with generous government relief. Meanwhile, spending fell over $500 billion, as stay-at-home orders forced households to not spend at restaurants, rock concerts and ballgames. By April 2020, Americans had socked away a record 33 per cent of their disposable income.
Armed with a stockpile of savings, Americans’ pent-up demand for social interaction, recreation and experiences will be unleashed in H2/21 in a tide of “you only live once” (YOLO) spending. All told there is nearly $4.3 trillion sitting in US money market funds as of the end of 2020. That’s an increase of $700 billion compared with the end of 2019. Airlines and hotel companies, anticipating a demand surge, will be hiking prices in H2 compared to 2020. For example, a room at the Ritz Carlton in Miami, which was $460 in December 2020, is being offered at $881 in November 2021, according to the hotel’s website.
YOLO spending against a backdrop of constrained supply could push inflation well above the Fed’s 2 per cent target in H2. Without continued central bank buying, intermediate-term interest rates could rise later this year. Pressure is building already: our copper/gold model, which compares pro-cyclical copper against defensive gold, suggests the 10-year Treasury note should yield 1.9 per cent, not the current 0.9 per cent. We attribute the yield differential to the Fed’s bond-buying program, which is currently running at $80 billion/month for Treasuries and $40 /month for mortgages.
2. The Fed Flinches
Increased demand in H2/20 will put pressure on prices and force central bankers, particularly the Fed, into an uncomfortable position. The rate-setting Federal Open Market Committee has pledged to keep overnight interest rates near zero until 2022 at least. They also plan to let inflation “run hot.” Bond investors are beginning to price in 2+ per cent inflation, according to the yield differential between inflation-protected Treasuries and fixed-rate notes. While we don’t believe Chairman Powell & Co will hike their benchmark Federal Funds rate, we wouldn’t be surprised if they scale back their bond purchase program, which is considered an emergency measure. That could set up the equity market for another “taper tantrum.” Thanks to central banks holding interest rates below the inflation rate, most of the equity markets’ return over the last decade was due to valuation expansion, not earnings growth or dividend yield. Higher inflation coupled with steady overnight rates would push “real rates” further into negative territory.
Without the benefit of valuation expansion, investors will need to rely on “organic” equity returns through earnings growth and dividend yields. Generous earnings yields require relatively low price-earnings ratios. We expect “quality at a reasonable price” to lead markets higher for the next several quarters. Stripping away valuation expansion from market returns over the last 10 years shows that large cap still dominates small cap, but value dominates growth. The Russell 1000 Value Index, for example, outpaced the Russell 1000 Growth Index by nearly 2 percentage points per year when relying only on earnings and dividends. The Fed is virtually out of ammunition. Without its help, further valuation expansion appears unlikely, in our view. We believe investing in reasonably priced companies with strong balance sheets and consistent dividend histories is the best way to play the next leg of this market cycle.
While US large-cap valuations are stretched, other markets are poised to catch up this year. The S&P 500 is trading at its highest valuation on several measures, including price-to-earnings and price-to-sales. US markets are similarly stretched. Within the US large caps, however, economically sensitive sectors, like financials, energy, materials and industrials, are more favorably valued by historical standards. Master limited partnerships and energy infrastructure are currently trading in the bottom quartile of their historical valuation range. Looking beyond the US, emerging market equities are better positioned on a price-to-sales basis than their asset class counterparts. We believe sectors and markets that trailed during 2020 have the potential to outperform last year’s winners in 2021.
4. Investor Optimism Could Lead to Disappointment
Investor optimism, as gauged by the number of respondents identifying as “bulls,” is currently situated in the 72nd percentile of its historical range. While readings above 90 would be considered extreme, the current level of bullishness still suggests investor complacency. Borrowing money to buy equities on margin is another indicator of bombastic bullishness. Margin balances rose 50 per cent between March and November to just over $722 billion, according to FINRA. The growth in margin debt undoubtedly helped propel the market’s 40 per cent gain over the period.
In a world where the markets, at least over the near term, respond to the intersection of reality and expectations, low expectations are better than high expectations. While we share investors’ enthusiasm for H2/21, a lot could go wrong between now and then. The pace of the recovery, for example, depends on the rollout of the vaccine and, so far, the results are underwhelming. President Trump initially pledged 300 million doses by January 2021 when announcing Operation Warp Speed. That estimate was slashed to 100 million in the fall. After Pfizer adjusted its production estimates, Health Secretary Alex Azar promised 40 million doses on hand and 20 million vaccinations by the end of the year. As of the first week of January, however, only 2.6 million vaccinations have been recorded by the federal government. President-elect Biden promised 100 million doses in his first 100 days, but one million vaccinations a day appears farfetched given the current rate. Substantial delays in inoculations would push back reopening dates, leading to economic and financial disappointment. Any meaningful pullbacks could be exaggerated to the downside, like last March’s pullback, albeit not to the same degree, thanks to burgeoning margin balances. We would view 10%-plus pullbacks as longer-term buying opportunities.
5. Innovation Investing Stands the Test of Time
For hundreds of years, innovation has transcended market cycles, economic downturns and political upheaval. In his book The Rise and Fall of American Growth, Robert Gordon explored how massive innovation transformed life in America in the 100 years between 1870 and 1970. Gordon argued that period unleashed the most disruptive innovation in human history. Imagine: in 1870, three-quarters of Americans lived in isolated, rural homes without running water and electricity. They relied on horses for transportation. Most Americans were born, lived and died within a several-mile radius. Even though the country’s first transcontinental railroad opened in 1869, it was mostly dedicated to commercial use. In 1870, nearly half of American workers either lived or worked on farms and about one-third were blue-collar workers. By 1970, 75 per cent of Americans had gravitated to urban settings. Nearly all households had indoor plumbing and were networked with electricity and telephones. The population of 1870 couldn’t have dreamed of traveling across the country by airplane nor imagined the potential possessed by ENIAC, the first digital computer, which was introduced in 1946.
Innovation is a constant that is fostered by creativity, talent and access to risk capital; those factors will continue to drive the way we live and work. Innovation will improve our health and extend our lifespans. The Cresset Investment Team has developed thematic investment strategies designed to harness many of the most disruptive and promising innovations we believe will have the most impact on our future. Our team has identified four powerful themes under which innovation and disruption will transpire:
- Demographic Developments – Aging populations in the developed world have increased awareness for health and longevity.
- Social and Political Trends – Online activity has flourished, connecting the world as a global community. These trends have had an impact on consumer spending, social interactions, business activity and even gaming. Societies’ reliance on data and the cloud, however, make all of us vulnerable to cyberthreats.
- The Fourth Industrial Revolution – Notwithstanding globalization and outsourcing, many already industrialized nations are reshoring critical manufacturing, facilitated by robotics and artificial intelligence.
- Sustainability – Climate change is an issue literally enveloping the globe. Alternative energy sources, including next-generation transportation, is gaining ground as the world gradually weans itself from fossil fuels.
Innovation, disruption and creative destruction are occurring at an accelerating pace. The telephone was invented in 1876 and it took 75 years for it to reach 50 million users. The radio was introduced in 1890; it took 38 years to reach 50 million listeners. The television was unveiled in 1927 and took 13 years to achieve 50 million viewers. The internet, available in the early 1990s, took four years to reach 50 million users. Facebook took three and a half years to reach that user level, while TicTok took only 19 days. Innovation cuts both ways. In 1988 Eastman Kodak dominated film photography and had nearly 150,000 employees. Twelve years later, the company had shrunk by half. Cresset’s thematic investment strategies seeks to harness innovation and disruption over a time horizon of 15 years or more.
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