The Markets and the Economy Are Connected

Almost anywhere you turn these days, you’ll find someone arguing that equity markets don’t reflect the U.S. economy. Allow us, once again, to disagree: We believe equity markets and the economy are absolutely connected but with nuances in time horizon. However, one may need to dig a bit deeper to find the connection. Certainly, markets pay heed to current economic events, but more importantly, they’re a discounting mechanism of how the current environment relates to the future one. Put differently, markets move based on expectations of how the future will look different from today.

There may be no better example than last year, when U.S. equity markets began their rapid descent in February before economic data plunged. The markets moved based on the expectation that the future would look different because of the severe economic disruption from COVID-19 closures. But then, well before economic data began recovering, markets began a rapid ascent. Overall in 2020, the U.S economy contracted by 2.3 percent on a nominal basis, which may seem at odds with the U.S. stock market advance in 2020. However, the equity markets’ push higher has been driven on the back of an economy that is rapidly digging out of the deep economic hole that occurred in the first and second quarters of 2020. And we're continuing to fill the economic hole in 2021, as economic growth is set to gain vigor amid a broader reopening and return to normal as more people get one of at least three (and likely more) highly effective vaccines.

We continue to forecast strong and broad economic growth in 2021 across nearly all segments of the U.S. economy. Given this backdrop, we believe that the economic recovery will lead to higher stock prices in the intermediate term but with much broader equity market participation and leadership than has occurred over the prior few years. In the December Asset Allocation Focus we stated our belief that this broadening of the equity market was already underway, and as we expected, it has continued in early 2021. We believe these trends will continue through the remainder of the year.

A continued broadening of a previously narrow economy and markets

For much of mid-2018 through mid-2020, a narrow portion of the U.S. and global economy was advancing, which created a narrow market environment. This started in mid-2018, with a trade war that was designed to harm manufacturing, exports and the more cyclical segments of the U.S. and global economy. Given this economic reality, it should not be surprising that the trade war also harmed cyclical sectors and asset classes around the globe. 

However, secular growth stories like U.S. technology and FAANG stocks were largely not impacted and powered ahead as their earnings growth stood above the crowd. We got a brief reprieve in late 2019 and early 2020 as the trade war came off the boil. But then COVID-19 and its subsequent economic closures had nearly the same impact.

This economic reality carried over to the equity markets. From the end of September 2018 until the end of September 2020, the S&P 500, with its top-heavy concentration in technology and communications services sectors, advanced nearly 10 percent per year. However, if you remove the impact of those heavy market-cap-weighted behemoths and equally weight the S&P 500, it advanced only 2.9 percent each year. When you break the S&P into growth (technology, etc.) stocks and value (cyclical) stocks, a more alarming divergence emerges: Growth stocks advanced nearly 16 percent per year, while value nudged higher by a whopping 1 percent per year. Moving down the capitalization spectrum, more cyclical U.S. Mid-Caps actually fell 2 percent per annum, while U.S. Small Caps dropped 9 percent per year. Lastly, it should not come as a surprise that more cyclical world economies languished, as did their stock markets, with Developed International stocks “rising” 0.16 percent per annum, while Emerging Markets rose 4 percent.

Contrast this to the past few months as economic activity has broadened and looks set to push forward on the back of massive fiscal and monetary stimulus, inventory rebuilding and pent-up demand as economies reopen. Not surprisingly, the relative winners have shifted as the economic environment is broadening. The S&P 500 is up 16 percent cumulatively from the end of September 2020 through the beginning of March 2021. But when you take a deeper look, the leaders have changed with every other aforementioned market beating the broad index. The equal-weighted S&P 500 is up 27 percent. Meanwhile, S&P 500 Value stocks have bested their growth counterparts 22 percent to 13 percent. U.S. Mid-Caps have catapulted ahead by 38 percent, and U.S. Small Caps are up a staggering 55 percent. Globally, International Developed markets are up 19 percent, and Emerging Markets have risen 27 percent. Simply put, as the economic backdrop has changed, so has the market backdrop. Markets are still strong but with different leadership. We expect this to continue for the remainder of 2021.

2020 stimulus leaks into 2021 

One of the biggest economic divergences in 2020 was that U.S. economic growth fell 2.3 percent from 2019 on a nominal basis. That happened while total U.S. personal income actually rose 6.3 percent in 2020 — count that as another way 2020 was like no other, given that these two measures of U.S. economic well-being have been historically tied at the hip. Think of it this way: Typically, someone’s economic output is someone’s income — but not in 2020 because of the huge stimulus packages that were provided by fiscal policymakers: $2.2 trillion in March 2020 followed by $900 billion in December, not to mention the likelihood of an additional $1.9 trillion in March 2021.

And it’s not just fiscal policymakers but also monetary policymakers that are a tailwind to the U.S. and global economy. The economy and markets are currently being enhanced by a Federal Reserve (Fed) that is determined to keep rates low and continues to buy $120 billion a month in Treasury securities and mortgages to keep liquidity ample and to nudge investors toward taking risk.  

The economy felt the impact of these actions in 2020, but 2021 is likely to be amplified because consumers have saved much of the stimulus money they received. As of the end of February, the U.S. consumer in aggregate is sitting on north of $1.7 trillion in excess savings — and that’s before any additional stimulus in March 2021. As the economy reopens and employment grows, this wall of money could have huge impacts on not just growth but also potentially on inflation.

Hedging 2021’s evolving economic and market risk  

We believe that for the first time in years, the prime risk is that the economy overheats, not underheats like much of the past years. We have long stated our belief that inflation is not a thing of the past. Tying into our earlier story of the impacts of the trade war, we point out that inflation in 2018, as measured by the Fed’s preferred measure Personal Consumption Expenditures (PCE), was running above 2 percent for nearly all of 2018.

However, while we note that inflation is a growing risk, our base-case forecast is that it is not a risk in 2021. Nearly 10 million fewer Americans are employed today than were at the start of the COVID-19-induced recession. How quickly we return to pre-COVID employment levels will likely determine the path of inflation, and we don’t believe that will be until 2022 or 2023.

Even then, the Fed is determined to sit on its hands and not tighten policy until inflation has been above 2 percent persistently. Given the Fed’s desire to focus heavily on the employment mandate, we believe it will wait until there is significant improvement in the labor market to tighten — even if inflation begins pushing higher in the near-term. While we believe persistent inflation is not a 2021 risk, we believe investors need to hedge against it. We think of it this way: The policymakers have essentially covered the equity downside risk with the threat of more policy if need be. The only thing that would disrupt their best-laid plans would be inflation. We continue to recommend that investors own commodities and Treasury Inflation Protection Securities (TIPs) as hedges against too much of a good thing.

Overall, we remain overweight to Equities relative to Fixed Income. As a review, in April 2020, during the heat of the market decline, we upped our overall equity allocation overweight by increasing exposure to more economically sensitive, relatively cheap U.S. Mid-Cap stocks. In late August 2020, we recommended investors shift some of their U.S. Large-Cap allocation (which we noted was increasingly dependent on the performance of a few “large growth” stocks) toward more economically sensitive cyclical value stocks. Since these dates, both shifts have paid performance dividends as the economy has broadened, and we expect this to continue into 2021. We also note our continued overweight to U.S. Small Cap stocks.

In January 2021, we further reduced our U.S Large Cap recommendation to neutral and reallocated the proceeds to Real Estate Investment Trusts (REITs), an asset class that we previously held as max underweight and are now slightly underweight. As the economy reopens and inches back to normal, we suspect this asset class will continue healing.

Within International markets we retain a neutral position in Developed Markets and are overweight in Emerging Markets, which stand to benefit from rising global growth and persistent low U.S. interest rates as well as accommodative monetary policy.

The recent rise in yields has caused many to worry about the relative valuation of equities. Nearly every analysis of the equity market begins with the comment that, yes, stocks appear expensive, but relative to paltry bond yields, they are cheap. We first point out that the recent rise in yields has occurred on the back of prospects for better economic and, importantly, earnings growth, with a minor simmering of inflation worries. We also remind that even after this push higher in interest rates, much of the U.S. yield curve still trades below current and expected future inflation. Given this reality and our forecast for strong economic growth in 2021, we continue to believe that equity markets overall hold better intermediate-term prospects than fixed income markets.

While rates have risen on the longer end, the Fed will remain anchored at 0 percent on the front end of the interest rate curve. Plus, the Fed may move some of its firepower to buying longer-dated maturities in an attempt to keep rates low if it believes intermediate- and longer-term rates have risen so much that they jeopardize its ability to reach its employment mandate.

However, we implore that you resist the temptation to pull your portfolio apart and judge the merits of each individual slice without the context of how all the pieces interplay together. Given our desire to continue tilting our portfolios toward equity-risk exposure, we maintain our conservative stance toward our fixed-income holdings and recommend high-quality, investment-grade bonds. With the U.S. yield curve now steepening and thus offering additional yield premium, coupled with the Fed’s likely desire to sit on the yield curve and not allow an aggressive rise in intermediate to longer yields, we continue to recommend investors embrace a duration near their benchmark targets.

Lastly, we have discussed 2021’s risk that inflation could surprise to the upside and throw a wrench in policymakers’ best-laid plans. While we don’t think this is likely, we continue to recommend that investors hedge against this risk and continue to recommend an allocation to TIPS. We note that much of the “easy returns” have been harvested here as inflation expectations have firmed from their COVID-19-influenced lows. But we still view this as a worthwhile diversification instrument to an overall portfolio.

Since the onset of COVID-19 in early 2020, only one “equity-like” asset class has provided investors with negative returns: Real Estate Investment Trusts (REITs). Broadly speaking, we believe REITs are the asset class that remains the “most COVID-19 impacted.” Put directly, it has the most structural issues to sort out in the intermediate to longer term from the pandemic, as companies and shops sort out their virtual vs. physical presence requirements. However, in January 2021, we determined that this reality was largely being reflected in REITs’ current prices, and we returned our max underweight to a slight underweight. As the world continues to open in 2021, we will be looking for opportunities to add to this asset class that has income-producing potential.

We continue to hold a neutral allocation in Commodities, primarily due to their diversification benefits and correlation to unexpected inflation. Building portfolios is about hedging risks, and we believe these risks may be evolving to more commodity-favorable inflationary risks. While recent history has not been kind to Commodities, perhaps the future will be as the economic back-drop shifts. We are not throwing in the towel on an asset class that may provide future diversification benefits as policymakers around the globe pull out all the stimulus levers to help their respective economies climb out of their COVID-19 economic valleys. And given our belief that inflation is the risk that could upend all the policymakers’ best-laid plans, we continue to recommend this asset class.

Within Commodities, we continue to recommend that investors “tilt” some of their broad exposure toward gold. If broad commodities are a call on future economic growth and inflation, gold can hedge against too little or even too much growth. Given this straddle and our desire to further diversify our portfolio, we continue to recommend targeted gold exposure within our commodity allocation. We’d also point out that if inflation does rise but the Fed decides to try and suppress its impact on interest rates, gold will likely provide portfolios with a pressure relief valve given its propensity to be positively impacted with negative real interest rates.

For those still not inclined to own commodities or gold solely due to their recent performance, we offer the following commentary. We believe monetary and fiscal policymakers will aggressively pull levers to stem any economic or equity market downturn in the future. Long-term readers know this has been a substantial basis for our equity overweight of the past few years. As we have said repeatedly, this doesn’t mean there won’t be shocks and downturns, but rather that any such events will likely be shorter because policymakers — especially the Fed — need markets to move higher to guide the economy and inflation higher.

Overall, this aggressive and quick use of monetary and fiscal policy as an economic and market backstop remains our central forecast. And why not? Currently there is no apparent “cost” on the other side to contemplate. Indeed, this remains our central forecast until there is a cost in the form of 1) an inflation surprise, 2) a rising interest rate market that doesn’t cooperate or 3) a dollar collapse. We believe this means commodities and gold play an important role in guarding against these unexpected events that could derail both the stock and bond markets. Given this backdrop, we continue to recommend that investors “spend” a small portion of their portfolio guarding against what could be a future market disruption.

Amid the chatter about a disconnect between the market and the economy is a growing chorus worried about a market bubble. Indeed, we have waded into the chatter with our claims that parts of the market today remind us a bit of the late 1990s. Think about it this way: Once again, we have day traders engaging in their “craft” through self-directed trading platforms guided by internet message boards. Most of the narrative in the stocks they trade is how these companies are changing the world through emerging tech platforms. People who buy these stocks appear willing to pay any multiple for the potential earnings largesse that may come to them many, many  years from now. Indeed, most of this investing is “earnings-agnostic” and rather focused on thematic investing. Lastly, we’d be remiss to not throw in that the U.S Large Cap stock market (the S&P 500) is similarly concentrated in technology stocks much like 1999, with a few high flyers making up a large amount of the overall market.

The pertinent questions investors must ask themselves are these: 1) Is this whole market overvalued? And 2) If the answer to No. 1 is “no,” do these pockets of overvaluation and the pullback that likely ensues take the overall market down? Our answer is that this is not a whole-market story but rather a slice or pocket of the market. While it certainly could cause a near-term broader correction, it would likely be short-lived given the economic growth we see in 2021 and the commitment from the Fed to not end the party too early.

The 1999 bubble that burst did cause an overall market correction. However, it was short-lived in many of the asset classes outside of the bubble. Those asset classes went on to post strong returns in the coming year. More importantly, the cause of that market correction was likely economic rather than market based. Think about it this way: In the late 1990s, the U.S. economy hadn’t experienced a recession since 1990-91, and the Fed was tightening monetary policy to slow the U.S. economy. Contrast that to today, when the U.S. economy is just exiting a recession and the Fed is still providing monetary accommodation to stoke the economy higher. We’d also remind that not all stock valuation is created equal and must be placed in context on the potential returns from other assets. Then the 2- and 10-year Treasurys each yielded roughly 6 percent respectively, while today they are at 0.14 percent and 155 percent.

Our fear is that investors have been lulled into complacency and have positioned their portfolios in the asset classes and segments that have performed well in the prior economic cycle. That cycle was heavily influenced by a few events that are unlikely to happen again in the future. We’ve said it before, but we will say it again: Recessions have consequences, and the policy and societal changes that occur as a result not only change the next expansion’s economic reality, but also shift market leadership. Back to our original thesis: The economy and market are linked.

The opinions expressed are those of Northwestern Mutual Wealth Management Company as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute individual investor advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non- proprietary sources. Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and its subsidiaries. Investment brokerage services are offered through Northwestern Mutual Investment Services, LLC (NMIS) a subsidiary of NM, broker-dealer, registered investment adviser, and member FINRA and SIPC. Investment advisory and trust services are offered through Northwestern Mutual Wealth Management Company® (NMWMC), Milwaukee, WI, a subsidiary of NM and a federal savings bank.

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