Will A Vaccine Deliver Inflation As Well As Immunity?
As the country anxiously awaits a safe and effective Covid-19 vaccine, we see a stock market rotation opportunity, away from growth and big tech, to small caps and value.
A Supply Shock, Not A Demand-Driven Recession
The Covid-related lockdown orders drove a negative supply shock through the economy, which was a completely different driver than past economic recessions, which were driven by a collapse in demand. As we all know, immediately following the Covid lockdowns, goods such as toilet paper and cleaning supplies were out of stock, while services such as restaurant dining, bars, gyms, cruise vacations and even dental services, still faced strong demand, but were mandated to zero. A vaccine, could mean a return to normal for all of us and at least a substantial recovery for these supply impacted sectors. Additionally, industrial output should accelerate, with reduced Covid-related capacity constraints on labor and manufacturing.
The Fed and The Government Got It Right
The Fed and the government (treasury, congress and the administration) correctly took the “do whatever it takes” approach to stabilizing the economy with rate cuts, bond buying and massive stimulus actions. These moves staved off the worst-case scenarios of a severe recession, and positioned the economy to restart quickly after lockdown restrictions are lifted. The positive impact of these moves are still likely rippling through the economy and should continue to support growth through at least the end of this year, further supporting post-vaccine economic acceleration.
Quantitative Tightening? Economic Cold Turkey Withdrawal?
The natural outcome of an economic re-acceleration is that there will likely be no additional stimulus actions. As the economy strengthens, there will be no need for another massive relief bill like the CARES act and no need for the Fed to accelerate its easing activities.
In our view, removing the potential for more stimulus is the first step towards reining in the massive stimulus that was extended, or said differently, the first step in quantitative tightening. Stronger GDP and employment data will likely remove any lingering expectations of further declines in interest rates.
Inflation Here Already?
While the S&P 500 has moved to a new all-time high1, it is hardly alone in setting new highs. Gold and lumber have both broken out to new highs2,3, while copper, silver and iron ore have also rallied strongly. Average hourly earnings in July rose 20 basis points, reversing Covid-related declines in May and June4. We think it is highly unlikely that the Fed would add stimulus with price indexes like these rapidly strengthening. There is even the potential for a post demand vaccine surge in inflation, wages and commodities. Such an increase could lead to a Fed rate increase, potentially setting up the economy for a version of stagflation where rates and inflation rise simultaneously at what are historically low interest rate levels.
What It All Means
In our view, the signs are clear. The economy is strengthening and the announcement of an FDA approved vaccine in the next 2-4 months will likely lead to accelerated growth, primarily in the industries that are still negatively impacted by Covid-19. Rising demand will likely lead to rising prices and wage growth, which should lead the Fed to back off its massive stimulus actions and obviate the need for the government to blast more economic stimulus into the system. These actions will likely drive higher interest rates off historically low levels, which could negatively impact growth stocks as investors have likely become too optimistic on the outlook for perpetually low interest rates in setting price targets using Discounted Cash Flow models5. Revenues and earnings for smaller cap industrials, banks, life insurers and consumer service companies will likely re-accelerate, drawing the attention of investors.
Thus, we see a rotation to small cap value accelerating into year-end. Carpe Diem!
1 On 8/21/2020, the S&P traded at 3399.96, setting a new all time high. S&P pricing data from Bloomberg.
2 Gold traded at $2069.79 on August 6th, setting a new all-time high. XAU Gold Spot Price data drawn from Bloomberg.
3 Lumber, LB1 Random Lengths Futures, traded at $859.90 on 8/24/20, setting a new all time high, according to Bloomberg.
4 Average Hourly Earnings from the Bureau of Labor Statistics for July 2020.
5 See our July 24th Market Musing “Its Time For a Value Add” where we talk about the likely impact of surging U.S. Debt levels pressuring rates higher over time https://www.reweyassetmanagement.com/post/it-s-time-for-a-value-add.
All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. These views/opinions are subject to change without notice. The information and material contained herein is of a general nature and is intended for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index.