Given fiscal and monetary stimulus, I believe this bull market can continue.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
Key takeaways
- With the Fed remaining extremely supportive and more fiscal stimulus seemingly close at hand, the economy should return to full speed eventually and markets are already betting on it.
- We are seeing a rotation from large-cap growth to cyclical stocks, like industrials and consumer discretionary, value stocks, small-cap, non-US, and commodities.
- If the Fed remains accommodative and fiscal spending increases, it's possible that earnings could continue to recover, the stock market could remain buoyant, and the rotation could continue.
I learned many years ago that when it comes to trading a portfolio, sometimes the hardest thing to do is to just sit there and do nothing. Hands off! This is especially true when we have the right bets on and those bets have become the consensus. There is a contrarian that lurks in all of us and often the temptation is to lean against the crowd. But the crowd can be right, and it can be right for long stretches of time.
In my view, contrarianism is only called for at the end of moves, which typically happen when investor sentiment has reached an extreme and there are indications that the trend is weakening.
As an example, think about how the weaker dollar theme has been the consensus. Yet, the dollar has kept heading lower in a very steady trend-persistent way. Just because everyone is seeing the same thing as we are, doesn’t mean we should fight the trend.
The rotation away from the big growers, like mega-cap tech companies, to value/cyclicals/small/non-US/commodities is in the same category. They are all part of the reflation trade, the movement of investors to riskier investments and those that may benefit from the economic recovery. The rise in nominal yields and TIPS breakevens is also a part of that. (TIPS breakevens look at the interest rate difference between a Treasury security and a Treasury Inflation-Protected Security and are used as a measure of inflation expectations.) This trade has worked for several months now (since the October S&P 500, or SPX, trading low), and while it is obvious to many, that doesn’t mean that it will soon stop working.
The recovery has broadened since last summer and the strong tape has persisted despite significant setbacks on the COVID front. With cases surging and the vaccine rollout incurring bottlenecks, many countries and states have extended their lockdowns.
With the Fed keeping the monetary spigot wide open and with more fiscal stimulus appearing to be on the way, the output gap should eventually close, and the markets are betting on a return to full capacity, even if that return happens later than expected.
It’s all about extending the bridge to the other side of the pandemic, and my view is that the vaccine rollout combined with ongoing fiscal and monetary support should do the trick.
COVID crisis vs. global financial crisis
The analog to the global financial crisis (GFC) cycle in 2009 continues to work well. Below is the analog from the price low in March 2009 to the low in March 2020. Right on track, both in terms of price gains and the earnings trajectory.
The GFC brings up a good history lesson in terms of the interplay between the fundamentals and the policy response. In the chart below I show the Federal Reserve Bank of New York’s (FRBNY) Weekly Economic Index (WEI) in the gray bars, and the excess liquidity (M2 growth minus GDP growth) as a proxy for the fiscal/monetary response in the yellow line. (M2 is a measure of the supply of money in the economy. It includes cash, checking and savings accounts, and some types of investments like retail money market mutual funds.)
During an economic downturn, when one zigs, the other zags. That’s what happened in 2008 and it’s what is happening now. Eventually the jaws will close again.
The eventual recovery from that slump usually causes a rotation from growth to value and from large caps to small caps. That happened in 2009 and it’s (belatedly) happening now. Small caps are miles ahead of value in this regard.
The question now becomes what the policy response will be when the economic output gap finally does close. By how much will the jaws shut? Will the liquidity impulse wane as it did in 2010? Or will the fiscal/monetary spigot continue to flood the system with liquidity, even as the economy returns to potential?
I am betting on the latter.
If we see more fiscal spending (per the $1.9 trillion plan just announced) and the Fed does not lean into this by taking the punch bowl away, then we could see the market’s high valuations be sustained even as earnings continue to recover.
In that scenario, with earnings bottoming and the fiscal/monetary cocktail continuing to inject liquidity, the market could well continue to post solid returns amid a broadening tape and an ongoing rotation.
The next question is whether real rates will rise or fall? Rising (or less negative) real rates on the back of nominal rates rising faster than TIPS breakevens would be a negative for the reflation trade.
What would the Fed do in that scenario? Will it let rates rise and cause a taper tantrum, or will it start some form of yield curve control in a repeat of the 1940s playbook (which I have highlighted many times). I suspect it will be the latter, but the question is whether there will be a major hiccup in the markets that forces the Fed’s hand.
All in all, with more fiscal and monetary accommodation on its way, and the fundamentals of a closing output gap eventually coming to fruition, my sense is that this bull market will continue, despite high valuations and frothy sentiment among day traders. For those investors who are correctly positioned, this may a good time to do nothing.
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About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
