Small caps, value, and non-US stocks may continue to benefit from Fed policy.
by Jurrien Timmer, Director of Global Macro, Fidelity Investments
- The data on COVID is promising for both public health and the reopening of the economy. The number of people hospitalized with COVID is down while the total number of vaccinations is going up.
- The policy response to COVID by the government and the Fed has been, and continues to be, bullish for risk assets and inflation expectations—especially now that we appear to be on the path to eventually reach herd immunity.
- Looking at the effects of fiscal and monetary policy in the 1940s as an analog to the COVID crisis, I expect real rates could decline even further, driven by rising inflation expectations and a lesser rise in nominals.
- If the 1940s analog is the right one for today's market, there may be more life left in the rotation trade toward small caps, value, and non-US stocks.
By now market consensus seems to be that the second half of 2021 may produce an inflationary lift, the product of (1) a declining COVID curve, (2) a rise in vaccinations, (3) ongoing fiscal stimulus, (4) pent-up consumer demand, and (5) a Fed that is not inclined to take the punchbowl away anytime soon. It's a perfect storm of reflation.
This narrative has created a formidable reflation trade. Rising inflation expectations (not rising real rates) have driven a rally in commodity prices, and a leadership rotation from growth/large/US to value/small/ex-US.
Let's start with the COVID data. The number of US hospital beds being occupied by COVID patients has been declining for the past month or so. The peak was at 19.3% and the latest reading is 10.8%.
Plus, we have gone from zero to 48 million total vaccination shots given in the span of just a few months.
Needless to say, the data is extremely encouraging for both public health and the reopening of the economy.
So far there hasn't been much change in economic activity, with the US falling from 101 on the Bloomberg US Daily Activity indicator in February 2020 to 41 in March and then recovering to 70 in September last year and stalling out at 64. This is in line with the gross domestic product (GDP) output gap data, which shows the US economy going from 101% of potential to 10% below potential to now only 3.5% below potential. But if vaccines continue to be rolled out at a strong clip, hopefully, this output gap will close sooner rather than later.
A main feature of the pandemic is of course the policy response. Below I show the change (again, since February 2020) in the Fed's balance sheet, the US federal debt, and the M2 money supply. (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.) Since last February, the US debt has increased by $4.4 trillion, the money supply by $3.8 trillion, and the Fed's balance sheet by $3.3 trillion. It has been a formidable fiscal/monetary cocktail, much like we saw during the 1940s.
With the next tranche of fiscal stimulus on the way (which is expected to come in at $1.5 trillion or more), the fiscal policy response since the pandemic started will soon exceed $5 trillion. That additional fiscal expansion would normally suggest that the Fed would soon ratchet up its asset purchases to minimize the impact on Treasury yields.
But instead, the Treasury has announced that it will run down its cash balance at the Fed (dotted line below). So if we subtract this amount from the accumulated pandemic-related Federal debt, we now get a fiscal expansion almost exactly equal to the Fed's asset purchases. That's fiscal/monetary coordination that we don't see too often.
Finally, if we compare the percent change in earnings estimates since last February against the percent change in M2 and federal debt, we see that the jaws between the economic shock and the policy response are not closing yet. The 2 lines are converging but it's so far only the result of economic conditions improving and not of the policy response normalizing. Needless to say, that's bullish for risk assets and inflation expectations, especially now that we seem to be on the path toward eventually reaching herd immunity.
This brings back the 1940s analog, which is one that I have been highlighting for close to a year now. Back then, as the US was ramping up to join World War II, the debt-to-GDP ratio skyrocketed to 116%, all of which was monetized by the Fed. Not only did the Fed's balance sheet expand 10-fold, but it held policy rates at around 1% and capped the long bond at 2.5% even though inflation accelerated.
The chart below shows the analog to 1941–1946 in terms of the real S&P 500 (CPI-adjusted back then and gold-adjusted now). In the 1940s the US was still on the gold standard so the value of a dollar was linked to the price of gold. Comparing the CPI-adjusted value with the gold-adjusted value now is more of an apples-to-apples comparison. The gold adjusted value for today's SPX is found by dividing the value of the index by gold. The bottom panel of the chart shows real rates (CPI back then and the 5-year TIPS real yield now). Why use 5-year TIPS real yield instead of the 10-year? The 5-year yield is a better reflection of policy intentions, in addition to also reflecting inflation expectations.
If the analog holds (which I expect), real rates should decline even further, driven by rising inflation expectations and a lesser rise in nominals (possibly driven by Fed rate suppression).
While many investors fear another Taper Tantrum, either due to reduced asset purchases and/or a change to the Fed's forward guidance, my hunch is that the Fed is very far from removing the punchbowl. (The Taper Tantrum hit in 2013 as the Fed announced a plan to taper off the quantitative easing program that helped the economy recover following the GFC.) Indeed, the fed funds futures curve remains as flat as a pancake despite the 10-year Treasury now yielding 1.21%, up from 2020's low of .53%.
In any case, if the 1940s analog is the right one for today's market, there may be more life left in the rotation trade toward small caps, value, and non-US stocks.
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.