July 19, 2021

MIDYEAR OUTLOOK 2021:

PICKING UP SPEED

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Scott Brown, CMT, Senior Analyst, LPL Financial

It is hard to believe we have passed the halfway point of 2021. After a 2020 that would never end, the first six months of 2021 flew by. With the second half underway, we have updated our views of the markets and economy in LPL Research’s Midyear Outlook 2021: Picking up Speed. Below we provide a summary of those expectations covering the economy, policy, stocks and bonds.

ECONOMY: SPEEDING AHEAD

The U.S. economy has surprised nearly everyone to the upside as it speeds along thanks to vaccinations, reopening, and record stimulus. The growth rate of the U.S. economy may have peaked in the second quarter of 2021, but there is still plenty of momentum left to extend above-average growth into 2022. Despite the natural challenges of ramping back up, the recovery still seems capable of providing upside surprises.

We forecast 6.25–6.75% U.S. GDP growth in 2021, which would be the best year in decades. Last year’s 3.5% drop in GDP, the worst year since the Great Depression, may not be forgotten—but it has been left in the dust of 2020.

We continue to watch inflation closely but believe recent price pressures are transitory and will begin to work their way off gradually later in the year. As shown in Figure 1, the average U.S. expansion since World War II has lasted five years and much longer over the last few decades. There’s nothing on the horizon to indicate the current expansion can’t reach that mark.

July 12, 2021

THREE THINGS TO WATCH THIS EARNINGS SEASON

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

We ran out of superlatives to describe corporate America’s stunning performance during first-quarter earnings season. Despite lofty expections, results exceeded expectations by one of the biggest margins ever. So what will companies do for an encore? We expect more good news this quarter as more of the economy has opened up, while also acknowledging the second quarter will almost certainly end up being the peak in earnings growth for this cycle. Here, we highlight what to watch.

NUMBERS SHOULD BE GREAT AGAIN

After a remarkable performance during first-quarter earnings season, delivering an encore that will please investors will be tough. Recall that S&P 500 Index earnings grew 52% year over year during the first quarter [Figure 1], which was nearly 30 percentage points above expectations at the end of the quarter. Before companies started to report first-quarter numbers, we had thought 30% earnings growth would be pretty good; 50% was practically inconceivable.

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June 21, 2021

INFLATION AND WHAT THE FED IS SAYING

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

Inflation has been on the rise. Investors are not as interested in what’s happening now as they are in what’s happening next. Meanwhile, the Federal Reserve (Fed) shared its views at the conclusion of its last policy meeting on Wednesday, June 16. And while the Fed’s position that inflation is likely to be transitory has become stronger, not weaker, Fed members have seemingly different opinions on the future path of monetary support.

Inflation has been on the rise. Everyone knows it and feels the impact with every purchase. The Consumer Price Index (CPI) spiked to 5.0% year over year in May, the most since 2008, while core CPI (excluding food energy) hit 3.8%, the highest since 1992. Inflation has been rising and the Fed is watching. How will markets react to any potential inflation over the next year?

We do know this: Markets will be looking forward, not backward. By the time something becomes a “thing,” a meme, or makes a magazine cover, market participants are often past it, as we discussed in our June 16 blog, Why Inflation Worries Likely Just Peaked. Markets are no longer watching to see if inflation will spike. It already has. In fact, since the big upside surprise in the April inflation data, released May 12, many inflation-sensitive assets have been underperforming. Copper? Down. Lumber? Down. The 10-year Treasury yield? Down. Market-implied inflation rates? Down. Gold? Down.

At the conclusion of its last policy meeting on June 16, the Fed shared its view on what may be coming for inflation. In its updated forecasts, the Fed acknowledged it had missed on inflation expectations, upgrading its preferred core inflation forecast for 2021 from 2.2% all the way up to 3.0%. That’s a large jump, but that’s based on what’s behind us. The forecast for the same index in 2022 and 2023 scarcely moved, at 2.1% for both years.

Inflation is certainly still capable of coming in hotter than expected. The difference between now and earlier this year is that inflation expectations are already elevated. In order to see inflation assets really perk back up, we would probably need to see stronger signs that higher inflation may be persistent. To get a read on that, it may be better to look at prices that tend to be more stable. We know there are areas where we’re seeing extreme price moves, which is impacting broader measures of inflation. But what about prices that tend not to move? There is such a measure, developed by the Federal Reserve Bank of Atlanta, called sticky core inflation.

As seen in [Figure 1], unlike CPI and even core CPI, sticky core prices are not setting multi-decade or multi-year highs. Sticky core CPI is up 2.6% year over year. The last time it was that high was…2020. There are still some warning signs though. While you have to be careful annualizing monthly data because it multiplies small, potentially meaningless, moves, annualized sticky CPI in each of the last two months was over 4% and that hasn’t happened since 1992. But even sticky core CPI has had some price idiosyncrasies in the current environment. If you take just the median move of the CPI components, the middle change for any given month, 12-month price changes have actually been declining. And the last two months? Somewhat elevated but nothing special.

June 14, 2021

SUSTAINABLE INVESTING BECOMING MAINSTREAM IN FIXED INCOME

Jason Hoody, CFA, Head of Sustainable Investing, LPL Financial

Lawrence Gillum, CFA, Fixed Income Strategist, LPL Financial

On May 27, 2021, a couple of events in the energy sector occurred that demonstrated the continued mainstreaming of sustainable investing and underscored the risks and opportunities available to investors. While primarily thought of as equity-oriented, sustainable investing is becoming more mainstream in fixed income markets—and companies that fail to acknowledge changing dynamics may potentially face financially material impacts.

SUSTAINABLE INVESTING

Sustainable investing is an umbrella term to describe a range of investment practices that seek competitive financial returns and purposefully consider environmental, social, and governance (ESG) risks and opportunities. Approaches such as socially responsible investing (SRI), ESG investing, and impact investing all fall under this umbrella. These three approaches align with investors’ primary motivations for considering sustainable investing – aligning with international norms/values, improving risk-adjusted returns, and providing a positive impact on society.

TRANSITION RISKS

Equity returns in the energy sector have led the S&P 500 Index during 2021 as crude oil prices have soared and, on the surface, seem to show little concern for oil and gas companies’ approach to managing climate risks. However, energy sector bond investors appear to be reevaluating their holdings to get ahead of possible changes. Bond investors, who typically have a longer investment horizon, are increasingly having to consider the financial materiality of climate change.

June 7, 2021

POLICY SHIFTS MAY CHALLENGE MARKETS

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Fiscal stimulus, which was central to the market rebound in the last year, may start moving to the sidelines over the rest of 2021 and into 2022 as the recovery continues. Economic growth can compensate for the loss of government checks to households and businesses, but potential tax increases may be more challenging for markets to navigate. Business tax increases, in particular, may gradually pull gains out of markets about equal to their size, but with economic growth supporting corporate earnings, we believe a positive backdrop for equities remains in place.

During much of 2020 and early 2021, markets were focused on fiscal policy due to massive government efforts to help bridge the economy past the impact of COVID-19 restrictions. Markets liked stimulus as much in 2020 and 2021 as in 2009, and, to a smaller extent, 2018. Policy will still matter over the rest of 2021 and into 2022, but it will matter far less—despite some important debates going on in Washington. Markets may anticipate an increase in government spending if Congress passes some version of the Biden administration’s Build Back Better (BBB) initiative, but that spending will likely be spread out over almost a decade. The biggest risk may be around taxes, with businesses and wealthy households both facing the prospect of a higher tax burden to pay for BBB and help manage the deficit.

FEDERAL SPENDING UNLIKELY TO CHANGE MARKET TRAJECTORY

Much of the approximately $5 trillion in direct COVID-19 related stimulus in 2020 and 2021 did not flow through directly as government spending. Instead, the federal government used its borrowing power to distribute funds to households and businesses. That impact will fade over the reminder of the year but will be replaced by the private economy accelerating. There is some threat of a fiscal headwind from the decline in government largesse, but that headwind will be felt only if the private economy can’t make up the difference and we continue to expect above-average growth well into 2022.

Actual government spending is likely to continue to grow, but the rate of growth will not make a large difference to overall output in our more than $20 trillion economy. According to the Bureau of Economic Analysis, federal spending added an average of about 0.15% per year to gross domestic product (GDP) growth between 2000 and 2020, with defense and non-defense spending each contributing about half of that. Federal spending has not contributed more than 0.5% to GDP growth since 1986 and contributed only 0.29% in 2020. COVID-19 stimulus was more about borrowing and writing checks to businesses and households than growth in direct government spending.

But even a small contribution to GDP growth can be massive in absolute terms. With proposals for the two pieces of BBB reaching nearly $4 trillion—including $1.8 trillion for the American Families Plan (AFP) and more than $2 trillion for the infrastructure bill (known as the American Jobs Plan or AJP)—higher taxes would be needed to help finance the new initiatives. Let’s be clear though: With a 50/50 Senate (Vice President Kamala Harris breaks ties) and historically slim Democratic majority in the House, we think these final numbers will likely come at $2–2.5 trillion combined, as these initial numbers from the Democrats were a starting point for negotiations.

TAXES MAY CHANGE MARKET PATH, BUT NOT DIRECTION

Federal spending is generally funded by taxes or debt, and the Biden administration plans to raise taxes to help pay for BBB. President Biden has proposed increasing taxes on both corporations and wealthy households, including an increase in the capital gains tax, the tax on investment profits. Markets so far have taken the proposed changes in stride, largely due to expectations that the proposed tax increases will be reduced during negotiations and the economy will be strong enough to absorb the impact.

The Tax Cuts and Jobs Act (TCJA), signed into law by President Trump in December 2017, reduced the top tax rate on corporations from 35%, where it had been since 1993, to 21%. Before the TCJA, the top U.S. statutory corporate tax rate had not been under 30% since the 1940s. There were also other structural reforms in the TCJA, including changes to the way U.S. corporate profits from abroad are taxed, in an attempt to make U.S. companies more competitive.

President Biden has proposed increasing the corporate tax rate to 28%, but that should be viewed as a bargaining position and we believe the more likely outcome is that we see the rate end up closer to 25%. Alternative approaches, such as increasing the minimum tax on businesses and raising the top rate less—or not at all, are becoming part of the conversation. The negative news for markets is that corporate earnings growth will likely take a direct hit that is approximately equal to the size of any tax hike. Because the stock market is fundamentally driven by earnings growth, the tax impact will likely be a headwind for equity markets. On the positive side, this move has been anticipated for quite some time and should not be much of a surprise to markets. Further, as shown in [Figure 1], excluding the TCJA rate, this will still be the lowest tax rate in about 70 years and the effective tax rate has also declined.

May 24, 2021

STOCK MARKET GAINS LIKELY TO SLOW

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

After one of the best starts to a bull market in history, the rally has started to show signs of fatigue. A strong economic recovery lies ahead as the roepening continues, bolstering a very strong earnings outlook that is helping stocks grow into elevated valuations. However, in the second half of the year, as inflationary pressures build, interest rates potentially rise further, and this bull market gets a little older, the pace of stock market gains will likely slow and come with more volatility.

HISTORY DOESN’T REPEAT BUT IT OFTEN RHYMES

After a nearly 90% rally off the March 2020 lows, it’s not much of a surprise that since mid-April the S&P 500 Index has been choppy and generally moved sideways. Consider that the 1982 and 2009 bull markets both suffered from some fatigue several months into their second years, providing a useful historical analogue. With the U.S. economy picking up speed as the end of the pandemic likely approaches, the economic cycle is maturing. The pickup in inflation and related concerns about the Federal Reserve (Fed) pulling back support offer evidence of an economic cycle getting a bit older. Older cycles tend to bring more moderate stock market gains.

May 17, 2021

ECONOMY PICKING UP SPEED

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Barry Gilbert, PhD, CFA, Asset Allocation Strategist, LPL Financial

The economic recovery continues, as the recipe of vaccines, the reopening, and record stimulus all have combined to produce what should be one of the best years for growth ever. Although some economic indicators could be peaking or about to peak, the stage is set for this cycle of growth to continue for many years, which may surprise some investors. We discuss why inflation might be in the headlines, but still shouldn’t be a major worry for investors.

THIS ECONOMIC CYCLE IS QUITE YOUNG

The U.S. economic recovery is now in full swing. Despite the natural challenges of ramping back up, the recovery still seems capable of providing upside surprises. As a result of strides toward full reopening, rapid vaccine distribution, massive stimulus efforts, and support from the Fed, we recently upgraded our 2021 forecast for U.S. gross domestic product (GDP) growth to 6.25%-6.75%. Toss in a record number of earnings beats, resulting in S&P 500 Index first-quarter earnings growth of nearly 50% (FactSet), which is more than double the expectations at the start of the quarter, and it is clear the economy is humming right along. Last year’s 3.5% drop in GDP, the worst year since the Great Depression, is a thing of the past.

Technically, the U.S. may still be in a recession, as the National Bureau of Economic Research (NBER) hasn’t called the end yet. But considering we’ve seen various levels of output match or exceed pre-pandemic levels, it’s clear we aren’t in a recession anymore, as it likely ended last summer. Retail sales, for instance, were making new highs by June 2020 and have soared higher over the past year. NBER isn’t about being first, they are about being right, and it isn’t abnormal for them to call the end of a recession a year or more after it officially ended. We’ve found that ISM manufacturing and services data tend to peak about a year after a recession ends, and both appear to have peaked in the spring—another clue the recession ended sometime last summer.

Just because economic data is peaking doesn’t mean the new expansion is over. In fact, it’s perfectly normal to see the year-over-year levels of growth peak about a year after a recession ends, and be followed by many more years of growth. As shown in [Figure 1], the average expansion has lasted more than five years, with the last four cycles all lasting longer. The last expansion was the longest ever, making it to 11 years old before COVID-19 struck, and otherwise might have gone on even longer. However, this cycle may not last as long as the last one, as this wasn’t your average recession. Because the recession last year was likely the shortest ever (besting the six-month recession in the early 1980s) and the economy was supported by historic stimulus, some imbalances weren’t worked off like we tend to see in a normal recession. Corporate debt levels remain high, supported by low interest rates, and stock valuations never really reset. The good news is this new cycle of growth has enough going for it to be at least average, and even that would mean it still has another four years of economic growth left. There’s nothing wrong with being average!