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!

May 10, 2021

AMAZING EARNINGS SEASON

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial

Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

It’s embarrassing to admit this but in our earnings season preview on April 12, when the consensus estimate reflected a nearly 24% increase, we wrote that S&P 500 Index earnings growth for the first quarter could potentially exceed 30%. Fast forward to today and earnings growth for the quarter is on pace to double—yes, double—that 24% growth rate, which would mark one of the biggest upside surprises ever recorded. Here we look at how corporate America produced such a blowout earnings season and what it could mean for the outlook.

BLOWOUT NUMBERS

To call this earnings season a blowout would be an understatement. We wrote in our earnings preview that the combination of strengthening economic growth, booming manufacturing activity, rising estimates and positive guidance could potentially lead to double-digit upside, which implied earnings growth of about 35%. As shown in [Figure 1] , with nearly 90% of S&P 500 constituents having reported, S&P 500 earnings growth is tracking to a 49% year-over-year increase.

May 3, 2021

TIME TO SELL IN MAY?

THE WORST SIX MONTHS OF THE YEAR

“Sell in May and go away” is the seasonal stock market pattern in which the six months from May through October are historically weak for stocks, with many investors believing that it’s better to avoid the market altogether by selling in May and moving to cash during the summer months.

April 26, 2021

IS ALL THE GOOD NEWS PRICED IN?

Jeffrey Buchbinder, CFA, Equity Strategist, LPL Financial
Ryan Detrick, CMT, Chief Market Strategist, LPL Financial

Last week we discussed whether stock prices might be reflecting peak optimism. In that commentary we noted that while sentiment may be overly optimistic and a pickup in volatility would be totally normal, strong breadth measures suggest stocks still may have more upside. This week we tackle that same topic of peak optimism, but by looking at some valuation metrics. While valuations are elevated, they still appear reasonable when factoring in interest rates and inflation.

VALUATIONS APPEAR ELEVATED ON TRADITIONAL METRICS

Based on the most commonly used valuation metrics such as the price-to-earnings ratio (P/E), stock market valuations are elevated. This is hardly a controversial statement when considering the S&P 500 Index is trading at a P/E of 22 times the consensus earnings estimate for the next 12 months (source: FactSet). Even against the 2022 consensus earnings estimate, which may be a better measure given the strong earnings growth anticipated this year and next, the P/E of 20 is still several points above the long-term average of 17 since 1980. By that measure, we would say a lot of good news is priced in.

VALUATIONS LOOK QUITE REASONABLE WHEN FACTORING IN RATES

But we shouldn’t evaluate stock valuations in a vacuum. Going back to your Finance 101 days, the fundamental value of a stock is the present value of its future cash flows. When we discount future cash flows—a similar but purer measure of profits—interest rates come into play. That means we want to incorporate interest rate levels into our evaluation of P/E ratios. History shows higher interest rates have translated into lower stock valuations—and lower rates, our current situation, justify higher valuations.

To get this fuller picture, we calculate what’s called an equity risk premium, or ERP. This statistic compares the earnings yield on the S&P 500 (the inverse of the P/E) to the 10-year US Treasury yield. Essentially, an ERP compares the earnings generated by stocks to the income generated by bonds (in this case, the yield on the 10-year Treasury). By putting stocks and bonds in the same terms, they can be compared on an apples-to-apples basis.

As of April 21, 2021, the ERP for the S&P 500 Index was 1.9%, which is above the long-term average of 0.8% but well below the post-pandemic peak of 5.3% on March 31, 2020 [Figure 1]. (Higher values mean stocks are less expensive relative to bonds, and vice versa.) Using the earnings estimate for the next 12 months rather than the last 12 months pushes the ERP up to an even more compelling 3%. So, while we acknowledge stock valuations are elevated, compared to still-low interest rates they are quite reasonable.

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March 29, 2021

ARE WE ON THE BRINK OF AN INFLATION CRISIS?

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

Nick Pergakis, Analyst, LPL Financial

There is a growing debate over whether an expanding economy, in conjunction with historic fiscal and monetary stimulus, may cause inflation to overheat. Adding to the intense debate, the Federal Reserve (Fed) has shifted its policy framework, potentially allowing inflation to run a little hotter than it has in the past. Despite vocal calls for runaway inflation, we believe that any uptick in inflation will ultimately prove transitory due to slack in the labor market and other structural forces.

WHAT’S DRIVING THE INFLATION DEBATE

Concerns over an inflation scare are rising as investors question whether an accelerating US economy supported by pent-up demand will overheat amid a backdrop of historic fiscal and monetary stimulus. With roughly $3 trillion worth of fiscal stimulus set to take effect in 2021 and a Federal Reserve (Fed) that has expressed its commitment to maintain extraordinary monetary support until its objective of maximum employment is achieved, the concerns are reasonable. Adding to inflation fears, the Fed’s strategy to allow inflation to modestly overshoot its 2% target raises the concern that it may end up scrambling to raise interest rates to control inflation—potentially tightening financial conditions in the process. While we do believe inflation may run hotter than it has in recent years, we believe worries of runaway inflation are overdone and that the upside risk for core inflation will be capped at around 3% for the full year in 2021—and likely will run meaningfully lower.

NEAR-TERM PRESSURES APPEAR WELL CONTAINED

The US economy has come a long way, but it will take synchronized global growth before economic risks truly begin to abate, and this should limit inflationary pressure as well. Europe, Japan, and other regions have not been able to make the same progress on vaccination efforts, and mixed success in their prolonged battles against COVID-19 has led to slower economic activity relative to the US. We’ve also discussed how some areas of the economy have not participated in the recovery to the same degree, and the bifurcation between goods and services in the US is a perfect example. It’s no secret that service industries have borne the brunt of the economic impact of the pandemic, and this relationship is well illustrated by the changes in the core consumer price indexes (CPI) for goods and services [Figure 1].