Insight

Executive Summary

• U.S. COVID-19 infections and deaths have been steadily declining from January highs as vaccinations increase.
• Economic data shows the economy improving but employers are struggling to fill open positions.
• Tax increases for wealthy households in response to record government spending and increased inflation fears could cause market volatility over the next year.
• While Q1 earnings have been notable thus far, valuations remain extended while pockets of excess are beginning to slow in other areas of the market.

The 7-day moving average number of U.S. COVID-19 cases has fallen below 49,000 while the 7-day moving average number of deaths has fallen below 700 per day. Those numbers are down substantially from the peak January numbers of 250,000 and 3,400 respectively. Currently more than 44% of the population has gotten at least one vaccine dose, and more than 31% are fully vaccinated. Of those who are most at risk, people aged 65 or older, almost 83% have received at least one dose, and almost 70% are fully vaccinated¹. Between vaccinations and natural immunity roughly 2/3^rds of Americans will have some immunity to covid by end of this month.

The economy is heating up fast. Real GDP grew at 6.4% annually for the first quarter of 2021. The March jobs report showed an impressive gain of 916,000 jobs versus an expected 658,000 with strong gains in the leisure and hospitality sectors. The unemployment rate dropped from 6.2% to 6%. Housing starts, which is an indicator of the number of new residential constructions projects taking place over the month, rose 37% on an annually adjusted basis. Home prices continue to rise with S&P CoreLogic Case-Shiller National Home Price Index up 12% on a year-over-year basis, the fastest pace in 15 years². ISM Manufacturing PMI rose to 64.7% the highest level in 37 years and the ISM Services PMI rose to an all-time high of 63.7%³. Readings above 50 indicates expansion in the sector.

The number of job openings increased to 7.4 million, only about 200,000 shy of the peak reached back in 2018. Currently the average weekly state unemployment benefit is $318. Federal unemployment benefits of $300 per week have been extended through September 6^th bringing the total average unemployment benefit to $618 per week. A person who earns approximately $15 per hour and works 40 hours per week makes $600 per week. We are beginning to see the dichotomy between employers trying to fill positions and paying higher wages. They can either wait until the Federal assistance ends and hope to find people then or pay higher wages to fill open positions now. If demand remains high enough it may force businesses to increase wages which could in turn feed into higher prices and inflation. My colleague Jim Behr will be writing an article all about inflation in the coming weeks, but one of the driving factors of higher inflation is higher wage growth.

Last week President Biden presented his $1.8 trillion American Families Plan which would include spending on childcare, education, paid leave, and tax break extensions. This comes on the heels of a $1.9 trillion coronavirus relief bill passed in March, which included $1,400 stimulus checks and extended Federal unemployment insurance, and a $2.3 trillion infrastructure package that includes spending for roads, bridges, and internet. To help fund some of this spending the administration is proposing raising the top income tax rate from 37% to 39.6% and raise capital gains tax on those earning more than $1 million from 20% to 39.6%. In addition, stepped up cost basis at death and real-estate exchanges could become taxable events for amounts breaching certain thresholds. Both the American Families Plan and infrastructure bill are likely to be scaled back from the initial projections as more fiscally conservative Democrats like Joe Manchin may oppose unconstrained spending.

At its last meeting, the FOMC held interest rates at 0%-0.25% and left asset purchases unchanged. In their press release the FOMC described the recent rise in inflation as “transitory.” Fed Chair Jerome Powell has regularly stated his goal of having inflation run above the 2% target before altering any asset purchases or raising rates. Also, with their dual mandate, unemployment will need to continue to improve before making any policy changes. The market is currently pricing in a 13% chance of a rate hike by the end of this year.

Of the S&P 500 companies that have reported earnings so far for the first quarter, 86% have reported a positive EPS surprise and 78% have reported a positive revenue surprise. If 86% is the final percentage, it will mark the highest percentage of S&P 500 companies reporting a positive EPS surprise since FactSet began tracking this metric in 2008⁴. These are not small surprises either. The average earnings surprise is 22.8% above estimates while revenue surprises have come in 3.7% higher than estimates.

The market is certainly pricing in all of this good news. As of now the broad market indexes are just off their all-time highs. The forward P/E for the S&P 500 is 21.9x, well above the 25-year average of 16.69x. By almost any measure, market valuations are extended except when you compare the stock market to the bond market. Spreads, the amount of additional compensation above treasuries of similar duration that investors require for owning riskier credit, are the near their lowest levels in almost 10 years. With real treasury yields still in negative territory, we have seen pockets of excess form in different areas of the market this year. Cryptocurrency, Non-fungible tokens (NFTs), Special-Purpose Acquisition Companies, EV companies, and more have continued to garner greater attention and while the speculative excesses we saw earlier in the year have begun to slow those areas remain important to watch as the market grapples the possibility of rising inflation, higher rates, increased taxes, growing debt, and historically high stimulus. Because the market is always forward looking it has largely priced in much of the good news discussed and it would be reasonable to expect some increased volatility and more muted returns moving forward as the market searches for its next catalyst.

¹ – CDC COVID Data Tracker
² – Ned Davis Research: U.S. Daily Economic Perspectives
³ – JPMorgan Asset Management Economic Update
⁴ – FactSet Earnings Insight