Byron Wien: Three Troubling Issues
The economic fundamentals got off to a good start this year. The recovery gathered momentum as the increasing availability and improved distribution of vaccines fueled business activity. Real gross domestic product growth was projected to be between 6% and 8%, and value stocks rose. These stocks included financials, which benefited from rising interest rates, and energy, which gained as a result of higher oil prices. The market broadened out, benefiting all investors. The unweighted S&P 500 beat the weighted index by 4% in the first quarter. The old technology leaders weren’t, however, dead. They still accounted for 44% of the S&P 500’s gain as the index went from 3000 to 4000. That 1000-point move took only 434 days, just one-third of the 1,227 days it took for the index to rise from 2000 to 3000. Many investors seemed to have the feeling that they were in an environment devoid of risk, which is worrisome. Both the economy and the stock market responded favorably to massive government stimulus. Congress approved a $1.9 trillion relief plan and the Federal Reserve kept up its buying of Treasury securities at a rate of $120 billion monthly.
That signs of speculation increased is no wonder. Measures of investment sentiment showed extreme optimism. Margin debt has reached an all-time high. Companies with no earnings and big annual losses found their way into the public market either directly, through underwritings, or indirectly, using Special Purpose Acquisition Corporations. Companies with uncertain prospects and limited floating supply of stock in the public market became vulnerable to short squeezes. These signs of speculation gave investors a sense of apprehension, but the ample liquidity provided by the Fed kept the equity markets high.
My view is that there are at least three important issues facing investors. The first is the possibility of higher interest rates and the impact this would have on market valuation. The second is the virus and the impediments that stand in the way of returning to normalcy. The third is our relationship with China, which represents both an investment opportunity and a geopolitical, military and economic rival.
Most investors trust that Fed Chairman Jerome Powell and Treasury Secretary Janet Yellen are correct in thinking that while inflation and interest rates have moved somewhat higher, that condition is likely to be temporary. We are in the early stages of a strong recovery, when labor shortages might put pressure on wages, and supply chain problems could cause prices of raw materials and component parts to rise. Policymakers think that the level of inflation is not likely to become severe, and if it does, that they have the tools to deal with it.
I am not quite so optimistic. A year ago, the country was in a recession and a bear market, while COVID-19-induced lockdowns confined many people to their homes. The Federal government provided $2 trillion of aid to the flagging economy to enable it to get through this difficult period. Today, the economy is clearly improving. Real growth is positive, earnings are strong, unemployment is at 6.0%—down from a peak of 15%, and headed lower—and vaccines are becoming widely available.
Congress just approved a relief plan allocating $1.9 trillion, in addition to last year’s $2 trillion. We know that some people are avoiding going back to work because they are receiving generous unemployment insurance benefits that provide a higher net income than did their old jobs. The current shortage of labor in some industries, such as restaurants and retail, can be at least partly attributed to this dynamic, but this problem should be alleviated by September. On the supply side, the inability of ships to unload at Long Beach in California and the temporary closure of the Suez Canal are creating shortages of manufacturing components and oil. Potential labor shortages and commodity inflation are beginning to emerge even as many aspects of the economy are already strong. These are some of the reasons why I worry that inflationary pressures are being underestimated. The Purchasing Manager Surveys for both manufacturing and services activity are at breakout highs, and prices are rising. The output gap—which is the measure of what the economy is producing compared with its potential—is estimated to be $760 billion over the next three years. The new COVID relief package is almost three times that, assuming a money multiplier of 1.0x, and therefore it could be potentially inflationary. If the yield on the 10-year Treasury rises to above 2%, I think there would be a negative market impact, particularly on growth stocks. We are already getting a glimpse of this, as some of last year’s technology leaders have had weak relative performance in recent weeks. Based on the historical observation that trends often progress further than the consensus expects they will, a 2.5% or even 3% yield on the 10-year is possible.
The fact that layoffs have declined 80% from their peak is a further sign of strength in the economy. In March, almost all indicators were estimated to have come back strongly from their February storm-related declines, according to International Strategy and Investment. On a month-over-month basis, new home sales were up 24%, housing starts up 8.5%, existing home sales up 9.3%, industrial production up 3.1%, durable goods orders up 1.5% and consumer spending up 3.5%. Does this sound like an economy that needs a lot of fiscal and monetary help? The rig count has only recovered 20% of its decline as oil companies wait to see if the recent rise in the price of crude endures. The U.S. Federal Reserve and European Central Bank balance sheets are up more than 80% and 50%, respectively, since February of last year, and exports from Asia have increased sharply. Money supply is up 27% in the U.S. over the past year and consumer net worth is up 20% annually. There is plenty of buying power out there, and the economic strength is not only evident in the United States. Data from Europe and Asia are also positive.
The second issue that concerns me is the difficulties likely to be encountered in returning to normalcy. The Biden administration has an ambitious agenda to deal with some of the problems that have been with us for decades. Their top two priorities at present are controlling the virus and getting people back to work. I have my concerns about getting back to normal quickly. Many people have already been vaccinated and the wide availability of vaccines, including at drug stores, encourages hope that we will approach normal later this year. My definition of “normal” requires all kids being physically back in classrooms, including college students, and people eating indoors in restaurants and attending theaters, movies and sporting events.
The current pace of vaccinations is impressive. At this point, 22% of the U.S. population is fully vaccinated and over a third have received at least one vaccine dose. There have been over 31 million confirmed COVID-19 cases, and experts estimate that at least double that number of cases went unreported. The number of people who have been fully vaccinated, combined with estimates for total infections, mean that around 50% of the population should have some form of immunity against the virus (assuming minimal duplication of full vaccinations and infections). About 30% of the remaining group is children, who may be able to transmit the disease but rarely suffer its symptoms. Despite the public service announcements, a portion of the population does not intend to get vaccinated. Whether that group is big enough to prevent or delay “herd immunity” will have to be watched carefully. The good news is that a recent Ipsos poll showed that 90% of Americans knew someone who had received a vaccine or had received one themselves. This may bode well for people believing that the vaccine is safe and effective.
While the Biden administration indicated its willingness to try to develop a more constructive relationship with China on trade and geopolitical issues, the first meeting of high officials on both sides in Anchorage did not go well. China went into the meeting believing it had earned the respect of the world through its manufacturing capabilities and the way it was able to control COVID-19. The virus may have originated there, but tough measures enabled the country to bring the number of cases and fatalities down to manageable levels.
The United States approached the Anchorage meeting as though it was still the world leader politically and economically, and it was critical of China on human rights, intellectual property confiscation and military encroachment. China retaliated by arguing that our system of government was dysfunctional and we couldn’t get important legislation enacted on infrastructure, climate change and inequality. Regarding human rights, they suggested that the Black Lives Matter movement showed that the U.S. has its own issues to work through. The meeting ended without a joint statement of encouragement. This is important because finding ways for the first and second largest global economies to establish common ground and cooperate with one another would be beneficial.
There are issues of common interest. Climate change, clearly, but also Iran’s and North Korea’s nuclear programs. China is buying Iran’s oil and selling food and coal to North Korea, and these trade relationships limit the efficacy of efforts to be tough on these countries. Further, as we all know, China and the U.S. are highly economically integrated, and China produces both finished goods and components used heavily in the United States (the trade deficit is about $400 billion: the U.S. imports $500 billion and exports $100 billion). Taiwan is also an important economic partner for the United States. As a major semiconductor manufacturer, it is a critical supplier to U.S. technology companies.
Looking ahead, the Chinese have one powerful positive going for them, and one significant negative. By 2023, they are estimated to be spending (on a purchasing power parity basis) more on research and development than the U.S. This is a conservative estimate, based on the assumption that the U.S. does not substantially increase its investment, and that China achieves the 7% growth for R&D spending that it outlined in its 14th five-year plan. (It may very well exceed 7% growth.) Money spent does not, however, always translate to results achieved. The U.S. is a high-cost producer, so if it wants to remain competitive on the world stage, maintaining its technological leadership will be essential. China clearly wishes to assume that leadership role during the current decade. The weakness challenging China is demographic. As a result of its one-child policy, the country will be hard-pressed to maintain its present growth rate with a rapidly aging population. While being tough with China is politically popular in the U.S., we believe that achieving a more harmonious working relationship between the two is imperative, and the March meeting did not move the two countries toward that end.
Whenever the equity market is hitting new highs, there are always observers who bring up indicators that show the market is dangerous. The difference this time is that some who are providing the warning are making excuses for what they are signaling. The Shiller cyclically adjusted price-to-earnings (CAPE) ratio is at 35, but Robert Shiller says that low interest rates may mean that is not going to be a problem. Tobin’s Q Ratio, which compares market value with adjusted net worth, is another indicator at a high, but investment strategist Ned Davis suggests that technological change may justify higher ratios. Finally, Warren Buffet’s favorite valuation metric is market value of equities divided by Gross Domestic Product. This ratio, however, may not take into account the significant portion of market value that is supported by foreign earnings that are not reflected in U.S. GDP. Nearly a third of S&P 500 revenues are generated overseas. None of these indicators are arguing that the market is cheap, and some caution is warranted.
The consensus has settled comfortably around a thesis of high growth with contained inflation, further vaccination progress and continued rallying in the markets. I am more concerned about inflation—and rates—surprising to the upside, and about the potential for U.S.–China relations to move in a direction that would be damaging to global economic prospects. While a strong recovery is unfolding, these are the issues which keep me from being complacent and make the case for strong active management.
Taylor Becker assisted in the research and writing of this essay.
The views expressed in this commentary are the personal views of Byron Wien, Joe Zidle, and Taylor Becker and do not necessarily reflect the views of The Blackstone Group Inc. (together with its affiliates, “Blackstone”). The views expressed reflect the current views of Byron Wien, Joe Zidle, and Taylor Becker as of the date hereof, and none of Byron Wien, Joe Zidle, Taylor Becker, or Blackstone undertake any responsibility to advise you of any changes in the views expressed herein.
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