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Economic Outlook

Economic Outlook

April 27, 2021
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As we move into Spring, there appears to be a sense of optimism over future economic growth prospects. The University of Michigan’s Consumer Sentiment Index rose to 84.9% in March[1], the highest reading since the outbreak of COVID-19. Several factors are contributing to the positive outlook, including a growing availability of vaccines, falling number of cases, and the ease of restrictions on pre-pandemic activities such as dining out, shopping, traveling, and other day-to-day activities. Another key contributor is the recent relief package. Although the prior stimulus saw the majority of funds being used to bolster savings and pay down debt, the onset of warmer months ahead and the shift in many socioeconomic conditions mentioned above will likely see a substantially greater portion of this round of funding being injected into the economy through consumer spending.

Further evidence of future growth is supported by recent increases in long-term treasury yields, signaling investor expectations for stronger growth and higher inflation. The 10-year U.S. Treasury yields have risen significantly in recent quarters, despite 2-year U.S. Treasury yields remaining near zero. Short-term rates are largely driven by Fed rate policy, while long-term rates tend to be driven by investor expectations for economic growth and inflation. Thus, the gap between the short-term and long-term U.S. Treasury yields, known as the “Yield Curve”, is reflective of an expectation for strong growth ahead when it widens and trends upwards. Historically, periods of steepening yield curve have been concurrent with economic cycles shifting from contraction into early stages of recovery.

Market Update

The market continues trending upwards, consistent with the optimistic economic outlook. The S&P 500 reached all-time highs in March and continues trending higher into April. Despite the positive outlook for economic growth, some are concerned this optimism is creating a false sense of security and resulting in investors taking undue risks. In a recent interview, Federal Reserve Bank of Dallas President Robert Kaplan said, “There’s no question that financial assets, broadly are at elevated valuation levels.” [2] and that “Equity market cap, divided by gross domestic product (Buffet Indicator), that’s at a historically elevated level.” These elevated metrics could be signaling bubble-like activity across several asset classes. Loose monetary policy and irrational investor behavior appears to be contributing to the overall increase in prices, however the Fed’s indication that it will keep short-term rates near zero and the overall positive outlook for the economy as evidenced by the increase in Consumer Sentiment Index and long-term U.S. Treasury yields will likely continue driving prices higher in the near and intermediate terms.

Many sources have been reporting on the elevated “Buffet Indicator” ratio, though some have responded with questioning over the efficacy of the metric, pointing out that GDP Statistics do not seem to fully incorporate the shift in economic landscape such as the impact of the digital age. Even Buffett himself has warned of the limitations of the metric in past interviews and Berkshire Hathaway shareholder meetings. The key takeaway is that conclusions over an equity market bubble and whether the market valuations are sustainable in the near and intermediate term should not be made solely based on a single ratio or metric. Below is a representation of the “Buffett Indicator”:

With the 10-year Treasury rates reaching near 1.70%, while 2-year rates remain below 0.25%[3], bond prices will be negatively impacted as longer-term yields continue to rise. The price declines could be compounded even further if interest rates begin to increase as well. Some may argue that shifting to shorter duration bonds can help mitigate some of the negative pricing impact, though this will result in a reduction of already limited yields. Another strategy could involve shifting to bond market sectors that are less sensitive to Treasury yields and short-term interest rates, such as Muni and Corporate bonds – an attractive option within the bond market during periods of time when interest rate risk is heightened. However, this only lessens the impact of interest rate increases and does not mitigate interest rate risk entirely, while exposing investors to higher credit risk and volatility in pricing when equity market volatility is high.

Another interesting development in the market is the shift in the Growth vs. Value trend line. Over the past decade we have seen Growth stocks substantially outperform Value stocks, however with valuations at unprecedented levels, the rotation out of Growth stocks and into Value stocks appears to be gaining momentum, reminiscent of the shift we saw during the bursting of the tech bubble in 2000. The Russel 1000 Growth vs. Value line has begun a steep decline. A downward trendline here indicates that value stocks are outperforming growth stocks. Again, this sharp declining trend is reminiscent of the late 1990’s right before the tech bubble collapse. This trend is further reinforced by the fact that Value stocks appear to be less overvalued than growth stocks, and rising rates (as we are seeing with the increase in the 10-year U.S. Treasury) have historically had a positive effect on Value stocks and a negative impact on Growth stocks. [3] https://ycharts.com/

Smarter Way Takeaways

Incorporating a NEW Value vs. Growth Indicator (Gamma)

There appears to be an opportunity to enhance returns by shifting out of Growth stocks and into heavier weightings of Value stocks. Our models will begin to incorporate a Growth versus Value market indicator, thereby increasing the weighting of Growth holdings when Growth is outperforming and shifting to more Value holdings when Value is outperforming. Our new designated Growth versus Value indicator is Gamma and will provide input for our Large, Mid and Small Cap models going forward.

Replacing Bond and Fixed Income asset classes with Structured Note Investments

Further, in light of the negative prospects across most segments of the bond market, we will be utilizing other means of mitigating draw down and reducing portfolio volatility without sacrificing yields. As part of our portfolio construction and allocations, we will be replacing our fixed income and bond exposure with structured note investments. These structured notes provide principal protection through a “Barrier” or “Buffer” against downward price movement, while also achieving either a specified potential yield or upside participation in the growth of the underlying investment it is tied to. We see this as a way to help reduce volatility and draw down without giving up opportunity for upside portfolio growth or yield for income. These changes will help achieve our model and allocation objectives more effectively, while simultaneously eliminating drag and negative pricing movement in fixed income and non-correlated asset classes when inflation and interest rates rise. We will further explain how structured notes work in the next section.

Classroom Concepts

Structured Investments (SIs), or more typically referred to as “Structured Notes”, can be used to balance traditional equity portfolios with a specifically defined risk and return scenario. Structured notes offer the ability to incorporate exposure across traditional or hard to reach underlying asset classes, to achieve growth or generate income. More specifically, SIs are defined as market linked CDs or Notes that are tied to various market outcomes with the associated yield or returns payable at recurring calendar dates and/or maturity. Essentially, SIs are structured and issued by large banking institutions with varying degrees of principal protection, maturity terms, and yield or growth participation options. SIs are typically created by these issuing institutions through purchasing zero coupon bonds or CDs (which inherently trade at a discount from par value) then taking the remaining capital and investing in sophisticated options strategies involving the underlying asset(s) that the SIs are linked to. SIs are issued in denominations of $1,000 and can have a broad range of maturities such as 12 months, 15 months, 18 months, 3 Years, 5 years, and 7 years, and further can have a broad range of risk and return profiles with varying degrees of principal protection as well as yield or growth participation targets. SIs are an attractive alternative to bonds to complement an equity portfolio due to their ability to mitigate principal draw down through downside “Buffers” and “Barriers”. Look for further details and examples of Growth and Yield Structured Notes in upcoming communications.

Our Market Signals

CIGNX (Economic Strength Indicator)

CIGNX is our indicator for determining the health of the United States economy and the chance of an upcoming recession. A recession is two consecutive quarters of negative GDP growth; thus, it is impossible to know with 100% certainty that we are in a recession until 6 months after it has started. CIGNX aims to circumvent this 6-month delay. CIGNX gives us a measure of the strength and trend of the U.S. economy on a scale of 0% to 100%. Anything above 50% is a positive trend; anything below is a negative trend. When the reading dips below 40%, a recession may be nearing and our models would be adjusted accordingly. It is used as an input for managing our Dynamic and 401(k) Allocations.

CIGNX is currently positive at the beginning of April, with a reading of 63.6%, an increase of 3.2% from last month’s revised reading.

Alpha/Omega (Equity Market Indicators)

Alpha and Omega are a pair of equity market trend indicator algorithms managed by our Team. Alpha is a short-term indicator that tends to be more active, while Omega indicates longer-term trends and is less active. We use these trend indicators to provide input for our Dividend Growth, Large, Mid and Small Cap models; as well as our Dynamic and 401(k) Allocations.

Both Alpha and Omega are positive, resulting in 100% exposure in our Dividend Growth, Large, Mid and Small Cap models.

Gamma (Equity Market Growth vs. Value Indicator) NEW INDICATOR

Gamma is our third equity market trend indicator algorithm managed by our Team and will be applied going forward. Gamma is a trend indicator that identifies key market metrics, which indicate the likelihood Growth versus Value sectors may outperform the other in the future. We use this trend indicator to provide input for our Large, Mid and Small Cap models.

Gamma currently indicates Value is more favorable, resulting in a heavier weighting in Value Equities in our Large, Mid and Small Cap models.

~Diligently Yours,

Your Smarter Way Portfolio Management Team