Preparing Your Portfolio for a “Coiled Spring” Economy

So far in December, U.S. stocks have reached successive highs, even after the broader benchmark S&P 500 and tech-heavy Nasdaq indices both rose by 11% in November, while the Russell 2000 Index of small-capitalization stocks jumped 18%. The resolution of U.S. election uncertainty, combined with better-than-expected vaccine news, account for the bullish sentiment that has brought a rush of cash from the sidelines into markets

Yet, the rotation to new market leadership that we expect continues to move in fits and starts, even amid a steady global economic recovery, higher long-term rates and a steepening yield curve. The mega-cap tech stocks that have led the market for the past 10 years remain dominant, and the benchmark 10-year Treasury yield is still stuck below 1% (now at 0.97%).

We don’t expect those conditions to last. Much like a coiled spring, we expect the U.S. economy to surge early next year, with policy-fueled expansion pushing up long-term interest rates, while powering a rotation in stock-market leadership. Here are four main reasons why:

• U.S. consumers are surprisingly strong. Never before have we seen such high unemployment (currently 6.7%) accompanied by rising personal incomes, a savings rate that has doubled in one year, lower credit-card balances and higher net worth. In aggregate, U.S. households now have less debt than disposable income—that ratio is about one-third lower than during the 2008 financial crisis. The power of increased spending capacity matched with pent-up demand for deferred vacations, restaurant meals, sporting events and entertainment could fuel economic growth, as the pandemic starts to recede sometime next year.

• The housing market is picking up speed. Rising U.S. home values are making many Americans feel wealthier. New home construction is rising, with housing starts in October up nearly 5% from September. Strength in the housing market has a multiplier effect, with rising sales leading to more spending on home improvements, new appliances and other household goods.

• Inflation looks poised to surprise on the upside. Federal Reserve stimulus has dramatically expanded the money supply. Price declines in the service sector, due to the COVID-19 recession, have so far helped to mask that pressure on inflation. But if services inflation returns to its three-year pre-pandemic trend of roughly 3%, the Consumer Price Index, a key gauge of inflation, may quickly overshoot the Fed’s 2% target next year.

• More fiscal and monetary stimulus seems likely. The Fed remains committed to keeping interest rates low long term. At the same time, Congress seems much more inclined lately to pass a new fiscal stimulus bill before year-end. President-elect Joe Biden’s selection of former Fed Chair Janet Yellen as the next Treasury Secretary suggests a more coordinated policy response between fiscal and monetary authorities, which could result in more government spending and debt monetization. That would likely add to dollar weakness and higher inflation. 

Caveats remain. Still weak U.S. labor markets could mute consumer spending—and inflation. Problems with the vaccine rollout could emerge. The Fed could manage to keep interest rates low. However, we believe those odds are low, and suggest that investors shift their portfolios, adding small caps, cyclicals (such as financials, industrials, materials and consumer services), and non-U.S. stocks (from Japan and emerging markets, for example), with 2021 set to usher in higher inflation, a steeper yield curve and new market leadership. 

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Dec 7, “Reflation: A Coiled Spring.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.