In 1992 James Carville was credited with coining the phrase “it’s the economy, stupid” to highlight a key factor driving opinion in the Presidential election of that year. In a similar fashion for 2021, one might summarize the primary factor impacting financial markets as “it’s all about the liquidity.”
While this is an economic oversimplification, the fact that M2 (a broad measure of money) has increased 25% in the U.S. due to quantitative easing and Federal Reserve balance sheet expansion (up +80% in 2020 with further expected expansion of +20% in 2021), it should not surprise us to see equity valuations at all-time highs.
The massive purchase of treasuries and other fixed income securities by the Federal Reserve injects money into the economy as the Federal Reserve purchases bonds from banks via newly created bank reserves which the banks can lend to borrowers.
The Fed introduced quantitative easing (QE) after the 2008 financial crises before tapering its QE program in 2013 (which became known as the “taper tantrum” as bond yields spiked up). The COVID-19 pandemic created such economic turmoil last year that the Fed increased its balance sheet massively with bond purchases to guard against massive asset deflation and a sharp sustained recession (2Q20 annualized GDP was down -33%).
However, the key question now is what will happen with the liquidity residing in bank reserves? As bond prices have gone up with all the Fed buying (interest rates react inversely to price and have gone to historic lows), equity prices have followed, driven both by the attractiveness of future corporate earnings valued in today’s dollars as well as the lower P/E (price to earnings) ratios in equities relative to bonds.
A further factor in this economic equation is the ongoing issuance of government debt to fund historically large federal budget deficits which grew to $3.1 trillion for FY20 and is estimated to hit $4.2 trillion in FY21. If rates were to begin an expected move up, what would be the clearing price for U.S. treasuries and what would that rise mean for equity valuations? The election of President Biden and the balance of power in Congress will likely bring about notable fiscal policy changes over the next two years. Corporate taxes are likely to go back up to 28% along with a possible increase in the top personal tax bracket and a potential rise in capital gains taxes. How will the markets respond to these potential changes?
Therefore, keeping an eye on key economic metrics (inflation, unemployment, housing prices, etc.) will be important as we move through the year. The velocity of money (V) will also be an important variable to track. If the amount of money in the economy speeds up (the number of times $1 is used to purchase multiple goods), then price increases are likely to follow. To date, velocity has remained low as household savings has outpaced consumption.
The forecast for 2021 GDP growth is quite good, ranging between +4% to +5% for CY21, and corporate earnings are showing nice gains for 4Q20 and similar estimates for CY21.
As COVID immobility fades away with vaccine effectiveness and herd immunity, and travel and retail purchases pick up, we will experience a significant tail wind helping economic growth. However, this scenario could also bring with it higher than expected inflation and rising interest rates.
A different but credible scenario would view our current economic situation and unemployment levels as below capacity thus delaying any near- term increase in the velocity of money and avoiding disruptive changes in prices and interest rates.
The pandemic has opened up a number of innovative opportunities in the economy which will be the source of continued future GDP growth and value creation. Digital transformation is expanding and supporting economic growth in impactful ways fueling productivity gains which may serve to delay eventual inflationary pressures.
We cannot lose sight of the positive signs coming out of the reshaped post COVID economy. However, the basic relationship of money supply and prices cannot be ignored. The potential for market surprises and an unexpected rise in interest rates due to price inflation remains embedded in our economic situation given M2. The only question is when it will materialize and how effective the Fed will be in managing our interest rate environment.
Prudent fiscal policy will also be important as we put the COVID pandemic behind us. We are blessed as a nation that the global economy uses the USD as its reserve currency. We should not take that for granted.