2Q21 Market Outlook

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
April 06, 2021

Summary
We are beginning to experience an acceleration in global growth led by the United States. The expansion will be stronger than normal as we are starting this period of economic growth with record levels of liquidity, record level of personal savings, trillions of additional stimulus coming and over $2.5 trillion still not spent from previous relief packages, pent-up demand amongst pent-up consumers, low inventory levels which will need to be built up through additional corporate investment, and a supportive Federal Reserve and Congress.
However, concerns about mounting inflation and higher interest rates are increasing market volatility, and the tug of war continues between this steepening yield curve, an accelerating economy, and the change in market leadership between value and growth stocks.

COVID Vaccinations
President Biden’s comment this week that we will have 200 million vaccinations by the end of April, twice what was initially anticipated, offers us confidence that we are moving towards our goal of herd immunity faster than we originally anticipated. At least 31 states will be giving all adults access to vaccinations by mid-April and many more by May 1st. The government has locked in supply to vaccinate 400 million people by the end of July, about 70 million more than needed.

Daily & Cumulative U.S. COVID Vaccinations (Source: CDC)
Unfortunately, Europe is not doing nearly as well. Still, we remain optimistic that it will improve rapidly. Those abroad will most likely be vaccinated before year-end as supply increases, putting the virus in the rearview mirror as we enter 2022.

Monetary & Fiscal Stimulus: The Twin Towers of Liquidity
Governments and monetary authorities have provided extra liquidity and funding for individuals and corporations. This excess liquidity will remain in the system for years boosting global growth above historical rates.

Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen testified before Congress last week. Their messages were clear and consistent that they will do everything in their power to stimulate and support the economy until unemployment moves back to pre-pandemic levels, even if it means inflation running above 2% for a sustained period. Both expect and believe that higher near-term inflation will only be transitory as corporations catch up with demand, supply lines are improved, and more capacity comes online. We, too, believe long-term inflation will stay contained due to global competition, technological advancements, and the rise of disruptive technologies transforming industries and our economy.

Weather problems last month, chip shortages, and a bottleneck in the Suez Canal point out the need to bring supply lines home. President Biden addressed this problem in his multi-trillion infrastructure bill announced last week. We do not expect the Fed, ECB, BOJ, and Bank of England to begin changing policies until well into 2022, permitting the global economy to run at rates well above historical averages. The bottom line is that all monetary authorities have our backs, limiting any corrections when, and if, they occur.

The $1.9 trillion-dollar stimulus plan is currently being rolled out. We expect nearly $900 billion will hit the economy before the end of the year and over $1 trillion rolling over into 2022. The $2.0 trillion infrastructure stimulus bill announced last week will, if passed by Congress and signed by the President, supply funds for roads, bridges, ports, climate change, and bringing back critical supply lines to America. Shortages and supply line issues drive home the need to build back America stronger and reclaim critical supply lines in key industries.

Proposed financing for this infrastructure package includes higher taxes on high-income individuals and corporations. The tax package also includes closing loopholes and better collections.

Higher Corporate Tax Rates
Although the President is asking for a 28% corporate tax rate, we do not expect the corporate rate to go above 25% as it would not keep U.S corporations globally tax competitive, which Treasury Secretary Janet Yellen said was one of her goals. Raising corporate taxes creates a disincentive to corporations from investing in employees, research, and plants, and studies have indicated that higher taxes are evenly borne between employees and shareholders with respect to who pays for higher tax rates, employees through less employment and lower wages, and shareholders through lower market values.

We expect that few, if any, Republicans in the House, and none of the Republican Senators will vote in favor of higher corporate tax rates having fought to lower these rates just four years earlier. As a result, the Democrats in the Senate will move forward on their own to move the bill along to the President for his signature utilizing the reconciliation process.

We estimate if the corporate tax rate climbs to 25%, earnings growth among the S&P 500 companies will drop over 3%. Subtracting this incremental tax bite from S&P 500 earnings would result in the market trading today at just over 20 times earnings (price/earnings ratio). We believe that a 20X Price/Earnings ratio is sustainable and appropriate considering historically low interest rates. However, a corporate tax rate at 28% would not only put our companies at an economic disadvantage at a critical time in our competition with China, but also would decrease current earnings by over 10% which, when coupled with increasing interest rates, could force us into a market correction or worse.

Current Economic Indicators
While February’s economic data was penalized by weather, most recent data are strong despite supply issues. Here are the most recent key data points: jobless claims fell to 684,000 last week, the lowest since the pandemic began; the flash U.S. composite output index rose to 59.1; the flash services business activity index increased to 60, an 80 month high; the flash manufacturing PMI hit 59.0, a two month high; manufacturing output hit a five-month high as production is ramping up to meet demand; new order growth is rising at its fastest pace in over in 6 ½ years, but supply chain issues are limiting output, and consumer sentiment hit 84.9, the highest level since the pandemic began just over a year ago.

We expect above-average growth in production as manufacturers attempt to normalize inventory levels which are presently at multi-year lows. Problems in the Suez Canal are not helping matters as supply lines are further challenged, and now that the tanker is free of its earthly clutches, shipping experts believe that the back log with take up to 3 months to clear.

Despite a rise in coronavirus cases abroad, foreign economic data have begun to improve. For instance, European manufacturing PMI jumped to 62.4 in March, service sector PMI increased to 48.8, and the composite PMI rose to 52.5, up from 48.1 in February. Premier Li of China said last week that growth could easily exceed its 6+% target for 2021, and long-term growth will average above 5.5%.

Leading Economic Indicators
The Composite Index of Leading Indicators, otherwise known as the Leading Economic Index (LEI), is an index published monthly by The Conference Board. It is used to predict the direction of global economic movements in future months. The index is composed of 10 economic components whose changes tend to precede changes in the overall economy. Businesses and investors can use the index to help plan their activities around the expected performance of the economy and protect themselves from economic downturns. The ten constituents as follows:

Average weekly hours worked by manufacturing workers indicates both consumer income and business demand for labor to engage in ongoing production.

Average number of initial applications for unemployment insurance indicates possible changes in unemployment, which reflects the level of business activity and impacts consumer income.

The volume of manufacturers’ new orders for consumer goods and materials indicates businesses’ short term operational spending.

The new orders index (from the Institute for Supply Management PMI), which indicates whether orders for various manufactured goods are increasing or decreasing.
The volume of new orders for capital goods (except aircraft), unrelated to defense, indicates business plans for longer-term future production involving durable capital.
The number of new building permits for residential buildings indicates future spending on construction projects.
The S&P 500 stock index, which indicates the total value of the business sector and the nominal wealth of stock holders in the economy.

The inflation-adjusted monetary supply (M2) indicates the purchasing power of highly liquid assets available in the financial system for business and consumer borrowing and spending.

The spread between long and short interest rates, which indicates bond market participants expectations for future performance of the economy.

Average consumer expectations for business conditions indicate forward-looking consumer sentiment for the next six to 12 months.

The LEI reached 99.8 in February which rejoins the upward trajectory of this indicator prior to the pandemic and continues the monthly increases seen in this predictive indicator.

Positive Underlying Fundamentals
Due to these factors above, we believe we are on the verge of a sharp acceleration in global growth led by the United States. The expansion will be longer and greater than previous expansions as we are beginning this economic expansion with record levels of liquidity, record levels of savings, trillions of additional stimulus coming with over $2.5 trillion still not spent from previous relief packages, pent-up demand amongst pent-up consumers, low inventory levels which will need to be built up through additional corporate investment, and a supportive Federal Reserve and Congress.

Operating margins, earnings, cash flow, and returns on invested capital are expected to be robust over the next several years as managements have learned to do more with less, are spending heavily on technology to improve all facets of their businesses and are focusing on their strengths by reducing/eliminating their weaker, less profitable segments of their operations. Additionally, we expect significant increases in dividends and buybacks over the next few years, which supports higher stock prices.

Sector Allocation
We remain focused on companies most leveraged to the global economic recovery: industrials/capital goods/machinery companies; industrial commodities/agriculture; financials; technology at a reasonable price; transportation, and energy. Energy is an interesting sector in that it is not only an early economic recovery beneficiary, but also the Biden Administration would not mind seeing higher gasoline prices for some time as it would spur adoption of electric vehicles which helps one of their primary policy objectives; the environment.

We recognize that the financial markets are volatile and can correct at any time, but we have confidence in the long-term success of our economy, and we will stay the course investing in the long-term winners and avoid losses. We will continue to sell companies that, while having successful business models, have attained highflying valuations that far exceed our estimates for intrinsic value.

Corporate cost cutting during the pandemic has left companies with tremendous upside earnings leverage, and personal savings rates fueled by new employment and fiscal stimulus has created positive future spending capacity among consumers.

All things considered, interest rates aside, the economic fundamentals supporting the market are strong.

Finally, if the equity market gets spooked by the reemergence of the bond vigilantes and rapidly rising interest rates, we believe that the weakness in equity prices will be temporary and ultimately backed by positive economic fundamentals and actions by the Fed to stem interest rate increases if they believe that these rates are rising too fast.

The importance of Our Economic Profitability Research Process
Our investment selection process is informed by an Economic Profitability framework that explicitly addresses the four main drivers of enterprise value: profitability, competition, growth, and cost of capital.

Our Economic Profitability analysis has a focus on the balance sheet. Companies are not only expected to generate positive earnings and sales growth, but also they must provide an adequate return on the money they have invested. Accounting information based on Generally Accepted Accounting Principles (GAAP), although necessary, does not by itself adequately explain market valuations nor provide comparability between firms. The goal of any intrinsic value estimate is to remove accounting distortions to provide comparability over time, firms, and industries plus help answer how well is this firm/project managed (corporate performance), as well as what is this firm/project worth (valuation).

This investment selection process identifies firms that not only have superior free cash flow rates of return on capital less the firm’s weighted average cost of capital (economic profitability), but also where this economic profitability is growing in a sustainable way. Sustainability of this economic profitability is predicted by the company’s competitive advantage provided by one or more of the following: barriers to entry, lack of bargaining power of suppliers, competitive intensity among current industry players, bargaining power of customers, or the threat of substitutes. Without one or more of these competitive advantages, these superior economic profitability results will be quickly competed away. In our economy very few, if any, economic profitability opportunities exist forever, and our sustainability of these economic profits are a measure of how long it will take the market to overcome these competitive advantages. It is important to be making cash flow rates of return above your cost of capital, but it is more important from an investment perspective to be able to sustain these advantages for as long as possible.

Catching Up
We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link. In the interim, if you would like to get something on the calendar, please send me a note with some dates and times.

John