How Strong Are the Economic Tailwinds?
What’s in store for the economy and credit with a rebounding economy and pent-up demand?Download PDF
On May 21, we sat down with Dominic Nolan, senior managing director of Pacific Asset Management, to get his insights on the latest stimulus package, rising interest rates, consumer spending, Fed policies and more.
April saw equities moving ahead and even a brief respite for bonds as the 10-Year Treasury retreated from first quarter highs. Can you provide some context on the last month?
Let’s start with the S&P 500 Index, which was up over 5% in April and is up almost 12% for the year. For the first time in quite a while, the Russell 1000 Growth index outperformed, up almost 7% in April. For the year, the Russell 1000 Growth is up around 8%. The Russell 2000 Value Index was up 2% over the past six months and for the year is up almost 24%. The Russell 2000 Value is still firmly outperforming, but we did see a pause in April. I don’t think it’s coincidence that as interest rates found their zone, the Russell 1000 Growth started to pick up some steam. Higher rates effect longer-dated cash flows, which typically impact growth companies more than value companies. International markets are still underperforming the U.S. markets, but were still up 5% and 7% in emerging markets and developed markets, respectively.
What about the bond picture?
For fixed income, the aggregate index was up 79 basis points in April. Returns were above coupon for the first time in a while. Year-to-date though, it’s still down 2.5%. High yield was up 1% for the month and almost 2% for the year. The credit story is still strong. Floating-rate loans were up a half a percent in April, but for the year up are up 2.5%, which leads most of the major fixed-income indices.
U.S. Treasury Secretary Janet Yellen recently said that rates may need to be higher to avoid an overheated economy. What do you take away from that?
I think that’s really just some hedging to provide flexibility from the Fed and Treasury’s standpoint. Over the past nine months, inflation expectations are up almost 1%. That’s a lot. And you have five-year forward expectations now up above 2.5%. That’s above the Fed’s target rate of 2%. When you look through to the commodities, oil in the $60s vs the 20s only a year ago. Something you may or may not have heard about is lumber. You have a housing market that’s on fire, helping propel lumber up to over $1,600 per thousand board feet. It was $300 a year ago.
You have compromised supply chains and labor challenges, resulting in sub-optimal operations, with demand surging. So the real question is if inflation is structural or transitory. The Fed certainly leans in the camp of transitory. Personally, I also lean in the camp of temporary, but know there are a ton of distortions that are going to lead to, I think, inflation surging in various pockets over the next year or two.
As it relates to the Fed is bullish, not hawkish, with is an important distinction. Yellen’s comments give them flexibility to begin the narrative of tapering, which I think will begin this summer, setting up for possible tapering next year.
Do you have any sense for how markets might deal with the spending packages before Congress?
How the markets deal with them is uncertain, but let’s take a step back. There are two different packages here. The American Jobs Plan, also known as the infrastructure plan, is a $2.3 trillion package. And then behind that is the American Families Plan, which is about a $1.8 trillion package. Combined, that’s about $4.1 trillion. The American Jobs Plan proposes that businesses foot most of the bill by increasing the corporate tax rate from 21% to 28%. Swing Democrats in the U.S. Senate have indicated that they don’t want the corporate tax rate to go above 25%.
So we are already hearing that certain Democrats don’t want to move it to 28%. The Global Intangible Low-Taxed Income (GILTI) tax, which is a business is expected to be raised. And then a minimum tax on corporations that make over a hundred million. I view that as more of a Alternative Minimum Tax (AMT) on corporations for those that have had to experience AMT over the years. I would think the American Jobs Plan has a pretty good chance of passing, but not before a lot of debate and attempts at compromise. In the summer, I think they’ll move to reconciliation, which will allow the legislation to pass with a simple majority.
The American Families Plan provides funding for a universal preschool, free community college, childcare, and the extension of the child tax credit, among other things. I think that plan is going to be a lot harder to pass. To pay for the plan, it’s proposed the capital gains tax be increased from 20% to 39% for people making over $1 million annually. That’s an attack on high earners. Ending a step-up in basis for estates over $1 million dollars, that affects quite a few Americans. Ending carried interest, that’s an attack on private equity. And then ending 1031 real estate exchanges, which defers capital gains taxes, is a big attack on real estate, both commercial and residential.
For the next two months, the focus will be on the infrastructure plan. I don’t think the market will react well to sweeping tax changes across many different tries, but again, we’ll see. A lot of times these packages and how to pay for them end up looking much different than originally proposed.
We are looking at a pretty strong growth environment with some significant tailwinds. And when we look through to sectors, how strong are those tailwinds blowing?
In a nutshell, the economy is ripping, in my opinion. You’re seeing demand surge while supply is constrained. Let’s take a look at where we are today versus “normal,” which I’d go back two years to find. These figures are based on Bank of America’s daily credit card analytics.
Total card spend is up 14% from two years ago. That’s a big number. But let’s start with stuff that’s still down or being affected by COVID. Entertainment versus two years ago is still down almost 50%. Airlines, still down 34%, but remember at the height of the pandemic, it was down 80%. There are still international travel constraints, business travel has been slow to rebound, and there’s not yet free flowing state to state travel. Lodging’s down about 10% versus two years ago, but it had been off 40%. So, we are still seeing that improved substantially, and I think that will continue through the summer.
Where are the bright spots?
For anything outdoor, home, or vacation-related, the pricing power is firmly in the hands of the supplier. Furniture and home improvement up 40% versus two years ago. That’s consistent with anybody that’s been in the market to either buy or sell a home in the past six months. From two years ago, restaurants were up 9%, grocery stores up 15%, and clothing stores up 17%. And I’ll even drill down a little bit more anecdotally. The CEO of a very large outdoor sports retailer said on an earnings call that he has never seen anything like this. He made a comment that they expect to be under supplied in certain segments for years because of the demand surge. Our analysts are seeing comments come from restaurants, supermarkets, and retail that the labor market is tight.
When we dig into gaming, Caesar’s Entertainment CEO said the Las Vegas Strip occupancy reached 84% in April. That is higher than forecasts, and they expect to be sold out on weekends for the foreseeable future. Convention bookings are coming back. The second half of the year looks to be strong, and next year looks to be extremely strong for Vegas. The Nevada Gaming Control Board granted the Cosmopolitan of Las Vegas the ability to increase its gaming floor to a 100% capacity. The Cosmopolitan expects to operate gaming floors without social distancing restrictions or any plastic barriers, joining the Encore at Wynn Last Vegas in operating without COVID restrictions.
In April, we did see a pause in rates and a rally and bonds. Where do you see the opportunities now in the wake of that rally?
The economy is going strong, and that is good for credit. The Fed is still bullish. That is good for assets. Inflation is expected to move higher. So that to me is a headwind for duration, certainly from the standpoint of volatility. When you add those three big themes together, the floating-rate loan story is still very sound, in my opinion. And I’d add, the duration story is going to turn at some point, whether that is when the economy and rates move to a point where there is value at the long end, or things start to slow down a little bit. Duration may turn, but right now, the floating-rate story is compelling, given what’s going on with credit, the Fed and inflation. We started that narrative about five months ago and maintain it today.
Any thoughts on the different parts of the investment-grade curve?
The investment-grade story is still good. Also, if you’re of the belief that this inflation element is transitory in nature, again, intermediate-term rates might be at a point where it starts to look pretty attractive. And if things slow down, you have an anchor to volatility. At some point, if the Fed starts to taper, I think they begin a narrative to possibly move the short end higher. It’s weird, 2023 is little over 18 months from now. Although that seems a long way away, 18 months from now doesn’t.
To close out, what’s your non-economic thought this month?
Well, this is the last month of high school for my son. I told him and his friends, “School is never out. School is life and life is school.” I just continue to reinforce that we should learn every day, and we will never graduate. I asked them to think about what they want to learn this summer. School is never out.
Fund holdings and sector allocations are subject to change and should not be considered recommendations to buy or sell any security. As of 4/30/21, Pacific Funds fixed-income funds did not hold any Cosmopolitan or Wynn securities. Pacific Funds Strategic Income has a fund weight of 0.58% in Caesars Resort Collection, LLC.
One basis point is equal to 0.01%.
The Bloomberg Barclays U.S. Aggregate Bond Index is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. It includes those Russell 1000 companies with higher price-to-value ratios and higher forecasted growth values.
The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell1000 companies with lower price-to-book ratios and lower expected growth values.
The S&P 500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
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