March 15, 2021
Out of Hibernation
Economic tailwinds continued in February, potentially setting the stage for higher inflation and interest rates.
On March 4, 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.
February saw some mixed action, reversing the January drawdown in equities, but intensifying the move up in rates. What did you see happening?
S&P 500 was up in February about 2.7% and year-to-date it’s up a couple percent. We also are continuing to see the Russell 2000 Value Index lead the Russell 1000 Growth Index, a trend that started late last year. The Russell 1000 Growth was basically flat in February and negative for the year. Given the market action so far in March, it’s still struggling. But the Russell 2000 Value was up over 9% in February and up 15% year-to-date. This dramatic shift started to show itself around November, December, in line with the positive vaccine news. The international markets are behaving about the same as the S&P; the MSCI EAFE Index was up a couple percent and is now up a little over 1% for the year.
What about on the bond side?
That's where the real story is. The Bloomberg Barclays Aggregate Index was down one-and-a-half percent in February and 2% for the year, as we're seeing rates move up.
Within credit, high yield, which has a combo of credit exposure as well as some rate risk, was up in February. It’s up a little less than 1% for the year. And floating-rate loans, which are really a pure credit play, were up over 1% in February and a couple percent for the year. The reflating effects of the economic reopening can be seen in not only the equity markets, but also the fixed-income markets.
On the fixed-income markets, it seems the Fed may have been caught a little off guard as they have had to respond to moves in the bond market instead proactively leading, as we’ve come to expect from the Fed. What kind of reassurance are we getting from the Fed on rates and inflation?
I expect the Fed will largely stick to the script. They have said quantitative easing (QE) is going to go through at least the rest of this year. Unemployment’s still high, and Chairman Jerome Powell said earlier today that to consider raising interest rates, the Fed would need to see max employment, inflation at 2% and headed north of that. That’s a pretty accommodative stance.
I think at the end of the day, you have to expect the yield curve will continue to steepen. If we do have an overheating of the economy, they would probably begin narrating rhetoric next year to set up tightening conditions in 2023. If you take a step back, the difference this past 12 months vs. most of the past decade was the Fed finally got some fiscal support. When you look at the decade of 2010, this was really the only year they were able to get it.
In a nutshell, the Fed probably hopes that we get a little bit of inflation. I am in the camp, similar to Chairman Powell, that I do think that any inflation will be mostly transitory. To me, it could be one or two years where you see this inflation spike because there’s still some really large headwinds for inflation when you think about the digital world and technology, globalization, and concentrated distribution of capital dynamics. Those are monstrous, deflationary pressures.
The latest stimulus package now stands at $1.9 trillion. How does that amount of fiscal spending play into the recipe for higher rates?
We’re expected in March to get our third round of checks within a year. Here’s a resulting stat that I found very interesting. Personal savings over the past year totaled $3 trillion—or three times the normal level. So let’s do a little math and suppose consumers spend half of that excess, or $1 trillion. That’s 5% more to GDP—and they have another 5% they can spend on top of that without dipping into their traditional level of savings. That’s good for stocks. It’s good for credit, but typically bad for rates and inflation.
The next thing is you’re starting to see inflationary data from the reopening of the economy. The Purchasing Managers’ Index (PMI) data is moving higher for both manufacturing and service, but keep in mind, labor markets are still distorted due to these—I call them wonky—reopening rules, and supply chains are still disrupted. Transportation’s disrupted, supply chains are disrupted, labor is still disrupted. I think we’re in a transition period, where demand is going to outpace supply until these elements are in full swing. I believe this results in inflationary pockets over the next two years.
How are we seeing the recovery play out on a demographic basis?
First, let me say that this is based on Bank of America daily credit-card spending data. I find it interesting to look at these figures by age group because it’s a fair assumption that most Americans over 75 have had access to the vaccine, and their spending provides a glimpse into reopening behavior. Let’s break this down into four groups: people over 75, boomers, Gen Xers, and millennials. One of the spending spikes we have seen recently is with air travel. By age, those over 75 are spending four times the amount on airline travel this month versus September 2020. Boomers and Gen X around two times. Millennials up about 50%.
One of the conclusions that can be drawn is that when the over-75 folks got vaccines, one of the first things they did was to book travel, most likely to see family and friends because we don’t see the spike in lodging and dining. And because of how the vaccines are being rolled out, my guess is you’ll start to see boomers follow suit next, and then Gen Xers.
What about overall spending by sector?
Four months ago, the airline sector was down 75% year-over-year. At the end of February, it was down about 50% year-over-year. Entertainment is seeing a slight improvement, but it’s still down 60-plus percent year-over-year. Restaurants and bars are still down about 4 to 5% year-over-year. Lodging is down 20%, which is a dramatic improvement because they were down 40% year-over-year four months ago. Four months ago, gas spend was down 15% year-over-year. It’s now up. You’re starting to see the travel elements open up.
Looking at the home environment, it’s still very strong. Furniture and home improvement are still up 20-plus percent. On the retail side though, department stores were pretty flat four months ago, year-over-year. Now they’re up 20% year-over-year. What is tailing off is online retail. So online retail for most of 2020 was up 60 to 70% year-over-year, now it’s up about 50%. Still very strong but tailing off. In the end, traditional is certainly improving. Home is staying strong and online is strong but trending down.
How about spending regionally?
Only two states are down year over year as of the end of February, Oregon and Washington. When you look at the city level, Seattle, Portland, and San Francisco are weakest year-over-year. Detroit, Miami and Tampa are the strongest year-over-year. The story of major cities in Texas are currently distorted because of the winter storms. The rhetoric that we’re seeing regarding the southeast being open and recovering more strongly seems to be backed up by the spending. On the flip side, the data is showing that Oregon and Washington seem to be pretty far behind.
For March, we’ll be comparing year-over-year spending in the pandemic for the first time. What do you anticipate seeing?
I think we’ll start to see online retail numbers look much worse year-over-year because, again, online retail spiked in 2020. And then you’ll start to see these travel numbers have huge year-over-year improvements. But you’ll have to readjust because last March the economy was in a free fall.
How should we think about the bond market for the balance of 2021, especially given the significant moves we’ve seen to date in the rate markets?
I’m still in the same camp I was a couple months ago. Earnings are expected to be strong; QE is continuing; major economies are seeing new COVID cases drop; vaccines are ramping up; and more stimulus is coming. All of that is very good for earnings, very good for credit and risk assets. Rates and valuation are going to be the struggle. When you think about those risks, how do I get defensive? Well, certainly a way to get defensive on rates is still the floating-rate trade.
When you look at the risk, you look at the tailwinds for credit, and you look at the headwinds for rates or inflation. That seems to be, I think, a great way to be defensive and still receive income.
Any final thoughts?
I'll start with a story of my son. He is a senior in high school. And as you can imagine, much of what we viewed as a traditional high school senior year experience was not that for him. But he got a bit of good news this past week: the prom is on. Parents got together and said, “All right, we don’t know if the school is going to sponsor a formal prom, so we’ll put on a prom.” It will be an outdoor masquerade dance, which I thought was really clever. And they’re not disclosing the location until a week before.
This is what I learned: Faced with obstacles, they planned, they got creative and, more importantly, they acted. For similar reasons, I think that our economy going to fully open faster than we think. If you’re thinking in the back of your mind, “When we open up, I want to ... .” Whatever it is you want to do, I'd say start planning, get creative and begin acting.
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 MSCI EAFE Index is designed to measure the equity-market performance of developed markets in Europe, Australasia, and the Far East.
The Purchasing Managers' Index (PMI) is an indicator of the economic health of the manufacturing sector, and is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
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 theU.S. stock market.
Pacific Asset Management LLC is the sub-adviser for the Pacific Funds℠ Fixed Income Funds. The views in this commentary are as of March 4, 2021 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.
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