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March 2021 Economic Commentary

The Three Unknowns

Optimism reigns as the world opens up after a year of COVID-induced misery. By almost every measure, economic indicators are turning upward and market returns reflect this progress. Other than a correction in US large cap growth stocks, most risk assets classes are breaking out of their trading ranges. Investors have paid a premium for growth in a slow GDP growth environment over the last 10 years but the tables seem to be turning in favor of value stocks.
With rising rates and the expected explosion in global GDP this year, value stocks will see significant earnings acceleration, at least for the next several quarters. Portfolios will require a balance of both with the trickiest decision being whether or not to “play any defense” at all. Traditionally fixed income has helped lower portfolio volatility, and while that has not changed it could act as a drag on performance during this bull market run.
The three unknowns that could spoil this record run in risk assets are inflation, rising interest rates, and tax increases. Each one has the potential to rear its ugly head this year and force a very quick correction, but may not stop the secular bull run in the long term.
Late last month the markets were very choppy as the 10-year yield approached 1.5% and then blew past it. Since 1990, the average rate rise over seven market cycles has been 1.8% and the recent spike of 1.07% off the low gives us room to run. Many forecasters have picked the 2% number as a threshold that will clearly put downward pressure on stocks. It’s a nice round number well suited to trigger trading algorithms, so it may hold true, but we are still skeptical of such a convenient threshold.
Inflation is another area of risk, given capacity constraints across both finished goods and raw materials. As the economy accelerates toward full throttle we believe some inflation is unavoidable. While productivity gains and new supply coming on board will help mitigate price spikes, we are keeping a close eye on service sector inflation as well. Specifically, we could see significant wage increases necessary to lure back workers into a hyper-energized consumer feeding frenzy.
Finally, will the threat of “paying your fair share” be realized in 2021? Given the high level of current spending and what’s in the pipeline with regards to infrastructure and other initiatives, it seems clear that increased taxes are in our future. What has been telegraphed are increases to the highest individual tax brackets in addition to corporate rates, but whether this will dampen consumer demand remains to be seen. S&P 500 earnings will take a hit, but the market has proven to have an appetite for higher multiples as long as fiscal and monetary stimulus is in high gear.
As we juggle these risks in the face of the “Great Reopening” we will continue to focus on proper asset allocation as well as stock selection. Generating alpha as all boats are lifted gets difficult but as I have mentioned before, our Investment Committee will be saying “no” more often as we explore new ideas. It’s in this arena of dislocation and overvaluation where the most mistakes are made. Please call or email me with any questions or observations at jess.ellington@AUBWM.com or 843-412-1420.

Past performance quoted is past performance and is not a guarantee of future results. Portfolio diversification does not guarantee investment returns and does not eliminate the risk of loss. The opinions and estimates put forth constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

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