The U.S. payrolls continue to surprise on the upside. However, the delta variant is spreading globally. The U.S. Fed also signaled an earlier rate hike, but the U.S. Treasury curve has flattened which may be the reason for technology stocks performance recently. With all these contrasting signals, we wish to express our views on the U.S. economy and the U.S. equity outlook for the remainder of the year.

The conundrum is why U.S. interest rates are falling from recent peaks when the economy is growing. For example, payrolls have increased and the four-week moving average for initial jobless claims are now less than 400,000, the lowest level since early March 2020. The fear is that a Federal Reserve policy could upend the cycle or that organic growth without stimulus will be short lived. Another possible answer is that global fixed income reallocations to the U.S. have been precipitated by the rebound in the U.S. economy due to the trillions of dollars of stimulus spent to fill the economic pandemic hole and generally widespread vaccinations allowing the reopening of the economy. This investor demand has been supported by the Fed currently buying $80 billion of Treasuries and $40 billion of mortgage-backed securities per month and increasing their balance sheet by nearly $4 trillion over the last 16 months to ensure there is no economic backsliding and increased labor participation.

The rush to buy U.S. Treasuries has been so fast and furious, the 10-Year yield has dropped from above 1.75% in late March to below 1.40% as of this writing. Per JP Morgan’s model, U.S. Treasury yields appear to be at least 25 basis points too low, a three-standard deviation event, and the largest such divergence since early fall 2020. 

Treasury yields are nearly 3 standard deviations below their model-implied fair value.

Residual of J.P. Morgan 10-Year Treasury Fair-Value Model, (bps)

Source: J.P. Morgan, CFTC
* Regression of 10-year Treasury yields on 5Yx5Y seasonally-adjusted TIPS breakevens (%), 3m3m OIS rates (%), Fed policy guidance (months) J.P. Morgan US Forecast Revision Index (%), and CFTC spec positions in interest rate futures (3y z-score). Regression from 7/8/16-7/6/21. R-squared = 97.0%, SE = 11.6bp.

Technology stocks, specifically software and other members of the high price-to-earnings multiple cadre of growth stocks, have benefited from the decline in interest rates. All other things being equal, lower interest rates aid growth stocks because typically the bulk of their earnings are in the future. Discounting back growth stocks’ future profits at a lower cost of capital increases their present value whereas value stocks typically have near-term earnings and as such low interest rates have less impact on their present value. We believe the recent gain in growth versus value stocks has been purely on multiple expansion and not a reflection of higher earnings power. For example, in the 41 days since the end of May, the FAANGM (Facebook, Amazon, Apple, Netflix, Google, and Microsoft) price-to-earnings (P/E) multiples have increased on average by 9.75% and each of the six stocks P/E multiple has moved in line with their price increase over the same time period.

P/E change since May 31 through July 8, 2021: Facebook 5.0%, Amazon 15.5%, Apple 14.5%, Netflix 6.1%, Google 5.4%, and Microsoft 12.0%.

FAANGM Price Performance Since the End of May through July 8, 2021

Source: Bloomberg

We believe growth stocks have not been powered by changes in earnings expectations. In the chart below provided by Cornerstone Macro, the black line (Russell 3000 Value Index minus the Russell 3000 Growth Index earnings) shows the rising value company earnings versus growth stocks. The green line is the relative price of the Russell 3000 Value Index divided by the Russell 3000 Growth Index price. Taken together, value company earnings expectations are rising while their prices relative to growth are declining.

Value vs. Growth: Relative Earnings vs. Relative Price

Source: Cornerstone Macro

Our view on the U.S. economy is that it is poised for multiple years of much better growth than the GDP average 2.5% experienced since the end of 1991. After the 1Q2021 growth rate of 6.4%, our bottom-up estimate from company guidance of revenues and earnings is 6-8% for the full year 2021 and in the range of 3-6% in 2022. Even without the potential infrastructure bill and the next potential $1-2 trillion budget reconciliation bill, the pay it forward growth of the Fed’s increased balance sheet of $4 trillion and the fiscal spend to date of $2-3 trillion still has time to flow through the economy. The U.S. consumer alone has approximately $2 trillion in excess savings that could be spent as confidence increases, the economy fully reopens, and as jobs get back to pre-pandemic levels. To be sure, there are risks to this scenario as renowned contagious disease specialists warn of the Delta variant spread, especially for the unvaccinated, and Japan has entered a new lockdown.

U.S. GDP Since the End of June 1991: Average 2.5%

Source: Bloomberg

The risk of the Fed making a policy mistake is low but possible. However, notable is the New York Fed’s model of the U.S. recession odds for the next twelve months which have risen slightly to 7.1% (from the recent end of May figure of 6.1%) but remain lower than the average recession risk of 9.5% since the end of June 1991 and the five-year average of 13.7%.

NY Fed U.S. Recession Odds For the Next 12 Months Since the End of June 1991: Average 9.5%

Source: Bloomberg

U.S. equity outlook for the rest of the year:

Our expectation is that the stock market will pause as investors digest 2Q2021 earnings and guidance but that money will follow earnings growth which is expected to be up at least low double digits for the rest of the year.

After a generation of declining bond yields, investor fixed income overweights, and their commensurate gains, the outlook for real returns for bonds is negative given the U.S. 10-Year Treasury is currently yielding 1.35% and conservative measures of inflation over the same time period range from 2-3%. We believe the current massive monetary and fiscal stimulus plus consumer confidence unfettered by Covid-19 continues to be supportive of U.S. equity markets and a potential “super value” cycle. Even if an investor at a minimum believed in reversion to the mean, a further spread of positive value index outperformance would necessitate a 57 percentage point (or 5700 basis points) relative move just to bring the value and growth indices back to 2016 levels.

An S&P 500 dividend yield greater than the U.S. 10-Year Treasury yield historically is rare.

The occurrence has occurred more frequently since 2007. In October 1962, the two nearly converged and the S&P 500 increased 26% on an annualized basis over the next two years. Since then, the S&P 500 yield has surpassed the 10-Year four times for several months. Each time has been a positive tipping point for equities. For the two years post each event, the S&P 500 has returned at least 20% on an annualized basis. The most recent period commenced on August 5, 2019. In the 22 months from 9/1/2019-6/30/2021, the S&P 500 has returned 25.5%. Once again on July 7, 2021, the S&P 500 yield eclipsed the 10-Year. It remains to be seen if that condition will continue. If so, equities may be poised for another strong run.

S&P 500 Dividend Yield vs. 10-Year Treasury Yield*

Source: TCW Equity Research, Ibbotson, Bloomberg, FactSet
* 10-Year U.S. Treasury Yield data only available back to 1962.

While we are positive on the U.S. market, particularly versus emerging markets and U.S. fixed income securities, we believe value will return to favor as the positive CCAR results should lead to increased buybacks and dividend growth for the banks. In addition, second quarter earnings season starts in mid-July where cyclical companies, i.e., Consumer Discretionary ex-Internet Retail, Energy, Financials, Industrials, and Materials have seen the greatest and accelerated increases in their 2021 earnings projections. Further, we believe value is poised for multiple years of outperformance over growth similar to the results post the 1970, 1975, 1982, 1991, and 2000 recessions. As a side note, the relative valuations of growth versus value stocks are now back to record extremes of greater than two standard deviations.