Midyear update: The economy roars back

BY ALMOST ANY MEASURE, the U.S. economy is making an extraordinary recovery from one of the most challenging years in memory. With once-shuttered businesses and public spaces reopening, much of life feels like it’s returning to “normal.” A brisk pick-up in spending and business and consumer confidence lifted financial markets to all-time highs in the first part of 2021.

To be sure, challenges remain as businesses struggle to find workers, navigate supply shortages and meet surging demand. And a sharp spike in prices is stoking concerns that the economy could overheat. What could all this change mean for the rest of 2021 and beyond?  For answers, we asked Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank, for his perspectives on economic growth, inflation, taxes and other key issues, as well as how investors can prepare for the road ahead. For a deeper dive into the Chief Investment Office’s outlook, read “The Great Pivot.”

Q: Emerging from the pandemic, where does the economy stand and what do you expect for the second half of the year?

A: As the recovery gained momentum last year, we anticipated 2021 as a year of pent-up demand being released, and that’s what we’re seeing. Many consumers are using savings built up over the past year to spend on goods and services, especially travel, leisure and other experiences curtailed during the pandemic.

We expect this to accelerate for the remainder of 2021. Businesses should benefit from higher-than-expected growth, revenues and profits. Many will likely use excess cash for capital expenditures and productivity improvements in order to meet elevated demand and to help them overcome challenges such as worker shortages. In all likelihood this creates a positive environment for stock investors, despite potential risks, including rising prices.

Q: On that note, inflation is clearly a concern for many people. Where do you see that headed?

A: The Federal Reserve (the Fed) targets an average of 2% as a healthy inflation rate, as measured by the Personal Consumption Expenditures (PCE) price index. We’re already at an above average rate for the PCE, and we wouldn’t be surprised to see it rise further. So far, the Fed has been reluctant to step in with inflation-control measures, such as raising interest rates or tightening the money supply, until unemployment drops to pre-pandemic levels. They’re banking on inflation coming down naturally as savings return to more normal levels and consumers slow down their spending. Still, we expect elevated inflation well into 2022 and beyond. And the Fed recently signaled its willingness to raise rates in 2023, if needed to keep prices and the economy from overheating. Investors who are concerned about this might consider a greater emphasis on cyclical industries, such as financials, industrials, materials and energy, which tend to perform well at such times.

Q: How might the concern over rising prices affect bond yields and what should fixed-income investors consider?

A: Amid rising inflation, economic growth and higher wages, we expect bond yields to continue to rise from the extremely low levels of recent years. Strong economic growth favors equities over fixed income, but bonds remain important for portfolio diversification. Because of our view that yields will likely move higher, we believe investors should consider bonds of shorter duration and greater exposure to corporate bonds and other forms of credit over Treasurys.

Q:  Passing a major infrastructure spending bill has been a big priority for the administration and Congress. What effect could this have on the economy, and which industries could potentially benefit?

A: Whether it’s roads, bridges and airports or enhanced cloud computing and broadband internet, better infrastructure means better connections, fewer hurdles, quicker time to market and stronger economic growth. Smart cities, the next great area of infrastructure development, will require major upgrades in data transmission capacity for healthcare and other industries. Another important area is sustainable infrastructure. Green tech may once have been seen as something that couldn’t exist without government subsidies. But as society prioritizes a response to climate change and places greater emphasis on moving away from reliance on hydrocarbons, renewable energy and other technologies represent significant long-term opportunities for investors. 

Q: What other industries or areas of the economy might stock investors consider?

A:  We believe that long-term investors should look for convergence points — key sectors that come together to create outsized growth potential. The best current example involves healthcare and technology, where laboratory science is converging with big data and the internet of things, creating opportunities for investors in companies that are innovating and bringing new products to market.

We also see opportunities in travel, leisure and entertainment as those industries rebound from the pandemic and consumer spending shifts incrementally away from goods and back toward experiences. That momentum could create a leisure and entertainment sector even larger than what existed prior to the health crisis.

Q: There’s also a lot of talk about tax increases these days. What might higher taxes mean for businesses, the economy and investors?

A:  Markets have already factored in the likelihood of higher taxes on businesses and affluent individuals, with the expectation that political compromise will push the final numbers lower than the highest proposals now being put forward. While business taxes do pressure earnings, strong corporate profits this year will likely lessen the impact. Likewise, for individuals, studies show that in the long term, higher taxes don’t curtail investment. A capital gains tax increase could actually prompt people to stay invested longer.

We don’t recommend major portfolio changes based solely on taxes; the main thing is to keep your asset allocation and investment strategy aligned towards your goals. That said, now is a good time to speak with your tax professional and financial advisor about opportunities to be more tax efficient with your decisions. For example, a fixed-income investor might consider tax-exempt municipal bonds, but only after carefully considering whether the cost and yield make them attractive relative to taxable investments, such as Treasury bonds.

Q: At what point might federal spending and rising public debts become a problem for the economy and the markets?

A: At the moment, the Fed and the Treasury are not concerned about adding more debt because interest rates — the cost of debt — are currently low. The risk is if inflation rises uncontrollably and the Fed is forced to raise rates quickly. The cost of debt would rise and a flattening or inverted yield curve (when short-term interest rates move higher than long-term rates) could signal that we’re heading towards recession. Instead, what the Fed and Treasury expect is that inflation will stay under control, the cost of debt will remain relatively low and economic growth will generate higher cash flows to pay down the deficit and public debt.

Time will tell. One clue is the strength of the U.S. dollar, which signals whether foreign and domestic investors still have confidence in the dollar and in the U.S. economy’s ability to withstand higher debt loads. Concern over government spending is clearly putting some downward pressure on the dollar, but it’s very subtle. And the dollar, going back to 2018 and 2019, has been strong, so modest weakening is not a concern, at least for now.

Q:  Are there other risks to the economy and markets right now?

A: Though no geopolitical crisis dominates headlines at the moment, problems from China-U.S. relations to tensions or conflict in the Middle East can arise quickly and cause disruptions. Another concern would be if new taxes come in significantly higher than expected. The market is already comfortable with some increases, but the highest proposals, if enacted, would force the markets to reprocess. A third risk we could see is higher regulation, which creates a backdrop of slower growth and can make things harder to get done.

Q: What steps should investors consider as they prepare for the road ahead?

A: The most important guidance may be to not overthink your responses to anything going on at the moment. For a long-term investor, success means being consistently good rather than occasionally great — following a strategy based on your personal goals rather than making precipitous changes in hopes of getting into or out of something at the perfect time. Your advisor can help you better understand how inflation, interest rates, taxes and other forces may affect your portfolio and suggest incremental adjustments, including rebalancing, to help make sure you stay on course as we move through the economic cycle.