The End is Near, with New Signs of Fear

Time to read: Minutes
Paul Zemsky

Paul Zemsky, CFA

Chief Investment Officer, Multi-Asset Strategies and Solutions

Barbara Reinhard

Barbara Reinhard, CFA

Managing Director, Head of Asset Allocation

We believe the economy will grow well above trend throughout 2021, as massive pent-up consumer demand is released by vaccination progress, states reopening and highly accommodative government policy.

In an extraordinary shift of fortune, most experts now agree that the worst of the pandemic is behind us — U.S. infections are down ~80% from the early January peak, ~10% of the adult population is fully vaccinated, ~20% have received at least one dose; and there is enough supply to vaccinate all adults by the end of May, according to President Biden. Although coronaviruses are here to stay and there may be new policies and precautions that didn’t previously exist, those measures that are economically constraining are almost over. Markets have been frontrunning this scenario for a while, but the economy, which has held up remarkably well all things considered, is preparing to lift off. U.S. 4Q20 economic growth was revised up to 4.1%, 1Q21 is tracking 4.5% and we forecast full year 2021 real GDP growth will be 5.7%.

Investors have responded by aggressively selling U.S. Treasurys. Since bottoming in early August at 0.51%, the 10-year U.S. Treasury yield has soared roughly 100 basis points (bp) to 1.5%. About 40% of this rise has come from real yields and 60% from inflation expectations. The move higher in rates has hurt long duration assets, with the Bloomberg Barclays U.S. Treasury 20+ Year index down nearly 10% YTD. Although only two months in, it’s the third largest calendar year drawdown for long dated U.S. Treasurys in over 30 years. Equities fared better than fixed income in February. U.S. small caps led the way again with the Russell 2000 returning 11.6% YTD. U.S. value beat growth by about 6% on the month, thanks to strong performance in the financial and energy sectors. A substantially steeper yield curve (the 2–10 spread widened by ~100 bp since August) helped financials; and a 70% increase in the price of WTI crude since the end of October was much needed for energy shares, which had a dreadful 2020 experience. Emerging market stocks trailed developed markets in February, but are slightly ahead YTD.

Tactical Indicators
Tactical Indicators
Figure 1. U-3 (headline) unemployment rate understates labor market slack

Source: Bloomberg, Voya Investment Management, as of March 5, 2021.

Figure 2. Inflation expectations surpassed 2%, suggesting core PCE should follow higher

Source: Bloomberg, Voya Investment Management, as of March 8, 2021.

Figure 3. Despite strong 2021 returns, VIX has remained stubbornly high

Source: Bloomberg, Voya Investment Management, as of March 5, 2021.

Portfolio Positioning

Investment Outlook

Significant progress in vaccination programs, states reopening, still highly accommodative government policy and the release of massive pent-up demand from excess consumer savings should drive economic growth well above trend throughout 2021. With immunity levels climbing, vaccine supply accelerating quickly, weather warming and people preparing to escape from their yearlong seclusion, the stage appears set for a big ramp-up in activity. Intent on combatting inequality and boosting incomes of lower wage workers, government officials will attempt to force unemployment to historically low levels by keeping their foot on the gas. Although down to 6.2% from its April 2020 high of 14.8%, the U-3 unemployment rate understates labor market slack, as the labor force participation rate is holding near a 45-year low (Figure 1), suggesting ample scope for improvement in the labor to population ratio — which will be critical given the demographic shift to an aging workforce. These circumstances, coupled with ascendant animal spirts, could create an ideal backdrop in which labor and capital can thrive concurrently.

History is always a helpful guide to the future, but the environment upon which we are embarking seems exceptional, which raises the odds of encountering something unforeseen. The prolongation of zero-bound interest rate polices from global central banks and virtually unrestrained fiscal expansion, including the latest $1.9 trillion COVID-19 aid package, certainly raise the specter of inflation and fast rising bond yields. While these are closely watched variables, which somewhat lowers the risk that they could spike out of control, they still pose considerable risks. Budding price pressures are propagating in commodities markets, building up in supply chains through swelling backlogs of key product components, such as micro processing chips, and presenting in purchasing managers surveys and in prices of Treasury inflation protected securities (TIPS).

That said, after two decades of the Federal Reserve’s preferred inflation metric — the core personal consumption expenditures deflator (core PCE, Figure 2) — averaging well below its 2% target, we believe deflation remains a greater risk; therefore, the Fed’s plan of “running hot” is reasonable. Whether, how much and how fast prices rise are debatable. We believe increases in both inflation and yields will be gradual enough, and the levels low enough, to not drastically tighten financial conditions. Barring an unpredictable, exogenous shock, we are confident that neither will move decidedly lower. As a result, we are content holding more stocks than bonds. Yes, rates are rising and narrowing the equity risk premium, but we see them moving mostly for the right reasons and find the stock/bond trade-off still positive.

The economic tailwinds forming have led to much better than expected 4Q20 earnings growth and should improve visibility going forward. We believe this transition to a more stable macro environment will continue to benefit our preferred asset classes: U.S. small cap and emerging market equities. Last year’s equity market returns were largely driven by defensive, pandemic protected businesses and earnings multiple expansion. This year, we anticipate higher corporate profits, particularly from the cyclical areas of the market, which should benefit from reopening and deployment of large amounts of cash on the sidelines.

Valuation multiples relative to history seem decreasingly useful at the asset class level in a world where policymakers’ involvement in economic and financial market affairs is so visible. Instead, we are closely gauging investor sentiment, monitoring global liquidity and watching for signs of excess leverage. The path of the U.S. dollar will be a key factor in the success of positioning in emerging markets. Recent dollar strength has been a drag on EM asset performance, but could serve to curtail domestic inflation pressures and ease related investor anxiety, which remains stubbornly high, as measured by the VIX (Figure 3).


Past performance does not guarantee future results.

This market insight has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.

The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

The distribution in the United Kingdom of this Market Insight and any other marketing materials relating to portfolio management services of the investment vehicle is being addressed to, or directed at, only the following persons: (i) persons having professional experience in matters relating to investments, who are “Investment Professionals” as defined in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “Financial Promotion Order”); (ii) persons falling within any of the categories of persons described in Article 49 (“High net worth companies, unincorporated associations etc.”) of the Financial Promotion Order; and (iii) any other person to whom it may otherwise lawfully be distributed in accordance with the Financial Promotion Order. The investment opportunities described in this Market Insight are available only to such persons; persons of any other description in the United Kingdom should not act or rely on the information in this Market Insight.

The Capital Markets Authority and all other Regulatory Bodies in Kuwait assume no responsibility whatsoever for the contents of this Market Insight and do not approve the contents thereof or verify their validity and accuracy. The Capital Markets Authority and all other Regulatory Bodies in Kuwait assume no responsibility whatsoever for any damages that may result from relying on the contents of this Market Insight either wholly or partially. It is recommended to seek the advice of an Investment Advisor.

Voya Investment Management does not carry on a business in a regulated activity in Hong Kong and is not licensed by the Securities and Futures Commission. This Market Insight is issued for information purposes only. It is not to be construed as an offer or solicitation for the purchase or sale of any financial instruments. It has not been reviewed by the Securities and Futures Commission.

Voya Investment Management accepts no liability whatsoever for any direct, indirect or consequential loss arising from or in connection with any use of, or reliance on, this insight which does not have any regard to the particular needs of any person. Voya Investment Management takes no responsibility whatsoever for any use, reliance or reference by persons other than the intended recipient of this insight. Any prices referred to herein are indicative only and dependent upon market conditions. Past performance is not indicative of future results. Unless otherwise specified, investments are not bank deposits or other obligations of a bank, and the repayment of principal is not insured or guaranteed. They are subject to investment risks, including the possibility that the value of any investment (and income derived thereof, if any) can increase, decrease or in some cases, be entirely lost and investors may not get back the amount originally invested. The contents of this insight have not been reviewed by any regulatory authority in the countries in which it is distributed. The opinions and views herein do not take into account your individual circumstances, objectives, or needs and are not intended to be recommendations of particular financial instruments or strategies to you. This insight does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction. You are advised to exercise caution in relation to any information in this document. If you are in doubt about any of the contents of this insight, you should seek independent professional advice.