Second Level Thinking: What Lies Ahead?

by Catherine Trinder Miller, June 3, 2021

“Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.”
Ray Dalio, Legendary Investor and Founder, Bridgewater Associates
  • We believe we are entering a new economic paradigm in which the interaction between growth, inflation, and interest rates will likely shift driving new asset class leadership.
  • Inflation holds the key; it’s too early to tell where inflation will settle.
  • Productivity has vastly improved providing potential for inflation mitigation and higher trend economic growth.
  • As we move into the expansion phase, we recognize this economic cycle progression is one of the fastest in history. The length of this cycle may be heavily influenced by actions of the Federal Reserve.
  • Federal Reserve policy uncertainty will likely drive higher volatility in coming months.
  • Have a plan, stay diversified, and stay the course.

The past decade was characterized by a period of slow growth, low inflation and low interest rates. At times, investors referred to this period as the ‘Goldilocks economy,’ not too hot, not too cold, just right. That doesn’t imply a period without volatility. Volatility is table stakes in investing. The ability to endure it is the price of admission for higher potential future returns. It was, however, a period during which U.S equity markets produced eye-popping total returns, over 400% cumulative from trough (March 2009) to peak (February 2020).1

A recovery of staggering magnitude by anyone’s measure.

Abruptly, the massive Covid-reset occurred. Our global economy ground to an almost complete stop. A first in recorded history. The size, speed and coordination of fiscal and monetary stimulus was shocking and a global depression averted.

A new economic cycle is unfolding. Historical precedent is limited. How key economic factors including growth, inflation, and interest rates will perform and interact in this cycle is anyone’s guess. And yet it’s possibly the most important question we can ponder. The trends and interactions of these three factors will largely define which assets perform and the complexion and length of the current economic cycle and recovery.

Over 50 years as a global macro investor [Ray Dalio] observed there to be relatively long periods, about 10 years, in which markets and relationships operate in a certain way (“paradigms”). Investors adapt to these paradigms and extrapolate them so they become overdone. This leads to shifts to new paradigms in which markets operate more opposite than similar to the prior paradigm.11

Which begs the question, what paradigm will define this new economic cycle?

A New Paradigm

As we spring back from one of the deepest and shortest recessions in history, we are entering a boom period of growth, with rising inflation, and still very accommodative financial conditions supported by exceptionally low interest rates.

Distorted by the shutdown of our economy, and now staggered reopening, economic data has been volatile. We expect this to continue through the summer. Supply chains are bottlenecked as global ports and economies vary in stages of reopening. Massive fiscal stimulus including transfer payments direct to consumers and supplemental unemployment insurance have further clouded the economic and employment landscape.

Recent economic data, in-part fueled by pandemic-driven behavioral changes, characterize the new regime as one of potentially higher trend growth, higher (but not hyper) inflation, and rising yields. Productivity and inflation, and their implications for interest rates, may be the two most important factors to watch.

Record Breaking Economic Growth

How many records can we break in a single quarter? In the first quarter of this year, retail sales rose at the fastest pace on record, disposable personal income and household net worth also hit record highs. In addition, ISM manufacturing reached the highest level since 1983 and CEO confidence hit its highest level in 40 years.

Fueling this booming growth is an estimated $12 trillion of fiscal and monetary stimulus from February 2020 to April 2021. Shockingly, the economic hole this stimulus was designed to fill is estimated at $2.0 trillion, onesixth of the stimulus size.2

Year to date, more than $50 billion of fiscal stimulus per week has been disbursed.3 Driven by this fiscal support, April retail sales rose 17.9% above February 2020 pre-Covid levels. As of March 2021, U.S. Personal Savings is $2.2 trillion more than it would have been assuming pre-pandemic savings rates.2

According to Blackrock’s CIO, Rick Rieder, at the current pace of recovery, we are on track to close a -10% economic output gap by year end 2021, 6x faster than it took us to close the -6% output gap from 2007. 

Earnings growth is rocketing higher as pent-up demand is released.

Earnings are the lifeblood of the stock market.

The long-term correlation between equity prices and earnings is 92%.4 S&P 500 earnings in the first quarter of this year exceeded analyst expectations by 325%, with actual year over year earnings growth of 52%! 5

The catalyst for strong U.S. equity market performance year to date is clear.

The second quarter is shaping up to be another huge quarter. Consensus analyst expectations are for 62% year over year growth.

In the second half of 2021, S&P 500 earnings growth is likely to continue, albeit at a slower rate. Trees don’t grow to the sky, especially when you’re moving a tanker the size of the U.S. economy.

Prosperity through Productivity

Stronger productivity growth is key to the economy’s long-term success.

Two primary factors drive economic (“GDP”) growth – growth in the labor force + growth in real output per worker (i.e., productivity). Aging demographics and uncertain immigration policies create challenging labor force headwinds. Productivity, on the other hand, is showing the first signs of improvement in over a decade.

According to Robert Gordon, a professor at Northwestern University who has studied productivity growth over the past century, reasons for optimism are increasing. Gordon estimates that productivity growth, which averaged 1.0% over the last decade, has the potential to accelerate to 1.8% in the current decade propelled by Covid-induced advancements in automation and technology. 6, 7  

Increased labor force productivity could be our saving grace when it comes to keeping inflation in check.

More productive workers imply fewer workers necessary to produce the same output. Therefore, even as wages accelerate, if productivity accelerates too, then end prices may not rise.

Implications for (slower) job growth could make the Fed’s goal of maximum employment more challenging. Payrolls remain 8.2 million below their pre-pandemic peak.10 

The Fed prefers a patient approach to tightening monetary policy providing time for payrolls to recover towards maximum employment goals.

The persistence (or lack thereof) of rising inflationary headwinds will set the pace.

The Inflation Conundrum

On the tip of most investors’ tongues is inflation. It’s a brain tease, especially for the Fed. They are fairly resolute in their belief that higher inflation will be transitory.

It’s too early to tell. The debate will continue through the summer as a staggered economic reopening distorts price data.

Sustainably higher inflation implies rising interest rates and tighter financial conditions. This uncertainty is raising eyebrows and alarm bells.

In the current cycle, wage inflation and inflation expectations may be the most valuable indicators.

Wage inflation is prevalent. So are productivity improvements. Hundreds of millions have new-found time and efficiency through Covid-inspired technological adoption that is not going away.

What about job switching? Most recent job switching rates remain 2% below the levels at the start of the pandemic in March 2020. We have yet to see alarming increases which could foreshadow more sustainable increases in inflation.

Consumer expectations of inflation also matter greatly. They have not yet risen to concerning levels. We monitor shifts closely as increases can catalyze more persistent inflation.

Consider this – if you expect prices to be higher tomorrow, your demand for a product (e.g., refrigerator, swimsuit, fishing rod) may increase today. Higher demand in the absence of greater supply pushes prices higher. If goods become more expensive, then workers seek wage increases to offset the expected loss of purchasing power. Higher wages, in the absence of productivity advancements, may flow through to higher goods and services prices.

When inflation expectations rise, it is difficult to decrease inflation, even if unemployment is high. It can be a challenging virtuous cycle.

For now, the Fed welcomes rising inflation expectations as the economy has been running below Fed inflation targets for years. To best achieve its goal of 2.0% long-term core PCE (“Personal Consumption Expenditures”) inflation, the Fed is willing to let PCE run above 2% for some time.

Secular deflationary tailwinds of rising debt, aging demographics, digitalization, and globalization are not going away. While money supply growth is at a record high, velocity of money moving through the economy is at a record low.

They jury remains out on inflation.

Don't Fear Rising Rates

Interest rates will rise; there is nowhere to go but up when you’re skimming the floor. While negative real rates (nominal interest rates – inflation) are a reality today, they are likely to normalize over coming quarters and years. 

While rising rates may be volatility inducing, they should not be feared when rising from low levels supported by improving economic growth. Increases are expected.

For perspective, in the period from 1965 – January 2009, stocks and interest rates moved directionally together until 10 year treasury yields rose to 4.5%. From February 2009 – Present, the inflection point was 3.6%.7 Current U.S. Treasury yields are well below these levels at 1.62% today. 8

In the first step of monetary policy tightening, the Fed will likely reduce its $120 billion in monthly bond purchases. Guidance regarding this curtailment, also known as tapering, could come as early as Fall 2021.

Rather than tightening too soon, perhaps the greater risk in this cycle is the Fed waits too long to adjust its policy stance.

Based on current estimates, the economic output gap could be closed as early as year-end. Typically, the Fed begins raising rates prior to the economy reaching potential. Is the Fed already behind the curve? Delayed policy adjustments risks economic overheating or rapid tightening with disruptive financial consequences. The Fed balancing act is extraordinary.

Fiscal Policy Spigot Remains Open

Like it or not, $4 trillion in additional government spending is on the table. Base case assumptions for higher tax rates are increasingly incorporated into 2022 earnings estimates. Analysts have a tendency to look through these adjustments, which reset the base from which growth can continue.

From a financial stability perspective, the U.S. government’s ability to cover interest expense and roll the debt is not currently in question. Higher taxation and entitlement reform are the longer-term concessions we expect to offset higher levels of current spending.

Managing Risks in Unprecedented Times

2021 is the only time in history when massive liquidity injections are happening alongside a booming real economy and financial markets. There is no playbook for the current environment.

The case for higher U.S. equity markets centers on the earnings power of the companies that comprise it. In low interest rate environments (i.e., U.S 10-year Treasury yields < 8%) in the seven decades since World War II, investors have been willing to pay 19x earnings on average.9 As of June 1, the S&P 500 is trading at 19.8x 2022 consensus earnings estimates, only slightly above the long-term average.9 The S&P 500 earnings yield, a measure of relative value, sits above historical averages indicating investors continue to be adequately compensated for taking equity risk.

Real yields (i.e., U.S. Treasury 10-year yield – inflation) remain negative, creating loose financial conditions which are highly constructive for growth.

The current pace of recovery suggests this could be one of the fastest cycles on record. We have never seen a peak to trough equity market decline (-34%) occur in as few as 23 trading days. Compounding the surprise was a rise to new all-time highs five months later. As of May 31, we are up 88% from the March 2020 lows.

The economy has shifted from hope to expansion. We remain overweight equities, albeit tactically below peak levels. Inflation uncertainty favors positions in both high-quality growth and more cyclical, value-oriented companies.

Should growth slow and inflation concerns wane, then companies with innovative products and strong market positioning are more likely to maintain margins and grow earnings. Should inflation rise driving yields higher, companies increasing earnings while distributing current cash flow through stable and rising dividends could perform well.

Small and mid-cap companies may benefit from higher operating leverage creating potential for stronger earnings recovery as revenues rebound. Active management and strong balance sheets are required.

We increasingly favor alternative asset classes such as real estate, gold, hedged equity, convertible bonds, and private markets (credit and equity) to diversify risks and returns. Bond positioning remains short duration favoring credit over government securities.

As vaccine distribution improves, a synchronous global recovery may follow. Some of the best opportunities in coming quarters may be found outside the U.S., where valuations are compelling and many economies are in earlier stages of recovery.

Across all asset classes, selectivity in underlying holdings is essential.

We expect volatility to rise as the new economic paradigm takes shape. By aligning investment strategy for your capital with your specific goals and timeline, you are best positioned to succeed. Thoughtfully diversify, be selective, have a plan, and stay the course.

In investing, no single strategy works all the time. The environment is constantly changing. Investors’ efforts to respond to the environment cause it to change more. Yet if we pay attention to economic cycles and the factors that drive them, we are better positioned to make sound decisions and come out ahead.


S. Equity market as defined by S&P 500; J.P. Morgan Guide to the Markets, May 31, 2021
Rieder, Rick, Chief Investment Officer, Blackrock, May 6, 2021
Rieder, Rick, Blackrock, Data includes Paycheck Protection Program, Unemployment Insurance, Direct Transfer (Checks), May 6, 2021
Source: Factset, RJ Equity Portfolio & Technical Strategy; S&P 500, Data from 2001-Present
S&P Earnings Scorecard, Refinitiv, Dec. 31, 2020 and May 21, 2021
McKinsey Global Institute Survey, Cambon, Sarah Chaney, Wall Street Journal, S’s Long Drought in Worker Productivity Could Be Ending, April 4, 2021
J.P. Morgan Guide to the Markets, May 25, 2021
Data as of June 1, 2021
Siegel, Jeremy, The Future for Investors, Data from 1954-Present
10 Kiernan, Paul, WSJ, Fed Seeks Answers in Jobs Report, June 1, 2021
11 Dalio, Ray, CIO, Bridgewater Associates, Paradigm Shifts, July 17, 2019

Any opinions are those of Financial Advisors Catherine Trinder-Miller and Theresa N. Benson, CDFA and not necessarily those of Raymond James. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision and does not constitute a recommendation. All opinions are as of this date and are subject to change without notice.

Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns.

Gold is subject to the special risks associated with investing in precious metals, including but not limited to: price may be subject to wide fluctuation; the market is relatively limited; the sources are concentrated in countries that have the potential for instability; and the market is unregulated.

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