Is the ‘recovery trade’ sustainable? A conversation about the markets and economy
The “recovery” trade is a hot topic of conversation, and so far the trends appear to support that storyline. But it’s important to watch out for blind spots and biases. Recently, we sat down to discuss what we’re seeing in the markets and the questions that could surprise us in 2021.
Read our mid-year conversation here.
Brian: Has there ever been a year that reminded investors more about the folly of trying to time markets? First, the S&P 500 Index bottomed in March amid peak pessimism. Then, there was the much anticipated, feared and contested presidential election and expected bout of extreme market volatility that didn’t materialize. In hindsight, I suppose that I learned too much about the contested election of 1876 between Rutherford B. Hayes and Samuel Tilden than was warranted. Now with COVID cases on the rise as well as new restrictions and curfews in place, markets appear to want to price in a full-bore recovery in 2021. Rates have risen, the US dollar has weakened, oil prices are at 7-week highs,1 high yield corporate bond spreads have tightened. Everyone is talking about the “recovery” trade and rotation to small caps and value. Are you buying it?
Talley: Yes. So far, it appears both of us correctly encouraged investors to look past the short-term political noise and focus on the longer-term economic signal. Every performance pattern you cited is a characteristic of markets and an economy that are in the initial stages of a budding recovery. In other words, the start of a new business cycle is a key driver of the “recovery” trade we’ve been espousing and the general rally in risk assets that comes with it.
While it seemed like wild-eyed optimism at the time, one upside risk I raised a few weeks ago was the potential for new treatments and/or vaccines for the virus that could meaningfully alter trends in the case count, an outcome that markets seem to be cheering. While I’ve firmly embraced the “recovery” trade, I question how much excitement is warranted. Don’t vaccines simply help the economy heal from the impact of lockdowns in Q1 and Q2? How do they take us to higher, sustainable economic growth rates, especially in the absence of additional significant fiscal stimulus? Is this just another false dawn or head fake for financial stocks and the value style of investing? Many of the industries that could benefit from an economic reopening are in the Consumer Discretionary sector, which I believe may offer cyclical growth perhaps now at a more reasonable price.
Brian: Isn’t this a question of time horizons? If in 2021 the economy recovers and the yield curve steepens, then wouldn’t that favor value? You seem to be making a point about the expansion that follows the recovery. I agree that the recovery should give way to a modest expansion like that experienced from 2011 to 2019, which favored structural growth stocks. Can’t value have its days in the sun as the economy recovers?
Talley: Yes, the 2021 growth outlook has received a near-term boost from easing fiscal, monetary, financial and credit conditions, as well as curve steepening, diminishing recession risk, a softer US dollar and improving global growth. To echo my thoughts from our previous blog on this subject, I think it’s possible that we could see a temporary or “mini” rotation to value. However, I’m unsure it’ll last. I think I called it a value rally of playable magnitude, but ultimately insufficient duration.
It seems we agree on the year-ahead outlook, but how could the secular economic outlook and longer-term prospects for value stocks surprise us? The economic potential of a nation is basically driven by its population and productivity. Given population growth of less than 1% and productivity growth of—surprisingly—4% year-over-year, could the US economy sustain a faster pace of activity?2 What if the pandemic sparks a mini “baby boom” and a resulting countertrend surge in population growth? In other words, perhaps the structural growth outlook has changed for the better, and the value stock bounce could last longer than we think?
Brian: I didn’t see you going there. Perhaps, although I’m not sure a surge in pregnancies/births is showing up in the data. The housing market has been booming as the 30-somethings finally form households, so maybe there is something to it. But you’re leaving me with a “on one hand, on the other hand” type of analysis with regards to the sustainability of the value trade. The current 10-year Treasury bond yield and shape of the yield curve seem to suggest a slower, longer-term trajectory of growth than your baby boom 2.0 scenario. Either way, it sounds as if we both agree that an economic recovery is upon us and the consumer, in aggregate, is in a uniquely strong position. That leaves me wanting a portfolio that is more cyclical than the broad market (including technology) while opportunistically taking advantage of the deeper value parts of the market tied to the US consumer. I’ll give you the final word.
Talley: Thought experiments like these are useful because they help me break out of my analytical comfort zone, thereby revealing hidden blind spots and cognitive biases. You make good points about the US consumer, housing market and up-and-coming millennial cohort. The secular economic outlook isn’t just about their children’s future consumption. It’s also about 30-somethings’ current consumption, which should ramp up as they form households, buy cars and spend more money on their kids. Even without a spurt in the birth rate, I’d take trend growth of 5% year-over-year.
But let’s table our structural debate for now. Suffice it to say we foresee an encouraging 2021 outlook favoring industries that were at the center of the pressure in the dark days of 2020. If we’re right, investors should benefit from outsized exposure to cyclical sectors such as industrials and materials, which we believe stand to benefit from an ongoing global economic recovery.
1 Source: Bloomberg, L.P. Based on West Texas Intermediate spot prices as of Dec. 15, 2020
2 Source: Federal Reserve Economic Data (FRED)
Blog header image: LeoPatrizi / Getty
All investing involves risk, including the risk of loss.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial professional before making any investment decisions.
High yield corporate bond spreads are the difference between the yields of high yield bonds and the yields of government bonds.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
The yield curve plots interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates to project future interest rate changes and economic activity.
The opinions referenced above are those of the author as of Dec. 17, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.