New year. New me. Let’s cut to the chase. Here are my three surprises for 2021:
The Fed makes a policy mistake
Aerospace & Defense stocks beat the market
Inflation undershoots lofty expectations
Each January for the past five years, I have grudgingly forecasted three surprises for investors. Apparently gazing deeply into a crystal ball and predicting market movements is expected from a Chief Investment Strategist. Typically, January’s Uncommon Sense article is the most widely read every year. There’s something titillating about this forecasting high-wire act, delicately tiptoeing between success and failure without a net. Undoubtedly, some folks are hoping for a splat, while most are simply searching for a profitable investment idea. Thankfully, I put my neck on the line just once a year.
Like so many other things in 2020, my three surprises were a disappointment. I managed to successfully predict one of three surprises last year. However, over the past five years, I’m a more respectable 11 of 15 in forecasting accuracy. The powerful combination of dumb luck and my simple forecasting formula has generated solid results.
It may be the three surprises headline that draws the crowd, but the most important lesson for investors is the annual reminder that investment outcomes are always highly uncertain. Yet, a thoughtful and consistent investment approach is firmly within their control. In fact, mixed with a little bit of luck, a solid process likely provides investors the greatest opportunity for persistent investment success.
Surprise Forecasting Machine So, what’s the secret sauce that has propelled me to accurately predict 11 of 15 surprises over the past five years? It’s simple, really. Forecasting a small number of high conviction surprises has bolstered my accuracy. Investors that make too many predictions often end up with mediocre outcomes as inaccurate predictions offset accurate ones. Three has been my lucky number.
In addition, focusing on a short time horizon has helped my results. The longer the forecast horizon, the cloudier the outlook. For that reason, my forecast period is the calendar year. And, finally, unloved assets with compelling valuations where a lot of bad news is already priced in and investor sentiment is decidedly one-way produce a fertile environment for surprises to emerge.
Applying this simple, disciplined and repeatable forecasting framework, let’s explore this year’s three surprises.
1. The Fed Makes a Policy Mistake The Federal Reserve (Fed) has been the single biggest contributor to financial asset price volatility this century. The Fed’s swift and aggressive actions at the peak of the pandemic panic added much-needed liquidity, protected the smooth functioning of capital markets and likely saved countless jobs and small businesses. Fed officials’ courage to boldly implement extraordinary monetary policies in response to both the global financial crisis and the pandemic was heroic. The economy and financial markets likely would have suffered more without the Fed’s gutsy actions.
Regrettably, no good deed goes unpunished. Soon, Fed officials will find themselves stuck between a rock and a hard place. Skillfully transitioning from the unprecedented monetary policy of the pandemic to a post-pandemic environment will leave very little room for error. And the Fed will likely make one of two policy mistakes.
The least likely error is that the Fed will prematurely tighten financial conditions later this year. For example, if the economy accelerates, inflationary pressures build and financial assets continue to rally excessively, the Fed may feel compelled to reduce its asset purchases, raise interest rates, or both. This could halt the economic recovery, reduce growth stocks’ valuations and magnify risks in speculative credits. Investors often react poorly to unexpected changes in monetary policy.
The Fed’s more likely mistake is keeping emergency monetary policy in place for far longer than the underlying conditions require, making it complicit in the creation of another financial asset price bubble. The groundwork for this scenario was laid in August at the annual Jackson Hole economic symposium where Fed Chairman Powell announced a major policy shift to an average inflation target. The Fed is confident that it knows how to tame inflation — it has done it before. But if the inflation toothpaste escapes, there may be no easy way to put it back in the tube.
Already, bubble red flags are everywhere. The initial public offering (IPO) market is on fire. Mergers & acquisitions activity is on the rise. The housing market hasn’t been this strong since 2006. And, perhaps the most damning red flag of all is the new young brazen individual investor class. Fueled by the intersection of technology, zero commissions and fractional shares, these young speculative investors are boasting of big stock market gains. TikTok, Discord and Reddit are overflowing with content about stock market trading. This may be the modern-day anecdote of Joseph Kennedy, Sr. selling his stocks just prior to the 1929 market crash after alarmingly receiving unsolicited stock tips from a shoeshine boy. Everybody is a genius in a bull market.
Riding the bubble’s creation is exhilarating. Unfortunately, when the bubble bursts fortunes are quickly lost — and it can take years for the economy and markets to recover. Look no further than the bursting of the dot-com bubble in March 2000 and the US housing bubble in the mid-2000s. My first surprise, a policy mistake by the Fed, could result in another asset price bubble by the end of this year.
Source: Bloomberg Finance, L.P. as of 12/16/2020.
2. Aerospace & Defense Stocks Beat the Market US government spending is expected to increase significantly under the Biden administration and a Democratic controlled Congress. Ordinarily, aerospace and defense stocks would be natural beneficiaries from these rising budget disbursements. But these are no ordinary times. President Biden and Congress will likely focus most of their increased spending on combating COVID-19 and, possibly, a more progressive domestic policy agenda. As a result, after years of favorable budget treatment from the Trump administration and Republicans, defense spending isn’t expected to increase under Biden. In fact, it may decline a little.
In addition, Boeing, a bellwether of the S&P Aerospace & Defense Select Industry Index, has failed to firmly put the 737 MAX debacle behind it. This has hurt Boeing’s stock price and further weighed on the outlook for the aerospace and defense industry. The potential long-term impacts on airline travel from COVID-19 aren’t exactly helping either. Not surprisingly, the prospects for reduced government defense spending and Boeing’s struggles have led to the sizable underperformance of the S&P Aerospace & Defense Select Industry Index. Funds tracking that index suffered outflows last year.
Aerospace and defense stocks are definitely unloved. The poor outlook for the industry might make this a compelling entry point for investors with some patience and a long-term time horizon. The US government is expected to spend $934 billion on defense this year. That makes it the second-largest item in the federal budget after Social Security. So, in the perpetual macroeconomic tradeoff between guns and butter, there’s still plenty of dollars being spent on guns. Interestingly, there is a major underlying shift in defense spending dynamics. The old guard bellwether companies of the aerospace and defense industry are being overtaken by upstart technology companies focused on cybersecurity, drones and space. This passing of the torch is increasingly reflected in the S&P Aerospace & Defense Select Industry Index – and it’s likely a long-lasting trend in defense spending that could possibly bolster future growth expectations for the industry.
Recent headlines underscore the persistent but evolving threats from Russia, Iran, North Korea and China. The sophisticated SolarWinds hack allegedly carried out by Russia is a prime example of the expanding risks to America’s security. Also, given the disturbing images from the US Capitol building earlier this year, some intelligence experts are now forecasting an increased possibility of domestic terrorist incidents. Sadly, the new Democratic president’s resolve may be tested early in his new term. These challenges will make certain that defense spending will continue to be a significant portion of government expenditures.
This environment may feel eerily familiar. Former President Obama faced a very similar situation in 2009, the first year of his first term. The country was transitioning from Republican to Democratic leadership. The world was recovering from the Global Financial Crisis and fiscal spending was skyrocketing. Defense spending wasn’t high on the Obama administration’s priority list in 2009. Yet, the S&P Aerospace & Defense Select Industry Index bested the S&P 500 Index by nearly 4% that year, rising slightly more than 30%.
History may not repeat, but it often rhymes. That’s why for my second surprise, I’m predicting the S&P Aerospace & Defense Select Industry Index will beat the market in 2021.
Source: CBO as of August 2020. Long-Term Implications of the 2021 Future Years Defense Program. *Projected.
3. Inflation Undershoots Lofty Expectations The 10-year breakeven rate, a measure that draws on pricing for inflation-linked Treasuries, surpassed 2% in early January. It’s the first time that inflation expectations have climbed that high since 2018. It suggests that market participants anticipate US inflation averaging at least 2% per year over the next decade. It may not sound like much, but for the first time in almost three years, investors are bracing for an increase in the rate of inflation.
With Democrats in control of the White House and both chambers of Congress, many investors are expecting a massive federal government spending spree, fueling inflation fears. Already, generous fiscal and monetary policies, with possibly more stimulus on the way, have weakened the US dollar. A falling dollar also contributes to building inflationary pressures because of higher import prices and rising demand for exports. And, finally, more COVID-19 vaccinations and the inevitable end of the pandemic are likely to unleash pent-up demand, boosting global growth and further sparking inflation.
However, current measures of inflation remain subdued. According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) excluding food & energy rose 1.6% over the past 12-months. The Fed’s preferred inflation measure, the Personal Consumption Expenditures (PCE) Index excluding food & energy increased a more modest 1.4%. Notably, the Fed’s own forecasts of inflation continue to be mild. For example, the Fed’s Summary of Economic Projections (SEP) released in December reveal that policymakers expect inflation of 1.8% this year, and their longer-run expectations peak at 2%. Admittedly, none of the current inflation data or Fed’s projections include the potential inflationary impacts of Biden’s $1.9 trillion stimulus proposal. The additional fiscal stimulus may inflame inflation expectations, but some Republican senators have already balked at the price tag and the proposal is likely to be negotiated lower.
Many cyclical drivers of rising prices continue to be headwinds for inflation. The labor market has had a remarkable recovery, but the unemployment rate is still elevated at 6.7%. The labor market was unable to generate wage inflation when the unemployment rate was at multi-decade low of 3.5% in February 2020. As the labor market rebounds from the pandemic, the unemployment rate is likely to fall. However, it’s unclear whether that improvement will finally increase wages. Rental rate increases are also one of the more noticeable drivers of inflation. As a result of the pandemic, most landlords are focused on collecting rents on time and in full each month, not on raising rents. Therefore, it’s unlikely that rent increases will push inflationary pressures higher anytime soon. And, there’s still excess capacity in many parts of the economy. Capacity utilization is the extent to which a firm or nation employ their installed productive capacity. It is the relationship between output that is produced with the installed equipment, and the potential output which could be produced with it, if capacity was fully used. According to the Fed, capacity utilization in December was 74.5%, a rate that is 5.3% below its long-run average over the past 47 years. Inflation isn’t usually a concern until capacity utilization eclipses 80%, suggesting it might take a while longer for prices to start rising.
Structural headwinds are a challenge to inflation too. Rising debt, wider deficits, aging demographics that reduce consumption, and the disinflationary forces of technology will all continue to constrain inflationary pressures.
The twin fiscal stimulus packages ($900 billion in December and Biden’s $1.9trillion proposal), the inevitable defeat of COVID-19 and the economic revival will result in an inflation scare in the first half of this year. Inflation figures and expectations will climb, potentially rattling markets. Don’t get fooled again. With cyclical and structural headwinds likely to keep inflation in check by the end of 2021, my third surprise for this year is that inflation undershoots lofty expectations.
Source: Bloomberg Finance, L.P., as of 01/26/2021.
System Malfunction? The annual three surprises article is always one of my favorites because it reveals so much about human nature. Hilariously, with forecasting there are too many behavioral biases to list. Logic and experience demonstrate that nobody can consistently predict the market's movements. And yet, here we are, both emotionally invested in my forecasting ability. Me, touting my luck as skill, and you, hoping my prediction accuracy can defy logic and experience. Both of us, pulling each other’s chains.
Behavioral blunders aside, my one for three record with 2020’s three surprises was disappointing. I successfully predicted that the market’s missing euphoria would be found. While most experts were expecting modest single-digit gains, I wrote that the market would be up big in 2020. And, it was. Unfortunately, I also predicted that the healthcare sector would beat the broader market. The sector returned a respectable 13.5% for the year, but it trailed the 18.4% return of the S&P 500 Index. I also expected the mighty US dollar to stand strong last year. Here, I reluctantly admit defeat. The most popular US dollar index, the DXY — a proxy for dollar trading versus major foreign exchange pairs — declined about 7% last year. However, while three-quarters of the DXY is derived from the euro and currencies related to the euro, those currencies account for only about a quarter of US trade. A better measure, the Fed’s US dollar trade weighted index, which includes emerging markets, indicates that the dollar fell just 2.5% in 2020. But close only counts in horseshoes.
As investors, we keep score. The beginning of the year is refreshing because we reset the totals and move forward. That’s why, for me, the most important message of the annual three surprises article isn’t the surprises themselves or last year’s record. It’s the reminder that while investment outcomes are uncontrollable, a consistent, disciplined and repeatable investment approach provides investors the greatest opportunity to be successful over the long term.
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