Markets are forward-looking mechanisms and right now they are discounting higher economic activity, according to Jeffrey Schulze, investment strategist at ClearBridge Investments.
He expects that economic activity is going to ramp up very quickly as the US attains herd immunity sometime in the second quarter of this year.
He highlighted how over the last week, the US has administered 3.2 million shots of the coronavirus vaccine on average, and that for each Covid-19 infection there has been 45 people that have been vaccinated.
“When you have numbers like that, herd immunity is going to be attained fairly quickly,” he said. “When herd immunity is attained, it's going to unleash a tsunami of consumer spending.
“As we reach herd immunity, consumers are going to have revenge spending - or deferred gratification - which is really going to boost economic activity, and it's all because of stimulus.”
He noted that the US stimulus package has been “unrivalled in modern history”. Policymakers have provided the US economy with $5.3trn worth of stimulus, which is more than 25 per cent of its gross domestic product (GDP).
He said: “If you look at the last five recessions, combined total stimulus provided to those recessions with 17.3 per cent of GDP.
“So the stimulus that you've seen today is one-and-a-half times the size of the last stimulus response to the recessions going back to 1980.
“From a historical context, the amount of stimulus that has been spent outweighed the total cost to fight World War Two for the US in today's dollars. This is a massive amount of money.”
Source: ClearBridge Investments
As such, the ClearBridge investment strategist is expecting an explosion of earnings activity as the spending moves through the US economy and it experiences a period of growth.
“I think if anything, analysts are expecting too little earnings growth in 2021 and 2022,” he said.
“I think they're still behind the curve because they were well behind the curve in the second quarter, the third quarter and the fourth quarter.”
Schulze expects analysts will have to ratchet up their earnings expectations for the S&P 500 over the coming quarters.
Whilst the S&P 500 is up over 10 per cent year-to-date, he expects about 7 per cent of that is due to earnings revisions coming higher.
“It's really been driven by higher earnings expectations rather than the markets getting ahead of themselves and being way too optimistic at this point,” he explained.
Performance of S&P 500 year-to-date
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Source: FE Analytics
Despite the stellar returns seen by the stock market, Schulze warned that it isn’t necessarily going to perfectly track the performance of the wider economy.
He looked at the 10 best years of US GDP growth and the corresponding S&P 500 return during those strong economic years.
On average across those years, there has been a 10.1 per cent return from the index. He also looked at the maximum drawdown (the peak-to-trough decline) during each of those years, where there was an average max drawdown of 12.1 per cent.
“Things tend to be choppy during these very healthy growth years,” the strategist warned. “You get a similar dynamic when you look at the first year following a bear market low, and the second year following a bear market low.
“The first year following that bear market low, you get well above long term average returns; the market goes straight up while experiencing minimal turbulence.
“It seems kind of incongruent - because you have a very strong market against a struggling economy - but the second year provides somewhat above average gains, but the market’s path is much more laboured.”
As such, Schulze anticipates the stock market to have a choppy but gradual move higher in the second quarter.
He said: “The Fed is clearly on the market’s side. The Fed is providing quite a bit of liquidity still, even in light of this very strong economic backdrop.”
To illustrate this point, he highlighted how the US Fed over the last year has done as much quantitative easing (QE) as was executed during the entirety of the Yellen and Bernanke eras.
Source: ClearBridge Investments, Federal Reserve, Bloomberg
He said: “The balance sheet in both of these situations have risen about $3.5trn, and the Fed is going to continue to do bond buying of $120bn per month, until they see substantial further progress in employment and inflation.
“Needless to say, QE is going to be at these levels, likely at least until the end of this year.”
Schulze also noted the Fed’s change in policy from targeting 2 per cent to averaging 2 per cent inflation over a long time period.
More importantly, he said: “The Fed is not going to act pre-emptively. They're not going to look at their models and they're not going to anticipate inflation, because monetary policy works with a drag.
“They're not going to raise rates until they actually see sustainable 2 per cent inflation and they see the unemployment rate back at levels that were pre-Covid, which was 3.6 per cent.
“What this really means is they're going to wait to raise rates until they see the whites of the eyes of inflation, and they're going to be purposely behind the curve.”
He believes this is good not only for economic growth, but for financial markets as well.
He said: “Put differently, the Fed usually moves the punchbowl from the party at 9pm. They're leaving the punchbowl out well past midnight this time around.”