Morgan Stanley
  • Wealth Management
  • Apr 5, 2021

Expect a Hotter, Shorter Expansion

Investors should keep an eye on policy actions and on potential for higher interest rates and inflation.

Some pundits are saying that 2021 is starting to look a lot like 2013. That year, having shaken off the last vestiges of the Great Recession, U.S. markets settled into a “Goldilocks” period of low interest rates, stable but not stellar economic growth and steadily rising markets. For many companies and investors, that was great while it lasted.  

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Fast-forward to 2021: U.S. stocks hit all-time highs in the first quarter as new fiscal stimulus and progress on vaccinations boosted profit outlooks. Longer-term interest rates rose too, with inflation-adjusted, or “real,” 10-year Treasury yields climbing from -1%, up to -0.65%. For many market participants, these conditions suggest that a short-lived growth spurt for the economy will soon give way to a more moderate expansion, lower-for-longer rates and benign inflation, much like it did eight years ago.

We view things differently. Far from a repeat of 2013, we expect this expansion to run hotter and shorter than the last one, bringing higher rates and inflation—with significant implications for investors. Here’s why: 

  • Aggressive policy response has driven a rapid recovery. The massive fiscal and monetary response to the pandemic has left consumers with the healthiest household balance sheets in years. And for companies, excess cash and profits as a share of assets are near historic highs. Even without a full rebound in employment, economic activity is poised to get back to 2019 levels, which would make this recovery the fastest since the 1970s. We expect GDP to grow 2 to 3 times faster in the next two years than in 2013-14.
  • New infrastructure spending should further fuel growth. Legislation calling for another $2 trillion for infrastructure upgrades, if passed by lawmakers, would mark the most radical shift in U.S. government spending priorities since the 1980s. We think such an infrastructure package will get done in Washington and will super-charge the next cycle of capital spending, dominated by upgrades in cybersecurity, 5G communications and clean energy. 
  • Inflation is poised to come back as the economy fully reopens in the second half of 2021. Not only do we begin this business cycle with goods inflation and rising commodity prices, but higher wages are also likely. Employment should be back to where it was before the pandemic by year-end, with more than a million jobs being added per month, which should put upward pressure on wages. 

This hotter but shorter cycle will likely bring elevated interest rate volatility along with headwinds for both stocks and bonds. We recommend keeping an eye on policy actions that could help drive economic growth, inflation and employment. Investors should consider re-tooling portfolios away from long-duration and rate-sensitive sectors and toward pro-cyclical allocations, emphasizing short duration, value and quality in equity and fixed income.   

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from March 29, “The ‘Real’ Deal.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report. 

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