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The Manley Macro Memo

Inflation is Surging, yet Interest Rates are Falling. What is More Important the Fundamentals, or the Liquidity Flows?

• Despite stronger than expected growth and inflation data, long-term interest rates have plunged over the past month. Many pundits believe that the sharp drop is signaling a peak in growth or pending economic weakness, likely due to the global spread of the COVID delta variant or the economic slowdown in China. While the growth rate may have peaked from an unsustainable level, the economy and inflation are too strong to justify a 1.20% U.S. Treasury bond. We believe that the enormous liquidity created by the global central bankers is overwhelming the fundamentals, driving yields artificially lower and giving investors false signals about the economy’s health.

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The Fed Admitted That Inflation May Not Be Transitory, but Actions Speak Louder Than Words.

Last Wednesday, the Federal Reserve surprised investors by stating that the inflation surge may not be transitory. Also, they revised their 2021 economic forecast revised higher. Real GDP is expected to grow at 7.0%, and inflation was revised significantly higher to 3.4% from 2.4%. Additionally, they signaled that the QE taper debate had started, and interest rates would rise sooner than previously expected. The Fed’s hawkish pivot led to a sharp but brief market decline and a rotation out of the economically sensitive sectors of the market. Although the Fed admitted that the inflationary surge might not be transitory, they continue to print $120 billion per month to buy financial assets, and they do not expect to increase short-term interest rates until 2023. Since inflation is currently 5% and interest rates are 0%, real interest rates (interest rates minus inflation) are the lowest since 1980 (see chart below).

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The Massive Stimulus, Successful Vaccine Rollout, and Better than Expected Growth Drove the S&P 500 to a Record High in March

Since the March 2020 Pandemic-low, the S&P 500 has been on a historic run. Unfortunately, most of this rally was due to a record increase in market valuation. According to Factset, the forward 12-month P/E ratio for the S&P 500 is 22.5, which is 41.5% above the 10-year average of 15.9. By most valuation measurements, the market has never been more expensive (see table below). We believe that this extreme overvaluation will yield muted gains and create a poor risk-reward over the long term.

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Rising Inflation Expectations and Higher Interest Rates are Causing the Bifricated Stock Market to Mean Revert

Despite the S&P 500’s overvaluation and poor risk-reward, we believe the bifurcated economy and stock market provide substantial opportunities in 2021. The mega-cap technology and the “stay at home” stocks prospered in 2020, but today their valuations are extreme, and difficult year-over-year comparisons will slow their growth rates. We believe that the market sectors that thrived during the shutdown are at risk as the vaccine is administered and the economy reopens this spring/summer.

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The Fed Response to the Global Pandemic Led to Asset Bubbles, and a Bifricated Market and Economy. We Believe the Market is Poised to Mean Revert

2020 was a difficult and trying year. The Coronavirus took more than 400,000 American lives, and the ensuing economic shutdown led to 17 million job losses and 4 million business closures. Incredibly, 20% of Americans’ income came from the government last year.

While Main Street suffered, Wall Street prospered. The S&P 500 appreciated by 18.4% in 2020, and the NASDAQ Composite jumped 44%, which was its best year since 2009. We believe that the Federal Reserve’s $3 trillion liquidity injection is responsible for the disconnection between asset prices and the fundamentals.

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The Manley Macro Memo