Focus On 2021 And 2022
Turn off your cable news networks. They will have you thinking short term because most of them do.
Our view remains that economic growth will accelerate in 2021 into 2022. Rapid response coronavirus tests will roll out, permitting faster and safer openings. Coronavirus vaccinations will accelerate in the second half of 2021 into 2022. The Fed and all monetary bodies will remain all-in forcing investors further out on the risk curve. We will have several demand-focused stimulus programs and global trade will rebound.
While the economy will not return to pre-pandemic levels until mid-2022, corporate profits, operating margins, and cash flow will exceed peak levels early in 2021 led by the financially strong, well-capitalized industrials, commodity, and transportation companies. We have continued to take advantage of market weakness to add more economic sensitivity to our portfolios consistent with our outlook. Technology remains a significant portion of our portfolios due to their sensational long-term prospects selling at reasonable valuations with discount rates so low.
The stock market remained under pressure last week due to the failure of our government to reach a much-needed new stimulus package; a substantial increase in cases in Europe which has pushed the euro down as governments consider new shutdown measures; the Republicans' push to appoint a new Supreme Court Judge further damaging relations with the Democrats; and Biden maintaining his lead in the polls. U.S stocks had their third-largest outflow last week with the money going into bonds and precious metals. Interestingly, gold continues under pressure too.
We get why investors are worried near term, but it does not alter our longer-term favorable view that the global economy, including the U.S., will improve sequentially as we move through 2021 into 2022 for all the reasons stated above.
Liquidity is what drives financial markets. The Fed and all monetary bodies will remain all-in for several more years providing liquidity far above the economy's needs, pushing investors further out on the risk curve. Federal Reserve Chairman Powell testified before both the House and Senate Banking committees last week pleading for more fiscal stimulus as the Fed cannot go it alone. He mentioned that the Fed has many more arrows left in its quiver to support the economy through the pandemic. We take the Fed/Powell at their word that the Federal Funds rate will remain near zero for three more years, which plays right into the discount rate and valuation for the stock market. Stocks remain undervalued today!
While the government has not been able to agree on a bill to replace its latest stimulus program, Secretary of the Treasury Mnuchin, along with Powell, kept the pressure on the Democrats to come back to the table during their testimony before Congress. While there are no assurances of a deal before the election, especially with the Republican push to appoint a new Supreme Court judge, we remain confident that at least one and possibly many more government stimulus programs will be passed after the election, regardless of who wins, to not only support those most in need but also programs to create millions of new jobs. Again, if Biden were to win, we do not expect him to raise taxes until mid-2022 at the earliest after the economy has surpassed pre-pandemic levels. We were pleased to see Congress pass a continuing resolution last week, which prevents our government from shutting down. At least that is something.
There were lots of good news last week on vaccines and better therapeutics, significantly lowering death rates and time spent in the hospital. If there is a positive from the increase in the number of cases, it has permitted the pharmaceutical companies to significantly expand the number of people in Phase 3 testing, which could prove to be very beneficial. Rapid response tests remain the bridge to all of us potentially being vaccinated. We expect ample availability during the first quarter of 2021, which will permit a safe acceleration in openings and economic activity. We have not altered our timeline and still expect that there will be vaccines available for all by the second half of 2021, which supports sequential gains in economic activity as we move into 2022. Over 100 great pharma companies are working on therapeutics, vaccines, and rapid response tests, which gives us a reason for optimism that we will win this war against the coronavirus.
Our economy has continued to improve as we move into the fall, led by the manufacturing sector. The U.S composite PMI output for September was 54.4, the services index at 54.6, the manufacturing PMI at 53.5, and output stood at 53.3, a 10-month high. It was commented that "U.S. business reported a strong end to the third quarter with demand growing at a steepening rate." Inventories throughout the economy continued to fall, placing the I/S ratio at a multi-year low, which supports our view that economic activity will continue to be positive in the fourth quarter even without another stimulus bill. It helps that consumer deposits are way above pre-pandemic levels, and credit card debt is down. By the way, the consumer comfort indices have fully recovered, too, with expectations of substantial spending gains ahead. Again, we do expect additional stimulus bills after the election, if not earlier, which will boost economic activity in 2021 and 2022.
We see a similar economic outlook abroad. While consumer spending may slow from the recent pace as outbreaks increase, the manufacturing sector remains strong as exports are improving, especially to China. Inventory levels are depleted, necessitating an increase in operating rates to build inventories back to normal levels. We expect an acceleration in growth abroad next year into 2022 for all the same reasons as we see occurring here. It does help that all governments, including Germany, have passed major fiscal stimulus bills, which will support better days ahead, especially as rapid response tests roll out.
While we are fully aware of the issues facing us today, we have not altered our favorable economic outlook for 2021 and 2022. It is a unique environment in so many ways as corporations make strategic moves due to the pandemic that will influence their futures. Change is in the air, which creates tremendous opportunities for us as we do firsthand in-depth fundamental research. We speak to at least three companies per day.
Our thesis of a Tale of Two Cities is playing out such that large, well-financed companies are increasing market penetration while reducing costs and capital spending. Therefore, we expect a significant increase in operating margins, operating earnings, and cash flow over the consensus as the economy improves in 2021 and 2022. We expect to see a renewal of dividend increases and buybacks supported by large increases in free cash flow as we move forward, which will support higher stock prices. M&A will increase meaningfully too, as the cost to acquire makes most deals anti-dilutive, excluding any synergies. All of this is good for overall stock prices.
Our portfolios continue to evolve, taking advantage of market weakness and investor focus on the short term rather than looking out into 2021 and 2022. We continue to add to the industrial and commodity areas as we see production gains outstripping demand for at least another six months as inventories are built. We do not see much capacity growth ahead, which spells much higher operating rates, margins, profits, and cash flow than expected for several years. These stocks are not only undervalued on multiple bases but also sell well beneath intrinsic/replacement value.
Technology will remain over-weighted in our portfolios. There is no sector with better long-term fundamentals, growing multiples of GNP for years to come, with great operating margins and cash flow, and finally, sell at reasonable valuations with discount rates so low for so long. The new normal is a fact of life, and so is digitalization, software, smart devices, the cloud, 5G, more time spent at home, etc. How can you not be invested in this area?
The bottom line is that you need to focus on where we are going over the next two years rather than over the next two months. We see a meaningful improvement in economic activity and corporate profitability in 2021 and 2022 for all the reasons stated above. Accordingly, stocks are the place to be but remember that all stocks are not alike. Continue to sell bonds as we see the yield curve steepening as growth picks up.
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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
See also Business Cycle Indicators: 16 October on seekingalpha.com
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.