Portfolio Manager Doug Rao explains why stock valuations and interest rates are engaged in an ongoing tug-of-war as investors evaluate the potential breadth and depth of the economic recovery.

Key Takeaways

  • Stimulus and pent-up demand are priming the economy for a potentially fast and intense recovery.
  • However, higher interest rates, inflation and other factors could make the recovery complex and increase market volatility.
  • While it is normal for cyclical sectors to outperform in a recovery, as the end of the pandemic becomes more visible, we expect technological innovation to regain market leadership.

We have discussed ‒ and invested in ‒ disruptive companies for some time now. Last year, we saw disruption accelerate dramatically due to the pandemic, and the initial market recovery was driven by a select group of technology stocks that benefited directly from changes brought on by COVID. Indeed, digitization has been the biggest driver of economic change over the past decade, and we believe it will continue to affect virtually every segment of the market.

However, recently we have seen a leadership change to more cyclical, economically sensitive and smaller-capitalization companies. Stimulus and pent-up demand are priming the economy for a potentially fast and intense recovery. While it is normal for cyclical sectors to outperform in an economic recovery, as the end of the pandemic becomes more visible and life normalizes, we expect technological innovation to regain market leadership.

The Recovery Could Be Complex and Volatile

The steady rollout of vaccinations and subsequent drop in COVID-related hospitalizations in the U.S. have fueled recent optimism. As a result, growth projections have increased, and we have witnessed a consequent uptick in inflation expectations and Treasury yields. We believe these dynamics will lead to an ongoing tug-of-war between stock valuations and interest rates as markets evaluate the potential breadth and depth of a recovery and an appropriate risk-free rate.

While investors have begun to anticipate a full reopening, the economy currently remains hindered by social restrictions. Additional factors could make the recovery complex and increase market volatility, including the reorganization of supply chains and the potential for bottlenecks created by the rapid release of pent-up demand. It may be easier to stop an economy than to restart it, as we have seen with the current shortages in the semiconductor market. As near-term demand returns, long-term secular demand for microchips continues to increase. Industries like semiconductors and travel that have cyclical components ­‒ but that also benefit from secular tailwinds ‒ may be well-positioned for the recovery.

Further complicating matters is the fact that lagging vaccination rates in countries outside the U.S. could hinder a synchronized global return to growth.We have also seen significant bouts of market volatility from deleveraging events and increased retail investor participation.

In general, however, the U.S. consumer appears poised to help drive a recovery due to surplus savings and asset growth from a strong stock market recovery and rising home values. Consumers with both pent-up desire and the means to spend can help boost revenues while certain companies may also enjoy improved operating margins as a result of cost savings and behavioral changes made during the pandemic. In addition to tremendous fiscal stimulus ‒ Congress recently passed another sizable round in the form of the $1.9 trillion American Rescue Plan Act ‒ we also expect monetary policy to remain accommodative, further supporting the overall backdrop for equities.

Positioning for the Recovery

With the ongoing push-pull in markets and the likelihood for heightened volatility, we believe that strategic positioning during the recovery will remain vital. In general, equities’ potential for growth may provide a hedge during inflationary periods. Companies with pricing power that have historically underpriced their products should have the ability to pass through any increased costs to consumers. If labor costs rise, companies less dependent on labor ‒ like some in the technology sector ‒ may also be less exposed to wage pressures.

While we have recently seen companies with more cyclical characteristics lead the market in anticipation of increased engagement with the physical economy, we continue to believe innovation will be the primary driver of durable growth over the long term. As such, we believe it is important to focus on companies with sustainable business models and deeply rooted competitive advantages that have the potential to grow market share over a multiyear period.

The Right Side of Disruption