Last night’s Senate runoff in Georgia looks like it will be a clean sweep for the Democrats giving them control of the Presidency, House and Senate (with the VP holding the tie breaking vote). The margins in the House and the Senate are very small, so it won’t be easy to pass a major tax hike, which I think the market feels better about, but there is still anxiety there. The biggest impact by far is that expectations for fiscal spending and stimulus are now dramatically higher. This could potentially lead to substantially higher interest rates over time.
Over the last decade, both stocks and bonds have benefited from declining interest rates. As rates go down, bond prices go up and stocks become more competitive on a relative basis. This means they tend to fetch higher multiples. I’ve written many times on just how demanding these multiples are. I looked this morning at Starbucks, which got upgraded by a bank and it trades at 39 times forward earnings. That is a very aggressive multiple for such a mature, albeit still growing company. Many of these blue chip franchises trade at 2 or 3 times their usual multiples.
If we do see higher interest rates, financial stocks will be among the biggest beneficiaries as they will see considerable growth in net interest margins, earnings per share, and dividend payouts. When you combine that with historically low valuations, they are likely one of the few bastions of relative value in these very expensive markets. Additional stimulus now seems like a very good bet, which should greatly reduce credit losses, leading to reversals on previous write-downs.
International stocks have struggled to keep up with U.S. stocks over the last decade, after outperforming in the previous one. Both European and Emerging Market equities now trade at much more reasonable valuations and I believe we will benefit from our exposure there. If you look at real estate, healthcare, automobiles and commodities, inflation pressure already looks quite prevalent. The exceptions are areas such as textiles and flat screen TVs, which make up a much smaller portion of our spending of course. Inflation is a death knell for fixed income, although eventually it will lead to higher rates, so it could bring future opportunities there.
2020 was the year where everything that could go wrong went wrong, for value stocks, after a fantastic 2019. Growth outperformed value by the greatest margin in its history, but the long-term track record of value versus growth is still strongly in value’s favor. With the spread being wider than it has ever been and the prospects for higher interest rates, I’m very optimistic that better times lie ahead as far as our portfolios. We’ve also locked in some very high dividend-yielding stocks in areas such as critical infrastructure, that are just far more attractive options than bonds for instance. We will see how things play out but I think most people looking objectively at the prices being paid for the major stocks in the U.S. indices would be quite surprised at how expensive they are. Passive money flows seems safe but they can reverse quickly, which is the market went nowhere for 12 years after the Tech Bubble popped, but in those years, value had some of its very best returns. Higher rates and the disparity between growth and value could very well be the catalyst towards a new golden age for value, where pessimism could not be greater.