There is an interesting dynamic happening in the current environment, in my view: economic risks are falling, while market risks are rising. The two usually move in tandem.
Within the context of economic risks, I think we’re in an environment where risks are falling. I see many economic fundamentals pointing to “green shoots” and improving growth conditions, but below I’ll detail three largely underappreciated factors driving optimism.
- The Job Market
The first is the jobs market1, which I believe could be substantially stronger than many currently believe. In the Federal Reserve’s recently published Beige Book – which is based on surveys from major cities – I noticed a common theme: employers across the country are reporting shortages of workers, and many are desperate to hire.
The areas of the economy with the most acute shortages are part of the ‘reopening trade’, i.e., companies and industries that stand to benefit most from loosened and eventually removed restrictions. Think restaurant employees, drivers, child care workers, service industry jobs, and even jobs in information technology.
The labor force is estimated to be five million people smaller than it was before the pandemic, which gives the impression that the labor market is badly bruised. But it is also true that many people dropped out of the labor force for temporary reasons – people fearful of catching and spreading the virus, and/or those who are content living on expanded unemployment benefits. Those reasons may fade soon, and I think most people who want a job today can find one.
- Corporate Bond Markets
Another economic fundamental pointing2 to falling risks can be found in the corporate bond markets. The spread between speculative-grade, high yield corporate bonds and the 10-year U.S. Treasury bond has fallen to multi-year lows, as seen in the chart below:
Source: Federal Reserve Bank of St. Louis3
Indeed, the yields on low-rated corporate bonds sunk to a record low of 3.89% in February, indicating that companies can borrow cheaply in the current environment. Investors are the ones doing the lending, which tells us the market is not demanding much compensation for the level of perceived risk. Many would say this is a sign that investors are starved for yield, which I believe is true in part. But the other side of the story is investors may just be very confident in their outlook for the economy and see further signs of strength and improvement.
- New Business Formation
A final indicator4 underscoring falling economic risks is new business formation. The pandemic devastated many businesses, no doubt. But the tides are turning – applications for new businesses hit nearly 1.4 million in Q1 2021, which marks the second-highest quarterly total in over 15 years. Applications for businesses that could employ multiple workers also approached their highest quarterly tally, indicating that entrepreneurs have been emboldened by what they see as an opportunity for new growth. In my view, it’s a clear sign the U.S. economy is pushing ahead, with innovators and new growth opportunities forming in the wake of a major recession.
Bottom Line for Investors
I’ve made the point that economic risks are falling. But what about market risks being on the rise? In my view, it depends on where you’re invested. I’m seeing a lot of froth in particular asset classes and some individual stocks, but I think an investor’s risk is tied to his/her portfolio exposure. Many investors are abandoning long-term, diversified approaches in favor of chasing ‘hot’ asset classes or stocks. That’s bad news, in my view.
At Zacks Investment Management, in addition to the qualitative screening of the fundamental characteristics of companies we invest in, we analyze their correlation with our existing portfolio and with the overall market. Doing so allows us to ascertain to what degree our portfolios will be affected by large shifts in the market, such as market corrections. In other words, we constantly prepare for episodes of market volatility, which in my view, may arrive sooner than later – even as the economy improves.