Helping the markets, during the first quarter gross domestic product expanded a robust 6.4%. The pace of activity is well above pre-Covid levels, which is stunning considering that there are 5.4 million fewer full-time workers and 2.7 million fewer part-time workers now than in February, 2020.
One of the key economic indicators we are tracking closely is the pattern of change in interest rates. The Federal Reserve has indicated it would remain accommodative for an extended period of time; at least a couple years. Thus, short-term rates remain close to zero. Meanwhile, the 10-year treasury rate, which hit a bottom on August 4, 2020 at 0.52%, has since risen to 1.74% as of the end of the quarter. There are usually multiple reasons for longer term interest rates to increase, including rising inflation expectations, a return to normalcy in credit market conditions, and/or greater issuance of debt. We believe all of these factors are driving the current move in rates.
As the economy continues to open up, growth is expected to accelerate and then return to a longer-term growth rate of about 2%, perhaps by 2023. The growth is driven in part by pent up demand and record fiscal stimulus. Supporting the former, the personal savings rate has been at elevated levels during the pandemic. Morgan Stanley estimates excess savings of $1.6 trillion as of the end of 2020, with an additional $1 trillion to be added in 2021. This potential added demand in an economy where consumption represents about 70% of total GDP is tremendous.
Regarding the fiscal side, a record $1.9 trillion stimulus plan was already passed into law. Several weeks ago, President Biden introduced a $2.3 trillion infrastructure plan, and soon thereafter he proposed a $1.8 trillion ‘families’ plan. The details and odds of passage keep shifting, but to the extent this stimulus is not fully offset by tax increases, there should be massive expansion in most sectors and all regions.
Logically, we take these factors into account when assessing equity market valuations. Stock values are usually based on the present value of future cash flows. In isolation, the rising interest rates we are experiencing should reduce the present value of future cash flows. However, future earnings growth expectations have also been rising, thus increasing projected future cash flows. So far, the latter effect seems to be overpowering the interest rate effect, justifying higher stock market levels.
As for bonds, for portfolios under our management with a fixed income allocation, our moves to shorten maturities and shift some assets into securities with floating rates worked well. Last quarter, the rise in rates caused most bonds and bond funds to decline. Intermediate funds fell 5% or so; longer maturity funds fell more; but even Vanguard’s short term bond fund had a negative return. But the combo we held was up 1.7%. This return has no bearing on any future results, but given the outlook for rates, we are maintaining the current short/floating rate discipline.