So far, so good. The recovery that began in earnest last September continues to gain traction. Vaccinations are happening faster than anyone anticipated. The Federal Reserve is signaling that it will continue to hold interest rates down. Low interest rates will support the economic recovery. Economists project that economic growth in 2021 will come in somewhere between eight and ten percent.
Stock market valuations are at the high end of their historic range. This is not necessarily a problem if interest rates stay at the low end of their historic range as they are currently. U.S. stocks increase 85% of the time during economic expansions, and valuations remain attractive relative to fixed income. The U.S. remains in a global leadership position given the strength of earnings and the pace of vaccinations.
Last quarter, we projected that the S&P 500 would end 2021 at 4,400, implying a total return of about 14% for the year. Year to date, stocks are up more than ten percent. We have already made it about two-thirds of the way to our target. Finally, the economically sensitive sectors are starting to pull their own weight with energy, financials, and industrials leading the way. Earnings expectations are moving sharply higher, as banks are not writing off as many loans as they had projected.
If we maintain our present valuation, current 2022 earnings projections imply that the S&P 500 will be worth 4,563 at the end of 2021. This may be conservative if the strength in earnings from the first quarter of 2021 persists throughout the rest of the year, as I expect it will. It is unlikely that valuations will increase from the current level, but I do not anticipate that valuations will contract if interest rates are low, and COVID cases continue to decline. My best guess today is that the S&P 500 will end 2021 above 4,600—increasing more than 9% between now and year-end.
Now that the economy is on the verge of fully recovering from its Covid-induced recession, the question is whether the resurgence in stock prices is a rebound or if it will lead to something more sustainable. Only time will tell, but the place to look is corporate profit margins. In our last quarterly letter, I alluded to some of the substantial changes in how we work and live. As we figure out what our new normal will look like, it is highly likely that many of the money saving, productivity enhancing adjustments will lead to a long-term improvement in corporate profitability.
Take Google for example. About twenty percent of their overhead costs go towards corporate offices. If they can reduce the amount of time employees spend in the office, by just one day a week, they would decrease their need for expensive office space and increase their profit margin from twenty six percent to thirty percent. Valuations of corporations depend on corporate profitability. A thirty percent profit margin for Google should increase the valuation that investors are willing to pay for Google from 30 times earnings to almost 35 times earnings. If corporate efficiency increases across the economy, I expect to see a more permanent increase in corporate profitability, leading to a higher valuation level for stocks. Current stock prices do not reflect this possibility.
The Federal Reserve seems determined to spark higher inflation. Ever since the high inflation seventies and early eighties, inflation has trended lower. Despite exploding government deficits, interest rates are near all-time lows. The lack of inflation coincides with the recent lag between the income growth of the economic elite and the growth of the average household. The explosion in the value of stocks and real estate has not led to an increase in wages for middle and lower-income households.
Macroeconomic theory often fails to match up with reality. The prevailing view is that increasing inflation will reduce income inequality. I have no idea if this is true. We will not know until we test the theory. What matters to investors is that current conventional wisdom believes that the Federal Reserve can keep interest rates lower for longer, and that the impact to increased deficits is manageable. Based on monetary and fiscal policy alone, inflation seems inevitable.
There are so many complicating factors that modeling future inflation is pretty much impossible. We just finished a decade with the second slowest population growth since the 1790s. The only decade with a lower rate of population growth was the depression in the 1930s.
New household formation drives a huge amount of consumer spending and borrowing. Our society, and most of the rest of the developed world is now older on average than at any other point in history. People in retirement do not spend as much of their income as do people in their twenties and thirties. It is also possible that the higher levels of student loan debt are inhibiting the spending of recent college graduates. The government will do everything it can to cause higher inflation, but it is possible that their efforts will be insufficient.
If inflation stays where it is, the stock market should appreciate at about the same rate as earnings growth. If inflation increases modestly, investors will not overreact as they will assume that it is only a temporary reaction to the extraordinary steps the government is taking to counter the Covid-induced economic weakness. The only scenario by which valuations will fall is if we see rapid inflation. Even in this scenario, rapid inflation will lead to faster earnings growth as price increases are passed through to the consumer. Inflation is far better for stocks than deflation.
Throughout my career, I have learned that it is always darkest before the dawn. The inverse is also true. When we think nothing can go wrong, we are vulnerable to a blindside. We will continue to stick to the asset allocation that is most appropriate for your personal situation and do our best to maximize the productivity of your wealth.
