Economic growth rebounded sharply in the 2nd half of 2020 and has continued to gain momentum through the first half of 2021. A third round of estimates point to 1Q21 annualized GDP growth of 6.4%, with early 2Q21 numbers projected to exceed 10%.i Although this pace is expected to decelerate throughout the second half of the year, the Fed’s year-end 2021 estimates for GDP growth have bumped up slightly to 7.0% (originally 6.5%). ii We believe this bullish revision reflects an economic recovery that is moving along faster than expected, as well as a general sense of optimism about our ability to reign in the pandemic throughout the remainder of 2021.
With the availability and distribution of multiple vaccines, the US has seen the daily COVID infection and fatalities decline substantially since peaking in 1Q21. The 7-day moving average has fallen from roughly 250,000 (infections) and 3,500 (deaths) per day, to approx. 26,300 and 211, respectively. iii As of 7/15/21, more than 336 million vaccine doses had been administered in the U.S., and when combined with those who had previously been infected, the estimated U.S. immunization rate appears to be in the 70-75% range. iv
Recent trends suggest that we may not be quite out of the woods, as there has been a recent minor uptick in infections due to the emergence of the of the Delta Variant (“Delta”), a more contagious form of COVID-19, currently accounting for the majority of infections, hospitalizations, and fatalities. Although it’s unlikely the U.S. will revisit pre-vaccine contagion and fatality levels, it remains to be seen what impact this new trend will have on our economic recovery, particularly if further mutations prove capable of penetrating existing vaccines and treatments.
Though largely maintaining its dovish posture, the Fed’s rhetoric coming out of the June FOMC took on a slightly more hawkish tone. While still generally viewing inflation as a “temporary” phenomenon (a rhetoric change from “transitory”), Chairman Powell also acknowledged that the U.S. recovery is moving along quicker than anticipated. Their updated dot plot projections (plan for rate increases) indicate that some members believe inflation will actually persist, requiring the Fed to adjust its previous timeline for rate hikes up to 2023 vs. 2024. Before any rate hikes are implemented, however, the Fed would first begin tapering its open market purchases of treasuries and mortgage-backed securities (currently $80B and $40B per month, respectively). Some analysts believe tapering could begin as early as 4Q21, and the first round of rate hikes as early as 2022. ii
Despite June’s noteworthy shift in forecasts, it’s important to note that the Fed’s dot plot reflects a range of estimates that can and do frequently change. However, given the unprecedented nature of this recession, coupled with equity markets breaking all-time highs on a seemingly weekly basis, any change in tone regarding monetary policy is enough to inject volatility into markets that are already somewhat difficult to interpret. ii Regarding long-term strategy, Chairman Powell reiterated the Fed’s focus on unemployment and wages in determining the next phase of monetary policy actions, as well as a willingness to allow inflation to run well over the target 2% level for an extended period of time if necessary. viii Particularly while the workforce participation rate remains sluggish, it seems unlikely that a dramatic shift towards more contractionary measures (rate hikes) is likely in the near-term. That being said, substantial acceleration in wages could ultimately force the Fed’s hand to act earlier than anticipated, as wage pressure has historically been one of the most important drivers of inflation and therefore monetary policy. ii
The highly anticipated bi-partisan infrastructure package is still alive, despite having been substantially scaled back from its original form. At present, the package being negotiated is approx. $1 trillion, although it’s unclear if the required 60-vote threshold to defeat a filibuster can be achieved given the current political climate. At the same time, Democrats are also discussing pushing through a $3.5 trillion package on a party-line basis via a process called “reconciliation,” which only needs 50 votes to pass, though it is unclear if all 50 Democrats are on board.
The debate over infrastructure is a familiar one, with one side stressing fiscal conservatism while the other is pushing for government investment. However, this time the stakes seem to be higher in the context of a historic recession and debt levels not seen since WWII. iv Indeed, the federal balance sheet remains stretched, with national debt levels continuing to exceed GDP and are projected to reach approx. 103% of GDP by year-end. iv While it remains to be seen how the next round of fiscal stimulus will unfold, we believe a final decision will likely hinge on a cost benefit analysis between the government’s desire to ensure continued economic recovery and the unintentional inflationary consequence these actions could catalyze.
In hindsight, it’s shocking that S&P 500 earnings only declined by -13.1% in 2020. This result is likely attributed to the substantial growth that FAANG (Facebook, Amazon, Apple Netflix, Google) companies contributed to the overall index in the second half of 2020. That being said, 2021 estimates for S&P 500 earnings growth are currently hovering at around 35%, which is the result of a broader recovery that appears to be happening quicker than previously anticipated.i Unfortunately, the recovery has not been felt evenly across the entire economy, with service sector industries, such as restaurants, hospitality, and leisure, just now starting to recapture pre-COVID activity levels. But the trend is headed in the right direction.
While the snapback in earnings is encouraging, profit margins may tighten in 3Q, as input costs for raw materials and components have risen sharply due to supply shortages. Although some of these shortages can be attributed to supply chain disruption, due to economic shutdowns (particularly raw materials such as minerals, lumber, steel, etc.), it appears that the primary contributor to supply shortages has been businesses consciously reducing their output levels in anticipation of a more gradual recovery. This is particularly true in the semiconductor space, which has led to productivity shortfalls in a wide variety of sectors including automobiles, electronics, and industrial equipment.
As is typically the case, consumer spending continues to be the driving force behind domestic GDP growth. Buoyed by record high personal savings levels, unprecedented fiscal stimulus, and pent-up demand following various levels of restrictions/shutdowns over the past year, this trend has been amplified through the first half of 2021. As of April 2021, some industries experiencing the most growth from pre-COVID levels (April 2019) include light trucks (66%), computer equipment (58%), games & toys (53%), televisions (36%), and jewelry (28%). However, the spending boom has not been felt evenly across all sectors. As of April 2021, some industries most struggling to recapture pre-COVID levels include movie theatres (-89%), spectator sports (-65%), hairdressers (-46%), hotels (-38%), and taxis/ride-share (-30%).i The wide dispersion between “winners” and “losers” helps to illustrate the bifurcated economic landscape that COVID-19 has produced over the last year. Although likely to remain the backbone of our economic recovery, consumer spending is expected to decelerate over the remainder of 2021, as enhanced fiscal stimulus benefits cease towards the end of Q3, causing personal savings to gradually decline.
Unemployment continues to improve, with total nonfarm payrolls rising by 850,000 in June, resulting in an unemployment rate of 5.9%, or 9.5 million unemployed. Although these metrics are considerably improved from last year, they are still well above pre-COVID levels of 3.5% and 5.7 million, respectively.vi Furthermore, the rapid pace of job recapture that occurred at the recovery’s outset appears to have slowed in 2Q21. Many have pointed to the extension of enhanced unemployment benefits as a key disincentivizing factor delaying people from returning to the workforce. While we believe there is certainly some merit to this argument, there also appears to be a supply-demand mismatch within the labor market that is causing a deceleration in job growth that could very well persist even after the unemployment benefits expire in September of 2021. Geographic migration, shifting preferences towards remote work, rising retirement rates, and workforce exits related to childcare, seem to all be contributing to a slower, more uneven labor market recovery.
Digging deeper, we notice that the labor participation rate has only slightly recovered from pandemic lows, currently sitting at 61.6%, reflecting 3.5 million people who have left the workforce altogether. Some are unlikely to ever return, as many Baby Boomers saw the pandemic as an opportunity to retire earlier than anticipated, reflected in the retirement percentage, which jumped to 19.5% in April 2021, from 18.6% pre-COVID. ii Furthermore, the pandemic has exposed many individuals to the benefits of a remote work environment including the ability to work from anywhere in the world. As such, geographic migration occurring during the pandemic has resulted in a certain degree of frictional unemployment, particularly in the service industries (hospitality, restaurants, leisure, etc.), which could take longer to shake itself out, further delaying a full labor market recovery. Additionally, school shutdowns in 2020 caused families to recalibrate their childcare needs, leading to many dropping out of the workforce to care for their young children. While this factor should be somewhat alleviated this fall, as schools are set to reopen across most of the country, a resurgence in the Delta variant could further delay workforce reentry for many parents.
Though job growth is generally expected to remain positive for the foreseeable future, many factors have converged to create a very tight labor market. The pace of job gains is expected to pick up a bit once enhanced unemployment benefits expire and schools reopen in September, but overall, the pandemic appears to have created some structural and cultural changes to our domestic labor market that may need to be addressed before a return to “full employment” is attained.
Inflation surged in 2Q21 with the CPI increasing 5.4% YoY in June, it’s largest increase in nearly 13 years. vii While much of this increase can be attributed to base effect (due to economic shutdowns in 2020), conflicting viewpoints have emerged regarding whether the recent run-up in prices is temporary or the beginning of a long-term inflationary trend.
Those who view recent price spikes as largely temporary point to the convergence of supply shortfalls, caused by a combination of supply-chain disruption and producers underestimating supply needs, and pent-up consumer demand, buoyed by record high personal savings levels. For their part, the Federal Reserve appears to be more in this camp, as it has been reluctant (until recently) to even acknowledge the possibility of taking actions to counter inflationary pressure. The expectation is that prices will eventually settle down once productivity returns to pre-COVID levels and inventories are replenished. Furthermore, consumers currently chomping at the bit following a year of economic isolation will begin to curtail their spending habits as personal savings accounts are drawn down, further alleviating strain on the system.
Conversely, many business leaders and analysts are starting to believe that recent price increases may actually be the beginning of a longer-term trend. This camp contends that a tremendous amount of money has been pumped into the system, via unprecedented fiscal and monetary stimulus, which is unlikely to be flushed out anytime soon. They further argue that the excess stimulus has disincentivized many to reenter the workforce, resulting in a general inability for businesses to rehire at a pace necessary to keep up with consumer demand. As such, existing labor shortages have led to wage inflation, causing wage growth to exceed its 50-year average of 4% for the first time in more than 30 years. iv While this is certainly a good development for employees, steep and persistent wage growth that happens too quickly, has the potential of causing an upward inflationary spiral and may require a more aggressive monetary policy response to control.
It remains to be seen as to which side has the correct read on the situation at this time, though it’s likely a combo of both. Regardless, in our opinion it’s apparent that inflation will play a critical role in determining the pace and potential of our recovery prospects and will continue to be monitored closely by industry professionals for the remainder of the year.
2021 has been a roaring success for equities thus far, with broad-based indices posting their fifth consecutive quarter of robust gains. The S&P 500 and MSCI World indices are up 16.3% and 13.50% YTD, respectively. ix As is typical coming out of a recession, Value and Small cap stocks have outperformed on a YTD basis. But Q2 experienced a different leadership tone, with Growth and Large cap stocks leading the way, up 11.4% and 8.5% for the quarter vs. Value and Small Cap up 5.2% and 4.3%, respectively. 10 out of the 11 primary economic sectors posted positive performance during the quarter, with the more cyclical sectors leading the way, as the economy continued to accelerate. Real Estate, Info Tech, and Energy were the strongest performers in Q2, up 13.1%, 11.6%, and 11.3%, respectively. Conversely, Utilities, Consumer Staples, and Industrials were the poorest relative performers, posting returns of -0.4%, 3.8%, and 4.5%, respectively. xi
International stocks also generated solid gains in 2Q21 and on a YTD basis, although somewhat lagging domestic stocks. The MSCI EAFE Index of developed markets stocks grew by 5.2% in Q2, up 8.8% YTD. Emerging markets returned 5.0% for the quarter and are up 7.4% YTD. xi From our perspective, seemingly favorable recovery prospects along with a persistently low interest rate environment in the near term are likely to continue driving equities higher in 2Q21. That being said, against a backdrop of resurging infections, spiking inflation, and elevated equity valuations, the market is ripe for volatility and the risk of correction remains higher than usual for this stage of market cycle.
Unlike equity markets, fixed income has struggled thus far in 2021. As the pace of recovery accelerated significantly in 1Q21, so did volatility in the bond market. In 1Q21 we saw the 10-year treasury yield spike from sub 1.0% to a high of 1.74%, before settling back down below 1.5% by the end of 2Q21.x Yields are expected to end the year in 2.0-2.25% range.
Core fixed income enjoyed a bit of a respite in Q2, after posting its worst quarter of losses since 1981 in Q1. The Barclays Aggregate Bond Index has risen steadily since late March as long-term interest rates drifted lower, posting quarterly gains of 1.7%. However, this has not fully offset the losses brought on by the sharp interest rate spikes early in the year, and the index is still down -1.6% YTD. On the other hand, sub investment grade credit, which tends to correlate more closely with equities, has performed better. High Yield Bonds and Leveraged Loans have posted gains of 3.7% and 3.3% YTD, respectively. Emerging Market Debt was one of the best performers in Q2, up 3.9%, but still down -1.0% YTD. xi
Looking forward, a persistently low interest rate environment is rarely good for fixed income, and we believe navigating the credit markets will prove challenging over the next 12-18 months. Yields are likely to grind higher, pressuring prices, and robust economic activity is expected to keep credit spreads tight. i Investors seeking income, may want to consider alternative sources such as direct lending or private real estate investments which can also serve as a hedge against higher inflation.
The global economy is forging ahead as it continues to recover from the very severe, albeit brief, recession triggered by the COVID-19 pandemic. In our view, a confluence of factors has created favorable economic conditions including accelerating business re-openings due to the availability of vaccines and a decline in virus cases, aggressive monetary policy implemented by world central banks, and historic levels of fiscal stimulus in the US. Growth in 2021 is expected to be a blockbuster year, with the Fed’s median projection for 2021 GDP growth at 7.0%, the highest since 1978. The peak, however, is likely behind us with the pace of growth expected to decelerate in the second half of 2021 and into 2022.
Despite the Fed’s assurance that the rise in prices is “transitory” or “temporary”, inflation remains elevated, and many believe it is the beginning of a longer-term trend, which could lead to the Fed to tightening policy earlier than anticipated. Other concerns we see include the new variants of the virus, wage pressure on corporate earnings, high equity prices that risk a correction, and rising gasoline prices which could eat into consumers’ disposable income and erode confidence. A new infrastructure package should be a positive booster for GDP, but the timing and size of new stimulus is still very uncertain. As always, we strongly encourage you to connect with your fiduciary advisor to ensure your current investment strategy is in line with your risk tolerance, need for liquidity, and short-term/long-term goals.
|Andrew Mescon, MBA
VP of Strategy
Chief Investment Officer
i. JP Morgan – The investment Outlook for 2021: A midyear Review
ii. FS Investments Q3 Outlook: Zooming in on Inflation.
iv. JP Morgan – Guide to the Markets 3Q 2021 (as of 6/30/2021)
v. WisdomTree Economic & Market Outlook – Mid Year 2021
vi. Bureau of Labor Statistics – US Department of Labor
vii. First Trust Economics Blog
ix. FS Investments – Market Minute (7/9/2021)
x. US Department of the Treasury – Daily Treasury Yield Curve Rates
xi. Fidelity Quarterly Market Update – Third Quarter 2021
xii. Envestnet Economic and Market Overview – Second Quarter 2021
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