“One of the keys to successful portfolio management is to acknowledge risks without becoming obsessed by them.” — Cameron Crise
Second Quarter Summary
Global financial markets reverted to the late 2020 script of asset classes rallying together. U.S. stocks, both large and small, international equities of developed and emerging markets, most commodities, and even fixed income rose, though the path was not a straight line. The rotation away from value and cyclical stocks into growth and FAMANG (Facebook, Amazon, Microsoft, Apple, Netflix and Google) continued from late winter.
Overall, earnings for 1Q came in even better than their elevated expectations, helping equities to continue their upward climb and raising forecasts for the second quarter. Consumer spending for services spiked higher, reflecting recovery from depressed levels caused by the pandemic a year earlier. Meanwhile, housing remained red-hot, with prices appreciating at multi-decade highs due in part to limited supply, leaving many first-time buyers struggling to find a home.
Vaccinations, Inflation and Employment
Inoculations continued to proceed globally, with about 52% of the US and 61% of the UK total populations now fully vaccinated. Other countries have started to catch up, especially in the Eurozone and Canada. India had a Covid resurgence, due largely to a popular religious festival becoming a super spreader event. After selected regional lockdowns, however, new cases now are down over 90% from their early May peak, and vaccinations are picking up. Other countries, particularly in South America, are still besieged by the pandemic and have made limited progress so far.
The Delta variant of the illness is becoming the prevalent form of the virus, spreading quicker than earlier forms of Covid. Current vaccines seem to have somewhat less efficacy against Delta, though the rate of hospitalizations (and mortality rates) in vaccinated populations continues to be very low.
Economists had expected inflation to have a big bounce from last year, but many were surprised by the magnitude of the increase. April’s core CPI (Consumer Prices ex-food and energy) came in at an annualized pace of 3.6% vs. 2.6% in March, spooking the markets. It was followed by the core Personal Consumption Expenditure (PCE – the Federal Reserve’s favorite inflation gauge) at 3.1% annualized, a bit over the Fed’s 2-2.5% preferred range.
Chairman Jay Powell and others at the Fed have said that the increases are likely to be transitory. Indeed, most of the components that led the increase, such as used car prices, are temporary in nature. Supply chain issues, especially the semiconductor shortage, should also be resolved as production is increased. Others, including wage inflation and Owners’ Equivalent Rent (OER – a measure of the cost of housing) tend to be “sticky” – more long lasting. Unfortunately, we probably won’t know if wage inflation and the OER are a problem until autumn at the earliest. This has led to lively debate among economists, with both sides offering valid arguments to back up their claim.
Employment reports also missed consensus estimates, mainly to the downside. In April, Nonfarm Payrolls (NFP) came in at 266,000 (a good number in normal times), far short of whisper estimates of 1 million new jobs. May was better, with 559,000 vs. 675,000 expected. June finally showed robust growth, with 850,000 new jobs instead of the 720,000 expected, the most in 10 months. Various reasons for lower numbers include such disincentives as generous unemployment benefits, lack of child care keeping many women out of the job market, and fear of contracting Covid. This was compounded by many companies having trouble filling positions, partly due to skill mismatches.
The Federal Reserve’s New Conundrum: To Taper or Not
Uneven economic reports have the Fed “thinking about thinking about” tapering Quantitative Easing (QE), to paraphrase Chairman Powell. Some Fed members are even moving up their forecast of raising the shorter-term Fed Funds Rate by a year or more. Though the Fed is now talking about tapering, it appears the consensus will wait until September or October before committing to a schedule.
Interestingly, the response from the longer end of the bond market has been rather counterintuitive, with 10-year Treasury yields down 40 basis points to 1.35%. Such a response indicates that bond traders believe that central bank will not “fall asleep at the switch” and will be proactive in combating higher inflation if it persists. So far, the stock market has taken developments in stride and not reacted as sharply as it did during the Taper Tantrum in 2013.
Also influencing bond yields are concerns over the Delta variant and an imminent peak in growth. Our view: Although growth will peak soon, it will not decelerate in any meaningful way for some time. We also feel that the Delta variant is not as bad as feared, with existing vaccines still effective and boosters likely to come soon.
Meanwhile, a $1.2 trillion bipartisan infrastructure package is being considered in Congress along with a $3.5 trillion Democrat-only sponsored bill. Talks may drag on for several more weeks before a final bill comes to floor with proposed tax increases likely to be less than the Biden Administration has proposed.
The Outlook for the Third Quarter
- Real GDP (Gross Domestic Product) growth for 2021 is expected between 7-8% prompting corporate profits to continue to surge.
- One possible risk to the outlook is a major resurgence of the Covid-19, which is possible but not likely due to the availability of vaccines.
- Inflation is a wild card, but its persistence (or lack of it) won’t be known for at least a few months.
- With the Fed’s QE (Quantitative Easing) likely to continue for the rest of the year, equities remain the asset of choice, though returns will be moderate in the coming months.
- Bond prices should trend lower as the durability of the recovery becomes evident.