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Quarterly Market Review Q2 2021

Quarterly Market Review: Q2 2021

An Uncertain Transition

The economy is recovering rapidly but the pandemic and its aftermath are not quite done. This leaves policymakers with the dilemma of how to transition from crisis policies to more normal ones.

Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer

The reopening of the US Economy is happening apace, but it is a recovery unlike any we have seen before. The Covid-19 Pandemic, while fading, still presents challenges and risks, even as the percentage of the population achieving a good level of protection against the virus continues to rise. There are also issues surrounding the transition from the Pandemic Economy to a more normal one that present obstacles to make it go smoothly. Those obstacles are complicating the outlook for Federal Reserve policy and the timing of the end of extraordinary monetary policy support as fiscal stimulus and related policies lessen.

Consumer Credit Has Never Been Higher

Economic growth was 6.4% year over year in the first quarter and is expected to have been close to 9% in the second quarter: a figure that will be released at the end of July. For the year, the economy is forecasted to grow greater than 6.5% - a pace not seen since the 1980s. Much of the pace is due to the recovery from the deep Covid-19 Pandemic recession but there is also the continuing monetary and fiscal stimulus helping to propel activity. Household balance sheets are in great shape with debt service burdens reaching all-time lows and credit extended to consumers reaching an all-time high. The consumer is poised to spend and appears to be doing so as the economy reopens.

Quarterly Market Review: Q2 2021

An Uncertain Transition

The economy is recovering rapidly but the pandemic and its aftermath are not quite done. This leaves policymakers with the dilemma of how to transition from crisis policies to more normal ones.

Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer

The reopening of the US Economy is happening apace, but it is a recovery unlike any we have seen before. The Covid-19 Pandemic, while fading, still presents challenges and risks, even as the percentage of the population achieving a good level of protection against the virus continues to rise. There are also issues surrounding the transition from the Pandemic Economy to a more normal one that present obstacles to make it go smoothly. Those obstacles are complicating the outlook for Federal Reserve policy and the timing of the end of extraordinary monetary policy support as fiscal stimulus and related policies lessen.

Consumer Credit Has Never Been Higher

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Economic growth was 6.4% year over year in the first quarter and is expected to have been close to 9% in the second quarter: a figure that will be released at the end of July. For the year, the economy is forecasted to grow greater than 6.5% - a pace not seen since the 1980s. Much of the pace is due to the recovery from the deep Covid-19 Pandemic recession but there is also the continuing monetary and fiscal stimulus helping to propel activity. Household balance sheets are in great shape with debt service burdens reaching all-time lows and credit extended to consumers reaching an all-time high. The consumer is poised to spend and appears to be doing so as the economy reopens.

But there are apparent bottlenecks to the economy reaching its full potential as well as risks that could derail current progress. One issue is the jobs market and this is where the Federal Reserve has a dilemma on its hands. On the one hand, the unemployment rate has fallen from almost 15% at the height of the crisis to 5.9% as of June. That is a remarkable improvement but still much higher than the 3.5% level reached in 2019. There are 7 million fewer jobs than before the pandemic, a statistic Fed Chair Powell likes to cite when claiming there is still slack in the economy. However, there are 9 million job openings that are going unfilled at the same time, implying that labor conditions might be tight and firms are not attracting applicants – at least not at the wages being offered, apparently.

There are sufficient reasons to view the present labor shortage as temporary. One is that there are people who remain cautious about returning to the workplace due to lingering fears of the virus, but that should fade as vaccination efforts and general herd immunity improves. Another is that we are now in summer and many parents are choosing to stay home with their children until schools reopen. The same is true for many daycare centers that remain closed due to the pandemic. Of course, more generous unemployment benefits sent out to cushion the economic impact of the pandemic have likely discouraged some workers, but those outlays have ended in many states and are slated to terminate on September 6th. There is good reason to be hopeful that the present labor stalemate will ease after summer with many of the outstanding openings being filled.

Another obstacle has been on the supply-side. Due in large part to Pandemic disruptions, the supply of many manufactured and primary goods has been curtailed, and with the revival of the economy shortages have appeared for everything from appliances to tech components. Car production, in particular, has been so hindered that inventories have fallen to an all-time low, prices have risen and this has spilled over into the used car market where there is a price frenzy. But just as with the labor market, goods shortages are expected to be transitory and return to a more normal lever at some point, possibly later in the year or in 2022 at the latest.

Jobs

Car Production

Cars

 

The End of Extraordinary Measures

Forbearance Cliff Dead Ahead

 

The transitory issues aside, there is still the matter of the termination of the extraordinary measures put in place by the Congress in confronting the Pandemic. Already mentioned is the end of the additional unemployment benefits that have been a lifeline to so many. There is also the end of forbearance for mortgage and student loan payments as well as the moratorium on foreclosure and eviction. The moratoriums end at the end of the month and the forbearance ends in September.

At one point, these programs were fundamental to keeping the economy going and avert a deeper crisis. As of June 2020, the percentage of mortgages in which payments were suspended reached almost 9% of the total. Now, however, the scope of those measures has diminished. According to the Mortgage Bankers Association, fewer than 2 million households are taking advantage of mortgage forbearance, just shy of 4% of the total. In terms of the renter eviction moratoria, the situation is more serious but not as dire as it was. Moody’s Investors Service issued a report in which they estimate that the number of delinquent renters peaked at 9.4 million in January. This would equate to more than one-fifth of the nation’s 44 million renter households. Those households owed $52.6 billion in back rent, utility payments and late fees. Since that time things have improved markedly. The government provided $46.5 billion in assistance to troubled renters and their landlords and, coupled with the improvement in the jobs market, Moody’s estimates that the numbers of delinquent renters has almost halved to 5.6 million, equal to 13% of all renters, and accounting for $23.9 billion in arrears. Still a serious issue, but not one likely to derail the recovery. The matter of student loans remains a more serious issue and while forbearance there is set to end on September 30, there are signs that an additional extension, if not some other more political solution, will arise.

It seems likely that even as these extraordinary measures come to an end, this will not have a meaningful impact on the recovery. The one final obstacle, however, is the persistence of the Covid-19 virus and its variants. The Delta Variant is quickly becoming the dominant strain and is quite contagious. There is some good news and bad news on this front. The good news is that the vaccines already being distributed offer meaningful protection against Delta and between the relative success in getting shots in arms and the partial immunity provided to those who have already contracted Covid, estimates are that we are approaching herd immunity.

The bad news is that the distribution of immunity is very uneven and that there are pockets of the country that are still highly susceptible to meaningful breakouts of the pandemic. It remains to be seen how this will unfold, but there will still be some misery to come from Covid before the pandemic is truly over.

Low Southern Vaccination Rates
Progress to herd immunity

 

The Fed’s Turn

At the June Federal Open Market Committee (FOMC) meeting the US Central Bank chose to maintain its policies of zero short rates and quantitative easing (bond buying). However, the FOMC Members “Dot Plot” of where they expect the Fed Funds rate to be (each vote is a dot) implies a significant acceleration of rate hikes compared to the last meeting. Then, the median view was the rates would remain zero through 2023 and now that number is over 50bps by the same date. This has encouraged some to expect the first hikes next year even as that is not presently the Fed’s base case.

In addition, while the Fed has stated that it would maintain its bond buying program for now, they have opened the door for a “taper” of that program soon. Many believe the taper will be previewed as early as this month’s meeting on July 28 and commence at the end of the year or in the early days of 2022. The Fed has already announced that it would be selling the private sector securities (corporate bonds and high yield ETFs) it purchased at the depths of the crisis. This will be undertaken at a measured pace over the coming months. As it stands now, the Fed’s balance sheet will likely top $8 trillion before the taper turns into a net reduction in assets.

So, it appears that the Fed continues to take a “wait and see” approach to the problem of inflation, which has increased significantly in recent months. As covered above, the Fed believes that the recent price hikes largely stem from transitory disruptions due to the pandemic and related bottlenecks. The labor market, in their view, continues to show slack and therefore they believe that monetary stimulus is still required.

March 2021 and June 2021 FOMC DOT Plot
 

Critics of this approach believe that the Fed might be risking a more permanent rise in inflation. As it stands today, inflationary expectations remain well contained, but that could change fairly quickly. If supply chains remain impaired, workers remain sidelined looking for higher wages, and if globalization is indeed reversing to some extent, then there is a risk that inflation becomes inertial. Should this happen, some economists note, then the Fed would have to hike rates in a more dramatic manner, as it did in the run up to the housing crash, and risk a recession.

 

The Economy in a NAIRU straight-jacket

Not a Nehru jacket

If the critics are correct and the Fed has misjudged, the reason could be a renewed pricing power for labor where wages in a post-Covid economy get bid up markedly. Before the “Great Moderation” of inflation that took place from the 1980s until recently, it was commonly believed that one of the hard constraints to monetary policy was the NAIRU: Non-Accelerating Inflation Rate of Unemployment. It was the theoretical level of unemployment below which inflation would be expected to rise. This gave policymakers the trade-off between full employment and higher inflation. With globalization, automation and the decline of labor unions, the NAIRU faded as a real concern. But it is possible that the pandemic and other factors have altered this dynamic. A recent paper1 by academics associated with the Federal Reserve in San Francisco conclude that wages tend to rise following pandemics; returns on assets and real rates of interest fall; and debt sustainability rises. Perhaps Covid will not have as large an effect as the plagues they studied but there is some precedent examined here.

The most likely outcome remains the Fed’s forecast that the recent inflationary spike will prove to be largely transitory and that a return to a more normal cycle will appear over time. This outlook is based largely on demographics which point to lower long-term growth and inflation and the resumption of normalized supply chains where -- while possibly not as global as they once were -- will still be highly efficient and deflationary on their own. If the Fed is correct, then we should see a general normalization of interest rates with Fed Funds back to 2% or more over time and a more normal yield curve. Such would be a great comfort for fixed income investors.

 

Q2 Market Returns

The accelerated pace of U.S. vaccinations, a strong Q1 earnings season, and a reassuring Federal Reserve got the market off to a great start in April, continually making new highs throughout the month. A tight labor market and inflation concerns (and how the Fed might react) kept the markets relatively quiet in May, but the pause proved brief as the stock market rally resumed in June. The S&P 500 finished Q2 2021 up 8.6%, marking the fifth straight quarter of positive returns.

Large-cap stocks outperformed small-cap stocks in Q2 after two successful quarters of small cap leadership. At the same time, a rotation away from value stocks (5.2%) in favor or growth (11.9%) took place in Q2. Despite investor optimism, concern over the velocity of the recovery may have motivated investors to rotate out of the more cyclical categories.

Foreign markets have also benefited from the measured reopening of the economy but the pace of the recovery has been slower in many regions outside the U.S. Both the MSCI EAFE (5.2%) and the MSCI EM (5.1%) trailed the U.S in Q2.

Real Estate (13.1%), Technology (11.6%), and Energy (11.3%) all benefited from the re-opening of the economy. The Energy sector (+11.3%) also benefited from a 25% increase in crude oil, while Technology and Real Estate benefited from a move lower in interest rates. Rate-sensitive Financials (+8.4%) were hurt by more “hawkish” comments by the Fed, but were helped by the lifting of restrictions (due to COVID) previously placed on banks that limited their ability to return capital to investors (dividends and share buybacks). Consumer Staples (3.8%) and Utilities (-0.4%) continued to lag as the defensive groups have become a source of funds for investors as investors expect the economic recovery to continue, albeit at a slower pace.

Bond markets were unshaken by the growing inflationary talk, and much like the Fed, viewed concerns as temporary. The 10-year Treasury yield dropped .20% to 1.48% with longer duration and credit-sensitive investments performing the best. Aggressive sub-classes like High Yield (6.5%) and EM Debt (5.1%) performed the best.

Index Returns

Bears have long pointed to extreme valuations as to why this market advance has no legs. However, valuation metrics can be viewed as the ultimate indicator of investor sentiment. If future earnings prospects are attractive, P/E multiples are often higher as the expectation for the market to “grow” into its multiple becomes more probable. To date, the market’s advance (and the historically high P/E multiples) has been supported by a few positive developments centered around corporate earnings.

First, earnings growth over the last 12 months has validated investor enthusiasm. Q1 2021 S&P 500 earnings grew 53% year-over-year and the consensus estimate for Q2 2021 is over 64%. If the 64% growth rate holds, it would be the largest year-over-year growth rate in S&P 500 earnings in over a decade. Second, companies are reporting earnings that are beating already high expectations. According to Factset, actual earnings reported by S&P 500 companies have exceeded estimated earnings by an average of 19% over the last four quarters. Analysts and companies have also been more optimistic than normal in their earnings outlooks for Q2. Lastly, the idea that corporate earnings will fully recover quicker than expected has also helped validate the advance. Factset’s consensus for 2021 S&P 500 Operating Earnings is currently at $188 – nearly 20% higher than pre-pandemic levels – with all eleven economic sectors that make up the S&P 500 Index expected to have positive year-over-year earnings growth in 2021.

While growth rates will likely peak in in the coming months, the absolute value of earnings should rise. The E (Earnings) has caught up with the P (Price Gains), and the P/E multiple is now more reasonable. This is what the market was hoping for all along.

As growth accelerates, worry over inflation, and when the Fed will do something about it, will become the biggest wall of worry. According to the Federal Reserve Education Board, the 10-year Breakeven Inflation rate stands at 2.28%. This is the average rate of inflation that the market expects over the next 10 years based on the 10-year constant maturity rate and the 10-year inflation indexed constant maturity.

This becomes problematic for bond investors. The 10-year Treasury currently stands at 1.48%. Assuming the 10-year Treasury would ultimately trade at a yield above inflation, higher rates seem inevitable, and a positive return on longer-term Treasury Bonds could prove elusive for the foreseeable future. While abandoning bonds due to this return profile seems logical, bonds remain one of the best diversifiers to equities, and still serve a purpose in diversified portfolios. Reducing interest rate risk by shortening duration seems like a better choice to protect against rising rates in fixed income.

The key for equity investors is how moderate is the inflation. Moderate inflation is typically good for stocks. The bigger concern is at what level does higher interest rates hurt stocks from a valuation perspective (discount rate) and an asset class perspective (competition for investor’s capital)? Long duration equity assets (growth) will be most hurt by a higher discount rate. Right now, the dividend yield on the S&P 500 is only .10% below the 10-year Treasury and .50% higher than the 5-year Treasury. This makes stocks still attractive (relative to bonds) on an income and long-term growth basis. We don’t know what rate level begins to hurt equities, but the consensus seems to be that it is somewhere around 2.5% - 3.0% on the 10-year. This would suggest that there is a decent cushion before higher rates become problematic, everything else being equal. There may be greater safety investing in the laggards during a broad-based economic recovery as the cushion may be smaller for those asset classes that already trade at lofty valuations compared to other asset classes.

 

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1Longer-run economic consequences of pandemics? Oscar Jorda, Sanjay R. Singh, Alan M. Taylor February 2021 pandemics_jst_restat_final_feb2021_main.pdf (ucdavis.edu)

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