With inflation at multi-decade highs and inflation expectations inching up, the Fed has reprioritized its focus from supporting growth to quickly taming inflation. The Fed has stated (unequivocally, to our ears) that they would gladly risk a recession now via restrictive policy to avoid the bigger risk of higher and more entrenched inflation later. This is the right long-term policy, but means that economic growth will slow in the near term.
As we turn our calendars from the hot summer to temperate fall months, risk assets have started to cool with the weather, with volatility re-emerging in markets. Equities began the quarter by continuing their upward trend and breaking through record highs, driven by a dip in interest rates and robust corporate earnings reports.
And the beat goes on…
Essentially treading water for the first half of the quarter, markets found their footing and finished positive across every major asset class. Continued vaccination success, massive amounts of fiscal and monetary stimulus, solid economic activity, and earnings acceleration all contributed to the investor optimism that witnessed the S&P 500 deliver positive quarterly results for the fifth consecutive quarter, which is the longest consecutive streak since the nine-quarter stretch that ended in 2017. Though many of the quarter’s headlines centered around fear-invoking risks like inflation and sooner than expected modifications to the Fed’s accommodative policy, the markets appeared unphased as concerns of growth moderation sent yields lower and equities higher. While still lagging other major US equity markets year-to-date with a return of 12.54%, as markets shifted toward higher quality, the more interest-rate sensitive and growth-oriented NASDAQ led the charge with a second-quarter return of 9.49%, as compared to returns on the S&P 500 of 8.55% and 15.25% for the quarter and year, respectively. While only delivering returns of 4.29% in the second quarter, US small-cap stocks, as measured by the Russell 2000 index, garnered solid returns for the year of 17.54%, only to be outdone year-to-date by the S&P MidCap 400 return of 17.59%.
With uneven COVID containment across emerging market countries, along with varying degrees of inoculation success, surging commodity prices, and falling US yields, the MSCI Emerging Market Index delivered a positive return of +5% in the second quarter; bringing the year’s return across developing countries to 7.4%. Conversely, foreign developed countries (primarily Europe and Japan) continue to lag the US in vaccine rollout progress, though France and Germany are approaching 50% of their populations receiving at least one inoculation. Rising concerns over the Delta variant continue to threaten the near-term recovery. Fortunately, recent vaccination success and easing of some travel restrictions drove the cyclical heavy MSCI EAFE Index (Energy, Financials, Industrials, and Materials make up more than 40% of the index) +5.2% for the period, bringing the total for the year to +8.8%
Despite high levels of inflation reported over the quarter, long-term inflation expectations are actually down on average. When coupled with an overly accommodative and reassuring Fed, along with the looming fiscal cliff and Delta variant posing risks to the expansion, the market witnessed the yield on the 10-Year Treasury contract about 30 basis points (0.30%) to end the second quarter at 1.45%; still up more than 0.50% for the year. While the inverse relationship between bond prices and yields pushed the return on the Bloomberg Barclays U.S. Aggregate Bond Index up 1.8% for the quarter, the index remains down -1.6% for the year.
Though first quarter GDP accelerated at a 6.4% rate, the US still sat below its pre-pandemic growth levels. Massive amounts of Congressional and monetary stimulus continued to drive economic activity back into positive territory in the second quarter. The Conference Board forecasts that US Real GDP in the second quarter will rise to a 9.0% annualized rate and 6.6% year-over-year for 2021. While Bloomberg forecasts have moderated in recent weeks, they’re still anticipating second-quarter growth of 10% (from 11% in March), and 7.2% for 2021 (from 7.7% in March). Growth of 7.2% for the year would be the fastest annual rate since the economy surged out of the 1981-1982 recession. With the effects of the March Congressional stimulus package fading, several key economic indicators have demonstrated some recent softening. While consumer spending was robust in the first quarter (up +11.4%, according to Bloomberg), we’ve witnessed a normalization in retail spending in both April and May. Furthermore, as the economy has continued to reopen, consumers have started to shift their spending preferences away from goods and more toward experiences and services, like dining out and traveling. In general, consumers appear poised to drive significant pent-up demand, as evidenced by their elevated savings of 14.9% (more than double the post-Great Financial Crisis average), unprecedented consumer net worth, and an M2 Money Supply of more than four trillion dollars above average levels – up 18% year-over-year, and 30% higher since February 2020. Given that the consumer comprises roughly 70% of our economy’s output, spending should serve as a significant driver for economic growth for the remainder of the year. That spending should be supported further in the intermediate term from both the monthly child tax credit payments that are going out this month, coupled with the eventual spend-down of excess savings.
The Fed, Inflation, and Labor Market
Over the course of 2021, equity markets have become increasingly more dependent on overly accommodative central bank policy, where Fed policy appears priced to perfection and risks of a policy mistake appears more likely than not, hence the flattening yield curve. Though continually pressured, the Federal Reserve has remained resolute in their current policies and messaging, maintaining their accommodative stimulus through open-ended Quantitative Easing (QE4) and keeping rates historically low. This “anything it takes” mentality has seen the Fed’s balance sheet balloon to more than $8 trillion, with no real signs of slowing. The Fed is currently purchasing $120 billion ($80 billion US Treasury securities and $40 billion in mortgage-backed securities) per month and has indicated the intent to maintain this pace through 2021 and possibly into 2022, before beginning to taper their purchases. As we’ve communicated in the past, taper does not mean that the Fed will halt buying bonds; it means that they will slow the pace of their purchases. Tapering could reduce purchases from $120 billion per month to approximately $100 billion per month in a transparent and well-communicated manner. Perhaps the two most monumental changes coming out of the surprisingly hawkish June Federal Open Market Committee was the mention of “talking about talking about tapering” and revising their projection for rate increases from 2024 to 2023. The Fed continues to communicate that their decisions will hinge on actual data and not forecasted data. In the third quarter of last year, the Fed changed its policy framework to achieve 2% inflation and adopted a soft, or flexible, inflation averaging approach. This soft approach would hypothetically allow inflation to run above 2% for an undisclosed period, as long as the average falls back 2% over the long run. With so much emphasis on inflation, what’s often overlooked is the Fed’s dual mandate to both average their 2% inflation target and their commitment to achieving “substantial further progress” toward the goal of maximum employment.
Inflation measures the rate of increase in prices of goods over a given period, and high inflation levels can damage productivity and economic growth. Last year, prices fell in March and April and remained low in May, creating a low base for future year-over-year readings – resulting in price level changes that might be slightly exaggerated. But in looking at the economic data, it’s hard to deny inflation currently exists. The Consumer Price Index (CPI), a prominent measure of inflation, witnessed Headline CPI come in at 5% and 5.4% in May and June, respectively, which are the highest readings since 2008. After stripping out the more volatile food and energy components, the Core CPI registered its highest reading since 1991, 3.8% and 4.5% for the same respective months. While the increases in the basket of goods measured in the CPI in April, May, and June did include some noise resulting from the base effect, most of the price increases have been a result of significant supply chain disruptions, coupled with a significant surge in demand. During the pandemic, inventory levels were significantly depleted, and once the economy began to reopen, demand surged, causing a bottleneck in the supply chains. Many consumers have felt this if they’ve tried buying a car, buying a house, or even building a deck. This type of supply chain disruption is relatively normal during recovery periods and can be seen as mostly transitory. Therein lies much of the debate around inflation – will it be transitory (temporary) or structural (sticky)? When looking at the most recent two CPI reports, more than half of the total increase in Core CPI can be attributed to used cars, rental cars, hotels, and airfare. These small categories only represent a combined total of Core CPI of about 6%. Their large price jumps are due to reopening and supply chain disruptions, both temporary, or transitory. Conversely, the larger components like rent and healthcare represent roughly 49% of Core CPI and have experienced only modest price gains; though the two consecutive readings of 0.3% for rents is worth noting and will be important to monitor going forward. One of the major issues causing disruptions across nearly every economic sector is semiconductor, or chip, shortages. Our everyday lives have become dependent on chips; they’re found in nearly everything from automobiles, dishwashers, phones, computers, to microwaves, etc. Through May, the average order-to-delivery interval reached all-time highs of 18 weeks. In other words, if a single chip was ordered in May, it took 18 weeks for that single chip to be delivered – hence the severe disruption in production and significant spike in new and used car prices.
Over the coming months, perhaps the most telling variable to monitor for clarity around inflation’s transitory or structural nature will be wage growth. It’s difficult for inflation to be sticky or structural without upward wage pressure. June’s 3.6% year-over-year wage growth is worth noting, though not overly concerning. Should the labor market start to exhibit the same pricing power as we’ve witnessed in commodities, we could witness a wage/price spiral, causing yields to normalize quicker than anticipated and indicating inflation might last longer than expected. When wages increase, businesses must increase the cost they charge for their goods and services to compensate for the higher wages, adding to inflationary pressures. If prices remain elevated, workers will eventually demand another wage increase to offset the increase in their cost of living – making inflation more structural. To correct the labor shortages and hire workers to meet surging demands, employers are getting creative to hire and retain workers, including higher wages. Several retailers, like Walmart, have raised their internal minimum wages to $15 per hour or more. Once these changes are made, an employer can’t reduce employees’ salaries, making these changes more permanent. Additionally, during first-quarter corporate earnings announcements, nearly every announcement mentioned inflation and the rising input costs applying pressure to their margins, and furthermore, their intentions to pass those increased costs along to consumers. Much like wage increases, if a company can successfully pass along cost increases, and consumers are willing to pay those higher prices, then once supply chain disruptions normalize and their cost of goods fall in line, many companies are not willing to slash consumer prices – again making inflation more structural and stickier than transitory and temporary.
We partially agree with the Fed and Treasury Secretary, Janet Yellen that the current supply chain disruptions will start to work out, and price gains will start to normalize. We believe that inflation will be transitory in the sense that it should start to moderate sometime in the third or fourth quarter of this year from its current levels. However, we also think that we could be headed for a regime change in future inflation. In other words, the post-Great Financial Crisis inflation averaged less than 2%, and we wouldn’t be surprised to see the next several years running closer to the 3% range. Outside of that view, when looking at the June CPI numbers of 5.4% and 4.5% on Headline and Core, respectively, it’s understandable investors are fearful. However, we are still dealing with some base effects, which are causing overstated numbers. This same base effect will also impact year-over-year CPI data as we approach the second and third quarters of next year, except then we’ll experience a reverse base effect. This time next year, the base will be these elevated inflation results currently being reported, which could produce negative year-over-year CPI readings. Given the cliff experienced during the heart of the pandemic, followed by sharp V- shaped reversals, we anticipate several variables to suffer from base effects for at least another year or so, continuing to insert noise into the data. When looking at the metrics closer, about 50% of the components tracked in the CPI basket that contributed to growth came from transitory components like buying used cars (up 45% YoY) and dining away from home. Therefore, as production comes back online, many supply chain disruptions should dissipate and lead to a moderation in inflation.
The rest of the Quarterly Update covers the Federal Reserve, Congressional Stimulus, and other Implications moving forward. Read more.
The preceding commentaries are (1) the opinions of Chris Osmond and Eric Krause and not necessarily the opinions of PCIA, (2) are for informational purposes only, and (3) should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.
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