Market and Economic Outlook
Market Commentary - Q3 2021
Brushing aside mounting concerns about higher inflation and a more contagious Covid variant spreading around the world, investors bought assets of almost any stripe in the second quarter. For the fifth consecutive quarter, global equities marched higher as corporate earnings continued a strong recovery that outperformed already lofty expectations. In a bid to hedge potential inflation risk, asset classes like commodities and real estate have seen increasing demand this year leading to strong performance. Meanwhile, the bond market rallied throughout most of the second quarter and snapped its trend of rising interest rates that began last August.
Global equities closed the second quarter at record highs, capping off a strong first half of 2021 that saw shares advance 12.8 percent. Bullish sentiment was buoyed by the accelerating pace of vaccine distribution globally, leading to further lifting of pandemic-related economic restrictions. Worry about elevated valuation levels stayed on the back burner as investors continued to find paltry yields offered in the bond market.
U.S. stocks carried the torch in the second quarter, outperforming international equity markets. However, in a pivot from the prior two quarters, sectors with more sensitivity to the strength of the economic cycle took a backseat to more secular growth-oriented areas as questions emerged about the sustainability of fiscal and monetary policy support.
Falling long-term interest rates also reflected the possibility of a premature moderation in fiscal and monetary stimulus. The rate on the bellwether 10-year Treasury note fell 30 basis points from 1.74 percent at the end of March to 1.44 percent by the end of June. A flattening of the yield curve, as measured by the spread between longer- and shorter-maturity bonds, and further compression in credit spreads helped the bond market post healthy returns in the second quarter after fighting a steepening curve over the prior ten months.
At first glance, falling interest rates seem counterintuitive amid the highest inflation readings seen in decades. After all, it makes sense that investors should demand higher -- not lower -- yields if inflation is heating up. But it’s the second derivative of inflation that has the market’s attention. Namely, the implications for future economic policy and ultimately growth potential.
From toilet paper shortages to soaring home prices, the global pandemic has brought with it many atypical economic phenomena. Wild swings in both supply and demand across virtually all assets, goods and services have kept economists perplexed as to what current economic data says about the future. What began with fears of a deflationary death spiral at the onset of the pandemic had completed a one-eighty into worries over out-of-control inflation entering the second quarter of 2021. An unprecedented fiscal and monetary policy response to a rare, but economically devastating, event has muddied the economic waters by stirring up questions about a sustainable long-term equilibrium for both growth and inflation.
A key question for the U.S. economy and financial markets alike centers on the inflation outlook and its implications for monetary policy. The Federal Reserve (Fed) has been keenly focused on achieving a full labor market recovery while relaxing its mandate to keep prices in check under its recently revised policy-making framework. However, the exact length of the longer inflation leash remains in question as a surge in reopening demand is met by supply chain disruptions.
Prior to the pandemic, the Fed consistently undershot its stated goal of 2 percent inflation despite what at the time was the largest expansion of its balance sheet in history following the Global Financial Crisis. Embedded in the Fed’s mindset was that monetary policy impacted longer-term inflation, but with a lagged effect. In other words, they felt it was necessary to be more proactive than reactive to the price stability mandate. But even as unemployment fell to record low levels by the end of the last decade, models like the Phillips Curve that tie employment conditions to inflation proved to be “dogs that didn’t bark”.
Recognizing a disconnect between the academic assumptions about the impact of monetary policy on inflation and employment and the empirical experience, policy makers decided they had some cover to see how far they could push the limits of monetary policy to address the current crisis. Under the new framework, the U.S. central bank now aims to “achieve inflation that averages 2 percent over time” (emphasis added), while also seeking broader-based positive employment outcomes. This simple yet significant change opened the door for inflation targeting “moderately above 2 percent for some time” to compensate for the prior cycle’s underachievement.
On one hand, the change was welcomed by financial markets because the new framework gives the Fed more flexibility to get the economy back up to full speed. On the other hand, it introduces greater uncertainty given the ambiguity around the time horizon and, consequently, makes predicting the Fed’s next move that much more challenging. The exact definitions of “moderately” and “some time” remain elusive, perhaps even to the Fed itself.
May’s Core Personal Consumption Expenditures Index (the Fed’s preferred inflation marker), along with other inflation measures, came in well above expectations and at levels not seen in decades. This data was taken in stride by policy makers and financial markets with the expectation that current data is not necessarily indicative of a longer-term trend. As evidence of the transitory nature of the spike in prices, economists point to items like used car prices, which are surging as a knock-on effect of the supply chain disruption in the new car market.
The Fed’s employment bogey is clearer. 6.8 million fewer Americans are employed relative to pre-pandemic levels. Achieving the objective of bringing that number closer to zero, or what the Fed deems “maximum employment”, hit a snag as the pace of hiring fell short of expectations in April and May despite job openings and quit rates hitting new highs. Explanations for the failure to meet the increasing demand for labor ranged from enhanced unemployment benefits to caregiving challenges to ongoing pandemic fear. In reality, the shortfall appears to be a combination of these factors.
June’s increase of 850,000 non-farm payrolls relieved some concerns that the pace of hiring was off track after two consecutive disappointing months. Most encouragingly, employment in the sector most impacted by the pandemic, leisure and hospitality, saw the lion’s share of growth with 343,000 new jobs added in June. However, the nearly 2 million Americans that have left the workforce in the wake of the pandemic present a troublesome obstacle to achieving a full labor market recovery.
The “transitory” inflation narrative firmly planted in the market’s psyche prompted close scrutiny of June’s Federal Open Market Committee (FOMC) meeting for hints as to when monetary policy accommodation will be weaned from the system. Heightened attention was paid to the survey of FOMC members’ projections, also known as the “Dot Plot”, that suggested the timeline for tapering quantitative easing and eventual rate hikes could be shorter than previously expected.
In his press conference following the FOMC meeting, Chairman Powell was quick to downplay this shift in expectations by saying the projections should be “taken with a grain of salt”, and reinforcing the highly uncertain speed of the recovery given the unusual nature of the downturn in the economy. However, reading between the lines, one might suspect that the FOMC voting members are at least thinking about tapering despite comments to the contrary.
Forecasting future economic conditions is always challenging and this cycle’s unique forces in both directions makes that endeavor even more difficult. At the foundation of the ”wall of worry” for investors today remains the central bank’s ability to support the recovery. Should the inflation outlook shift from being transitory to something longer lasting, it will likely have major implications for Fed policy and subsequently all financial assets. More specifically, it might force the Fed to confront the paradox of having to tap the breaks to curtail inflation before the economy gets fully back on its feet.
Having learned important lessons from the 2013 “taper tantrum” and 2018’s “autopilot” remarks, the Fed is keenly aware of the market’s sensitivity to not only its policy actions, but also to mere guidance on what it might do in the future. For this reason, we expect the Fed to be extremely careful about when and how it introduces a pivot toward removing accommodation. There is no ambiguity about the delicate co-dependency between financial markets and the real economy – a reality policy makers cannot afford to ignore.
In For a Penny, In For a Pound
As an encore to the $1.9 trillion fiscal stimulus package passed earlier in the first quarter, the Biden administration crossed the aisle to reach an agreement in principle for the largest ever infrastructure plan with a price tag of $579 billion. While significantly scaled back from President Biden’s original infrastructure proposal that included funding for a variety of social programs, the package will add another booster shot to the already staggering $6.2 trillion economic antidote from the fiscal side of the house. In addition to scaling back the scope of the bill, an agreement with Republicans required that corporate tax rates remain unchanged. As a compromise, the new spending will instead be funded by increased enforcement of the existing tax code.
Up next on the fiscal policy agenda are more spending priorities that will include offsetting tax increases which will need to clear the budget reconciliation process to bypass a Republican filibuster in the Senate. Of particular concern for equity and corporate bond markets would be higher corporate tax rates that may accompany new spending proposals. With Democrats holding the narrowest of majorities in Congress, the administration’s wish list for its budget is expected to be scaled back to earn the support of more moderate members of the party.
Heading into the back half of 2021 we expect a continuation of the global economic momentum driving the speedy recovery in corporate fundamentals, while we are keeping a close eye out for potential catalysts that would alter the global economy’s longer-term trajectory. Despite our sanguine economic outlook, corporate earnings expectations have already reset to reflect a fairly optimistic scenario and comparisons to prior periods will become more challenging.
For this reason, we believe the pace of appreciation in equity markets over the first half-year is unlikely to be maintained in the second half. We remain most constructive on the more economically sensitive areas of the equity market, including energy, financials and industrials, that appear heavily discounted compared to more defensive peers in the healthcare, consumer staples, and technology sectors.
Within fixed income markets we expect intermediate to longer maturity interest rates to retrace their recent move lower and restart their upward trajectory as the global glut of liquidity slowly diminishes. Further, while corporate fundamentals continue to improve, increased merger and acquisition activity, dividend payouts and share buybacks could become a limiting factor to that trend. Given the already low risk premiums offered, we foresee limited opportunity for additional credit spread compression.
Among the most significant risks to our outlook and the current narrative in general is the fragile feedback loop between economic data and monetary policy discussed above. More specifically, the Fed’s pragmatism could be tested if inflation starts to look less than transitory. While some recent drivers of higher inflation readings are indeed likely to fade, other variables have the potential to take the baton and flip the script on the transitory story. Perhaps the most notable of those variables is rent, which represents about a third of the Consumer Price Index calculation and has yet to meaningfully accelerate despite a record surge in home prices.
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