As we close out the first half of 2021 and embark on the second, the best way I can characterize what I see coming is the calm after the storm. Don’t get me wrong: everyday will not be calm. But compared to what we’ve been through and the strength we’ve seen in the aftermath, I’m hopeful that the rest of this year will be marked with steady economic progress, careful transitions by policymakers, and markets that can adapt to a new environment.
At the start of the year, when the COVID-19 vaccine was just rolling out, it was difficult for many investors to believe in a solid, sustainable, and robust recovery. Since then, not only have many economic indicators exceeded expectations, but they’ve exhibited historic strength.
For instance, two-thirds of the jobs lost during the economic shutdown, about 14.7 million, have been added back. The unemployment rate has fallen from a peak of almost 15% during the crisis down to 5.8%. The Federal Reserve estimates that unemployment will fall to 4.7% by the end of 2021. Although we’re dealing with a stubborn number of unfilled job openings, it’s encouraging and a relief to see businesses creating jobs and planning to add even more in the second half of the year.
Unemployment and Job Openings
Sources: Clearnomics, Bureau of Labor Statistics
There is further evidence that business activity in many sectors has accelerated. The ISM Manufacturing Index is at its highest level since the early 1980s. Air travel has come back strongly as leisure travel saw a burst of activity and business travel has slowly resumed. Restaurant dining is going through a revival across the country as restrictions are fully lifted. Companies in all sectors, large and small, appear to be roaring back.
All told, US GDP is expected to have returned to its pre-pandemic level in the second quarter, which is six months ahead of the timeline we originally thought. The pent-up demand came out strong as consumers started spending on goods and services that were restricted for so long. The result has been undoubtedly positive for economic activity, but the swift rise in demand put a strain on supply chains and drove higher inflation readings, which I’ll cover in a later section.
I expect the positive economic momentum to continue through the second half of the year and into 2022. However, the year-over-year comparisons will become more difficult as the crisis periods fall further into the rearview. In order to maintain forward momentum in markets, the economy and businesses will need to generate new organic growth.
Rising Market Tides
Financial markets have been resilient during the first half of the year despite concerns such as rising rates and elevated valuations. And although broad stock indices have posted double-digit gains YTD, they feel hard-won when compared to last year’s impressive burst off the market bottom.
Surprisingly, the largest peak-to-trough decline this year has only been 4%, which is far less than the 30-year annual average peak-to-trough decline of 14.2%. While the market stumbled a time or two, it bounced back quickly to reach new highs. In fact, at the time of this writing the S&P 500 has posted 32 new all-time highs in 2021 alone.
Risk appetite continues to persevere, as demonstrated by the demand for a wide range of assets including technology stocks, cyclical sectors, small-caps, digital currency exchange, SPACs, IPOs, and NFTs-to name a few. Tides are turning under the surface as market leadership has broadened out and rotated among sectors and styles (i.e., growth and value). While tech reigned supreme last year, cyclical sectors such as energy, industrials, real estate, materials, and financials have benefited from increased economic activity and the expectation of stronger growth ahead.
Investors remain resilient even as broad market valuations hover near record highs. The forward 12-month price-to-earnings (P/E) ratio is around 21x, compared to a 10-year average of 16.3x. The Shiller cyclically adjusted P/E ratio, at 37x, is also at its highest point in 20 years.
While some have compared the current market valuations to the dot com bubble, a key difference in this cycle is that corporate earnings are recovering just as rapidly as the economy. If all goes well in second quarter earnings season, S&P 500 earnings-per-share will exceed pre-pandemic levels. As earnings rise, valuation measures such as P/E ratios should naturally compress and start to look more reasonable. Sometimes bubbles can slowly deflate rather than burst.
S&P 500 Earnings Per Share
Sources: Clearnomics, Refinitiv
Which Direction to Steer the Ship
Markets are a forward looking indicator, meaning they trade on expectations more than events, and expectations have been moving higher for some time. While I expect economic growth to come in strong for the rest of the year, I worry that high expectations have already been reflected in the market and it will take a lot to impress investors in the second half. Measures such as Citi’s Economic Surprise Index have plummeted as lofty expectations actually came to fruition and were no longer a huge positive “surprise”. This could make it difficult for markets to find solid direction as we move through the rest of summer and await the Federal Reserve’s message in fall.
I am optimistic that markets can produce positive results in the second half as we transition away from perpetual policy support and back to focusing on the strength of company fundamentals (such as the quality of its financial statements, competitive position, valuation, and future growth potential).
Part of that fundamental story revolves around the forward progress in earnings. I believe the strong earnings momentum in large-cap cyclical sectors (energy, industrials, and materials) offers attractive opportunities through the end of the year. I also think industry groups such as travel and entertainment can continue to benefit from increased activity both here and abroad. This is not to suggest that sectors not mentioned above (such as technology or communications) are poised to post negative results, but simply that in this phase of the recovery, I view the opportunity set as having broadened out considerably to include more of the value-oriented sectors. Lastly on the domestic front, there is strong earnings momentum in small-cap stocks that bodes well for their leadership carrying forward through the third and fourth quarters.
While US stocks have done well this year, it’s important to note that the recovery is a global story and international markets may not be far behind. Regions like Europe may soon play catch-up as they recover from lockdowns and international travel resumes. Furthermore, the European Central Bank recently raised its growth and inflation forecasts, and key interest rates such as the German 10-year Bund have risen, possibly indicating stronger investor risk appetite.
Choppy Crypto Waters
As a newer asset class, some cryptocurrencies have garnered significant attention from individual and institutional investors alike. Likewise, the dramatic swings in price of those coins have also been a hot topic. As the U.S. dollar faces downward pressure from inflation expectations, and large budget and current account deficits, interest in crypto assets could remain strong. However, investors must keep in mind the potential volatility that comes along with all types of crypto, and ensure their risk tolerance can cope with the twists and turns.
Bitcoin and the Stock Market
Sources: Clearnomics, Bloomberg
Inflation Simmer Reaching a Boil?
Perhaps the biggest point of contention among investors this year has been the surge in inflation. After being subdued for decades, many are wrestling with the idea of higher prices and what they could mean for consumers and markets alike. The jury is also still out on whether these high inflation numbers are here to stay or will be “transitory,” as the Federal Reserve expects. So far, rising prices have been the result of three forces.
Consumer Price Index
Sources: Clearnomics, Bureau of Labor Statistics
First, as pent-up demand was released back into the economy, prices of goods and services moved quickly upward and reflected the surge in activity. But when we measure inflation, we do it on a year-over-year basis, meaning the increase in prices for Spring 2021 is compared to the depressed prices from Spring 2020, which exaggerates the data and makes them seem quite large. This is referred to as “base effect”-comparing current readings to an unusually low base.
Second, supply and demand disruptions have caused price pressures in various areas. For example, supply-chain issues that resulted from factory shutdowns have limited the availability of semiconductors, which in turn affects the prices and availability of everything from consumer electronics to cars. Another example is the mass migration to the suburbs that occurred and pushed up the prices of new and existing homes and drove strong demand in home furnishings—all of which have contributed to inflationary pressures. As economic activity picks up around the globe, commodity prices are surging as well, pushing up the costs of many consumer goods.
The first two factors – base effects and supply and demand – could very well end up being transitory as the simple passage of time may iron out the wrinkles. That said, it’s the third factor that could drive longer-term inflation: fiscal and monetary stimulus. So far, over $5 trillion has been spent or proposed on a variety of pandemic and economic stimulus measures. The Fed also continues to buy $120 billion of bonds per month, increasing its balance sheet and pumping liquidity into the system. Although there seems to be some discussion about tapering those purchases, it’s still only in the conversation phase.
Turning the Titanic
In addition to supporting maximum employment, managing inflation is a central mandate of the Federal Reserve. And just like investors, this is a problem that the Fed has not had to deal with in decades. So much so that the Fed changed its approach last year to target an average inflation rate over a longer period, rather than put too much weight on any one reading.
At the moment, Fed officials have indicated that they are happy to wait and see, although we did get a sliver of appetite for moving the rate hike cycle forward in the last meeting. I expect the Fed to be extremely cautious in making changes to its policy and to be even more cautious in how they signal their intentions to investors. Of course, this won’t stop markets from scrutinizing the Fed’s every word, but it does give us a better chance at avoiding another “taper tantrum” like the one we saw in 2013.
Federal Reserve Balance Sheet
Sources: Clearnomics, Federal Reserve
As it stands today, market expectations and Fed guidance indicate a tapering of bond purchases beginning in 2022 and a rate hike (or two) in 2023. The exact timing is uncertain and with each new release of the dot plot, I expect the chances of a sooner rate hike to increase. Specifically, if economic data, particularly labor market data, continue to show strength, I believe a rate hike would be likely in 2022.
Although that could put pressure on high growth stocks and cause wobbles in the market if and when the Fed’s narrative changes, the reality is that most investors should neither fight the Fed nor fear the Fed. If tapering and tightening begin for the right reasons–i.e., because the economy is strong and inflation is persistent–financial assets can still perform well. It’s about the speed and method of changing policy, not the change itself. Markets have risen during rate hiking cycles in the past, and they can again. I view the prospect of tighter policy as a change investors will need to digest, but one that indicates our economy is on the right path.
Returning to normal rarely means returning to the exact same normal. Even as the economy recovers and bounces back, it will be different than it was before. There will be different drivers of growth, new policies for markets to navigate, and transitions for businesses to make. That said, I am optimistic about the resilience of the US economy and hopeful that markets can enjoy a pleasantly calm second half.
Photo credit: iStock/atakan
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