Stocks continued to rally in the 2nd quarter, largely due to a super-accommodative Fed and continuing recovery from the pandemic. Growth stocks, interestingly, resurged late in the quarter as interest rates declined (paradoxically in the face of high inflationary pressure). There certainly appears to be a correlation between the relative performance of growth and value stocks based on bond market action. If interest rates rise … value outperforms; if interest rates decline … growth stocks outperform.
The 2nd quarter 2021 was a period where almost everything went up in price: Food prices, gas prices, airfares, utilities, insurance premiums, stocks of all stripes, bond prices, commodity prices, gold prices, energy prices, etc. In fact, the Bureau of Labor Statistics recorded a 5.0% increase in CPI (Consumer Price Index) … the largest 12-month increase since 1992. The debate has now become whether today’s inflation is "transitory" as the Fed believes, or if it marks the beginning of a new inflationary or stagflationary era.
We do not have an answer — there certainly are both deflationary and inflationary pressures in the system. On the deflationary side, an enormous amount of public and private debt has first call on income, which keeps income growth subdued. And technology and automation keep a lid on wage increases. On the inflationary side, the explosive growth in money supply (M1) puts more dollars in the system and causes people to pay more for everything. Also, broken supply chains put downward pressure on supply and tight labor markets (due to continuing unemployment benefits disincentivizing work) puts upward pressure on labor costs.
Oil prices increased 20% during the quarter, which brought higher gasoline prices. Gold prices increased slightly, but cryptocurrencies (the other dollar alternative) declined with Bitcoin nearly getting cut in half. There was a lot of hype and hoopla around cryptocurrencies, but speculators were smashed in the second quarter — so a lot of that has quieted down. Perhaps because there are now over 11,000 different cryptocurrencies and an unlimited supply.
18 months after the pandemic started, the global economy is on the mend. The OECD forecasts that the global economy will expand by 5.8% for the year and recently bumped up its 2022 growth forecast to 4.4% from 4.0%.1 After a rough start, the vaccine campaign is progressing well in most advance economies. Developing economies are still struggling to secure enough vaccine, but that should abate over the next six months. The Global Health Initiative Center at Duke University estimates that pharmaceutical companies are on track to produce more than 10 billion doses this year, which should suffice to protect the most vulnerable members of society around the world.
Markets interpreted the June Fed meeting as being hawkish — meaning that it intends to raise rates sooner than expected. Short term (2- and 5-year) bonds increased in yield by about 0.10% in June and long bonds yields declined by about 0.40%. This "flattening" of the yield curve is bad for banks. The US dollar strengthened by about 2% and growth stocks reversed some of their underperformance from earlier in the year. The market is currently pricing in a full 1% of rate increases by the end of 2023.2
Since so much about investment markets is keyed off of the Fed, it’s worth considering the big questions that drive Fed policy: 1) How long will the US take to return to full employment; and 2) what happens to inflation in the interim. These can never be fully projected with any accuracy. At first glance, it looks like there is an unemployment problem with current unemployment rate at 5.9%. Yet the NFIB small business survey tells a different story with 48% of firms reporting difficulty in filling vacant positions, which is the highest level in the survey’s 46-year history.
To reconcile high unemployment with tight labor markets, there are four explanations: 1) generous unemployment benefits, which have brought down participation among lower-wage earners; 2) school closures had a huge impact on labor force participation among women with young children; 3) reduced immigration as visa issuance was down 99% at one point during the pandemic; and 4) an increase in early retirement.
Most of these are temporary effects as: 1) unemployment benefits are set to end in the fall; 2) kids should be back in school; 3) visa issuance should increase; and 4) the increase in early retirements was a one-off event with fewer retirements in the near future. The bulk of the labor shortfall is in retail and hospitality. In April of this year, retailers hired 800,000 workers and 1.42 million found jobs in leisure and hospitality. That represents 5.3% and 10.1% of total employment in those sectors. At that astounding rate of hiring with unemployment benefits still in place and kids out of school, we should be back to full employment by the beginning of 2022 (barring some kind of shock).
On the inflation front, more than half the increase in CPI in April and May was from higher vehicle prices and a rebound in pandemic-affected service such as airfares, hotels and event admissions. Outside of those sectors, the level of CPI remains below its pre-pandemic trend. Gasoline prices should decline from their seasonal highs and none of the measures of wage inflation are signaling a wage/price spiral. The University of Michigan survey showed that consumers’ expectations for longer-term inflation dropped from 3% to 2.8%.
Taking all of this in means that with the labor markets recovering, commodity prices declining, and inflation being not as bad as widely believed — the bond market probably over-interpreted the June Fed meeting as a signal that monetary policy will tighten sooner than it actually will. Interest rates on the 10-year Treasury declined from 1.75% to 1.3% and growth stocks strongly outperformed value since then (because of declining rates). But the Fed is likely to maintain a go-slow approach and will not likely begin tapering bond purchases until 2022 and not hike rates until sometime in 2023. This means that from here we should see the economy continue its recovery and we will see upward pressure on rates.
Historically, bear markets rarely occur outside of recessions or the unwinding speculative froths such as in 2008. Even the bear market in tech stocks beginning in 2000, was the beginning of a long bull market for value stocks. As such, with fiscal and monetary policy being supportive, and households having high levels of savings, the odds are low that the global economy will experience a major downturn in the next 12 months. But given the stock price rally year-to-date, investors have priced in an increasingly optimistic outlook and the gains in "growth" stocks from here will be harder and harder to come by. Especially because they are now extremely expensive. The best risk-rewards exist in "value" stocks.
So, to sum it up, strategy-wise we continue to favor "value" over "growth" stocks and cyclical over defensive. The Fed will probably combat market expectations that it will tighten policy soon, which would reverse the effects we have seen since June (declining bond yields, growth outperforming value, dollar rallying, foreign stocks lagging, etc.) Moreover, one factor we did not address is Chinese credit growth (because it is a long analysis that is beyond the scope of our update), but its credit growth declined considerably in the 2nd quarter. That has a big effect on all financial markets, and we expect that credit growth to stabilize, which will also contribute to reversing the above-mentioned effects.
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1 Source: OECD
2 Source: BCA Research