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July 8, 2021
High vaccination rates, broad economic reopenings, and the subsequent release of pent-up demand led to economic growth in the quarter that will be close to 10% when ultimately reported at the end of July. Historic fiscal and monetary stimulus combined to offset any negative impact of supply chain and labor shortages. Businesses, who became even more confident of ongoing economic expansion, increased spending on capital projects, particularly the spend on productivity enhancing technology investments. Consumer spending was boosted by strong jobs gains, increased wages in many industries and very high savings rates coming into the quarter.
Overseas economies have largely experienced a slower, more delayed recovery as relatively low vaccination rates allowed the second and third Covid19 waves to spread more widely and lethally. Renewed shutdowns and delayed reopenings caused double dip recessions in Europe, Japan, and Latin America with growth turning positive in these regions only near the end of the quarter. China was an exception as their recovery preceded that of the other developed market economies with the country now clearly in expansion moving into the second half of the year.
Financial markets produced strong returns around most of the globe. Continued loose monetary policy and another round of fiscal stimulus together helped drive equity prices higher in the U.S. Beneath the surface, the relative performance between the growth and value styles, or cyclical vs. non-cyclical equities, tended to favor the higher earnings growth sectors as interest rates stopped rising and actually declined from end of March highs. However, cyclical sectors such as Energy and Real Estate joined Information Technology and Communications Services among the top market performers as corporate profits increased markedly. Greater breadth of the equity market advance has led to a more sturdy and healthy market environment. While not rising at the same magnitude as seen in the U.S., international equity markets nevertheless produced impressive price performance on the back of economic growth in the U.S. and China as well as anticipation of a return to growth in their domestic economies.
The shift down and flattening of the treasury yield curve produced positive performance in the investment grade fixed income market. The directional move was somewhat surprising given the strong economic growth environment and the higher inflation indicators. This decline in rates likely reflects the market belief that the Fed will not prematurely tighten to slow the economy. However, investors should not rule out the possibility that lower rates can be a sign of a more dramatic slowdown in economic growth over the coming quarters. In addition to lower interest rates, below investment grade and emerging markets bonds were further supported by the prospect of improving economic conditions around most of the world.
The threat of excessive monetary and fiscal stimulus ultimately unleashing an inflationary cycle has climbed to the top of the list of market risks now that the severity of the pandemic appears to be largely under control. A pickup in the April and May inflation indicators was expected as 2021 prices are compared to those at the depths of last year’s recession. But the magnitude of price increases exceeded expectations as powerful reopening demand was met by the remnants of pandemic induced supply constraints in both product manufacturing and labor.
Within commodities, prices of most products increased notably at the beginning of the quarter stoking broader inflationary fears. Higher prices evoked two economic reactions. The first was an increase in supply as commodity producers boosted output. The second was a decrease in demand as higher prices caused consumers to defer or reduce purchase of the more expensive product. An example was the dramatic move in lumber prices and its impact on the hot housing market. Lumber appreciated 85% from the beginning of the year to the mid-May peak. Heavy demand for new homes and lingering labor shortages from the pandemic were the major factors in the price rise which dramatically increased the cost of homes and home improvements. These price increases dampened demand at the same time production of lumber ramped up to take advantage of the higher prices. Prices subsequently declined 55% over the back half of the quarter and moved into the third quarter lower than they were at the beginning of the year.
Not all commodity supply/demand issues have been resolved so quickly, namely energy supply which continues to be managed carefully by the OPEC+Russia cartel. Greater regulatory restrictions on drilling and transportation for oil and gas likely restrained the reaction of U.S. shale producers who have yet to meaningfully increase production at prices which are up 50-60% from the beginning of the year.
Labor shortages are another inflation pain point as potential employers are increasingly citing their biggest limitation being the inability to attract qualified job applicants. Mitigating factors such as the end of enhanced unemployment benefits, fewer childcare issues as children return to the classroom, and dissipating virus concerns could relieve some of the pressure. There may, however, be more permanent labor supply issues due to limited immigration, earlier baby boomer retirements, and labor skills mismatches. Any sustained wage pressure caused by these shortages could manifest itself in higher inflation and/or lower profit margins unless employee productivity increases as well.
Slowing, but still strong economic growth with central banks largely remaining accommodative continues to be a favorable environment for risk assets. As inflation rates decline with increased supply of both goods and labor, bond yields will increase only gradually allowing earnings growth to be the primary driver of equity prices. Having experienced delays in broad vaccine distribution and subsequent reopenings, international markets may close the performance gap with the U.S. over the coming months.
For more insights, contact a Cerity Partners advisor.
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Ben is the Chief Investment Officer and a Partner in the New York office. He leads the firm’s Investment Committee and is a member of...
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