Markets Higher Thus Far in 2021 as Monetary Policy Wanes, Growth Slows
Overview- Markets continued higher through the mid-year mark with most risk asset classes finishing stronger, with the one notable exception being precious metals. As of June 30th,
Treasury yields were higher across all maturities, with the largest increase in yields occurring in the belly of the curve--around the 7-year maturity. Despite inflation readings coming in higher than expected and real yields falling back to Covid-era lows, gold sits around 9% below its 2020 high.
What to make of inflation? By far the most followed topic of the quarter was the inflation story. Despite inflation readings at or near multi-decade levels across a variety of categories--from materials to
housing, energy, food, autos and labor-- longer-term inflation expectations have largely remained in line and anchored
near historic averages. This can be interpreted as a sign that market participants are anticipating the current bout of inflationary pressures will indeed be....wait for it...
transitory. Whether this will indeed be the case, we can't yet say for sure. It will take another 6 months and crossing over the 1-year reopening anniversary to see how far inflationary roots have entrenched in the post-Covid economy. Certain components of inflation measures are set to recede in the coming months--most notably used car prices, which accounted for 1/3 of the rise in June's CPI data, while other components--most notably housing, with
affordability now worse than 2008, set to push CPI higher. By Q1 2022, we should have supply chains back to full capacity and post-pandemic economic patterns established. What could cause a sustained inflationary spiral? Government spending has morphed from monetary to fiscal during Covid. A shift from capital to labor (see "wage share" chart) with respect to the level of wages and compensation employers must pay to attract workers could certainly set-off a cost-push inflation cycle, as businesses seek to pass on rising costs to customers.
Additionally, how much of the sidelined/saved government support payments, equity and housing appreciation accumulated during the pandemic (see "savings boom" chart) are spent as the economy reopens will also have a meaningful impact whether a "spend now" mentality leads to an inflationary consumer mindset.
Peak Liquidity. Federal Reserve policymakers, led by Jerome Powell, would like to continue pacifying market participants--hawks and doves--in both word and deed as Central Bankers balance inflationary pressures with employment growth during reopening. This task is becoming more difficult with each passing day. The Fed has acknowledged it may need to change the course of monetary policy, using June's meeting to pivot from its previous position of "not even thinking about raising rates," to at least thinking about raising them. More recently, Powell himself told the Senate Banking Committee, "We're experiencing a big uptick in inflation, bigger than many expected, bigger certainly than I expected, and we're trying to understand whether it's something that will pass through fairly quickly, or whether in fact we need to act." "Action" would entail the Fed moving to a less accommodative policy position. Though rate hikes are still not expected in 2021, the Fed may announce measures to taper its $120 billion monthly bond buying program as soon as September's meeting in Jackson Hole. As a result, this shift away from ultra-loose monetary policy means liquidity--measured by the Fed's assets as a % of GDP--has peaked, at least for now.
Peak profit growth compared to Covid low. The current earnings recovery compared to prior peaks since 1990 has been historic (see earnings and recessions chart below) and may have more to deliver. Earnings estimates for Q2 are expected to rise 64% (!) for the S&P 500 in Q2 compared to Q2 2020. Earnings grew 52.5% for Q1 vs. same period the year prior. Q2 2020 was the low point in S&P 500 earnings during Covid, so going forward, earnings growth will prove to be more challenging-- particularly if profit margins suffer from the inflationary costs outlined above. With no expectation for incremental monetary policy support--actually quite the opposite--a heightened risk for tightening policy, further pressure will now be on earnings growth to power markets higher in the near-term. Earnings do have another positive factor returning-- companies are
buying back stock again. An estimated $1 trillion of stock buybacks are expected this year. That's more than all the annual coupon income in the US Treasury, investment grade and high yield markets combined.
An industrial slowdown in 2H 2021? Transition from recession to recovery often marks a regime shift within market leadership from defensive toward economic sensitive sectors. In late 2020, cyclical sectors such as energy, materials and industrials took the leadership role as the economy emerged from the Covid recession. There is a compelling case for a multi-year expansion in cyclical sectors, for several reasons: 1) the expansion of government policy beyond monetary support to include infrastructure rebuilding programs, 2) the extent of gains from stay-at-home winners during Covid provides an extensive amount of "catch up" opportunity for the depressed cyclical and value sectors of the market and 3) the prospects for higher nominal interest rates and inflation provides a rebalancing cue to large asset managers that the era of deflationary asset allocation may be ending. Given these factors, it was surprising to see the "cyclical trade" wane, and old Covid era leaders reemerge in April--leadership that remains today. One explanation for the change--a
global industrial slowdown is now underway, as called for the Economic Cycle Research Institute (Global Industrial Production Index chart below). While this slowdown does not necessarily forebode a broader economic downturn and new recession, it implies lower profits for industrial companies and weaker commodity prices until the cycle turns higher. If this call is correct, it will also mean lower inflationary pressures and a continued pause in cyclical outperformance. One key catalyst for a renewed revival in cyclical areas--the
next fiscal spending package. How much will be passed through bi-partisan support, what additional amounts come through reconciliation--and how its paid for--will determine the extent of the economic boost.
Portfolio Implications. With global liquidity waning, profit growth peaking, industrial growth slowing, and historic valuation studies registering
extreme levels, the negative risk/return profile for the market should not be overlooked. For investors with risk-management objectives, portfolios are invested in equities, albeit at lower thresholds, with ample levels of safe haven assets (Treasuries and Cash). Worst-case outcomes for market losses could match historic levels, in the neighborhood of 50%, should a protracted bear market unfold. However, it is also important to acknowledge the most important lesson from the Covid response--policymakers are committed to use all available fiscal and monetary tools (See central bank balance sheet chart below) to stem this kind of market event. We know monetary policy provides support to asset prices. By keeping interest rates 1% (100 basis points) lower than pure market-based levels,
Fidelity's macro strategist estimates 5 P/E points to asset values--that's about 25%, or 1,050 S&P 500 points. And with an increased percentage of retired workers due to Covid, Social Security underfunded and the portfolio allocations of seniors above 65 containing
60-75% in risk assets according to studies, policymakers cannot afford another 2007-2008 like event.