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- With the consumer recovery going full steam in the U.S., the expected consequences of stronger growth are evident in economic data releases.
- Equities have been the place to be, and with fears of higher interest rates subsiding modestly, growth stocks could shake off some of the negative sentiment which has clouded the outlook for these names over the last few months.
- Investors have enjoyed strong returns in the equity markets in the first half of the year, and with the third quarter on the horizon, a pause may be in the works – at least, according to history.
The meaningful increase in inflation over the last several months has dominated the narrative in the market, and one would have to look back to 2010 to find a time when there was so much concern about rising inflation. The massive monetary stimulus following the financial crisis thrust inflationary concerns into the spotlight, and the threat of hyperinflation stemming from what appeared to be never ending easy money was difficult to shake for several years. What actually occurred, however, was almost a decade of low rates, low inflation, and most importantly, low growth, as it took years for the U.S. consumer to recover from the loss of wealth resulting from the bursting of the housing bubble.
Contrast that to today, when many U.S. households actually increased their wealth during the 2020 recession, and the federal government has injected meaningful fiscal stimulus into the economy to compound the monetary stimulus provided by the Fed. As a result, economic growth is accelerating and prices for goods are rising as well. While the longer term impacts of these higher prices are not yet known, rising prices resulting from stronger growth represents a more normalized economic situation – and coming from where we were last year, one that should be viewed as a positive.
So where are we seeing these economic improvements? First, let’s focus on businesses. The ISM Services PMI hit yet another record level in the month of May, gains 1.3% to 64 from the prior month, marking the 12th straight monthly increase as all 18 sectors accelerated. In addition, the ISM Manufacturing PMI rose to 61.2, as new orders jumped 2.7% to 67 from April to May. The broad based strength is producing concerns about higher prices for inputs and wages – concerns reflected in comments by survey participants.
CEO confidence, for its part, hit an all-time high in the second quarter of 2021. The measure, which is conducted by the Conference Board on a quarterly basis, rose from 64 to 73 in the first quarter of 2021, and then again to 82 in the second quarter. Most notable was the fact that 94% of CEOs reported better conditions than 6 months prior; this was up from 67%. In addition, there was a modest increase in CEOs who expect economic conditions to improve over the next 6 months; this metric went from 82% in the prior quarter to 88% in the survey. With only 2% of CEOs stating that their business was in worse shape than the prior period, the data appears to support the general consensus that the economy is improving more quickly than anticipated, which is resulting in challenges in finding qualified workers.
As for the consumer, confidence remained close to post-pandemic highs for the month of May, coming in at 117.2 after a very strong 117.5 in April. The survey continues to reflect incredibly strong current consumer sentiment, rising from 131.9 in April to 144.3 in May. However, the expectations index fell under the 100 mark to 99.1, likely as a result of a tick up in inflation concerns. The survey also indicated a sharp improvement in consumers’ assessment of the availability of jobs, which is consistent with anecdotal evidence derived from other reports.
Employment continues to improve as well, although not exactly at the steamy pace that economists have been forecasting. U.S. non-farm payrolls were once again lower than the stated consensus, and way below the whisper number, which was once again in the 1 million job range. The U.S. added +559k jobs for the month of May, less than the +671k expected, but well above the dismal +260k jobs added in April. The unemployment rate fell to 5.8% from 6.1%, led by gains in hospitality, education, and health care, and offset by a slight decline in construction (albeit non-residential). The participation rate ticked down slightly to 61.6%. While the print was certainly much stronger than April, the unemployment rate remains well above its pre-pandemic level, and the Fed is unlikely to find any reason to shift its position for at least this portion of its dual mandate.
As for inflation, prices are moving higher - not a surprise to anyone buying raw materials over the last several months. Core personal consumption expenditures index rose +3.1% year-over-year in April, above the expected increase of +2.9%. While this is below the +4.2% jump in CPI over the same period, the core PCE is the inflation measure that the Fed typically relies on, as it reflects a broader range of goods and services than the CPI. The measure is expected to be pressured higher in the coming months, but the Fed expects that pressure to abate somewhat in the back half of the year. The bond market appears to reflect a similar expectation, as yields have come down over the last month.
One of the areas that has been a bright spot over the last year has been the housing market, but some cracks have appeared as of late. Existing home sales fell for the third straight month in April, dropping -2.7% to an annualized rate of 5.85 million units. The decline in sale volumes is a direct result of lower supply and in turn higher prices, as supply is down to only 1.16 million, or 2.4 months of supply, and prices rose +19.1% year-over-year to a median home price of $341,600. High input prices have impacted housing starts as well, which fell by -9.5% from March to April – further exacerbating the supply issue.
With all that said, the markets posted positive returns for the month of May across the board, as equities still outpaced bonds, but the leadership shifted from U.S. stocks to international and emerging markets names. Commodities continue to be pressured higher by a sharp increase in economic activity, resulting in supply/demand mismatches for inputs. Value continued to trounce growth, led in large part by the sharp increase in interest rates since year end; should that pace slow, growth stocks could perform better in the next couple of months. Bonds, for their part, were essentially flat, with lower quality bonds outperforming higher quality bonds.
In focus: dog days of summer
Historically, I would be writing this letter with one foot out the door, having positioned portfolios for the inevitable “sell in May and go away” trade, and heading out for some much-needed vacation time. When trading was dominated by human intervention, summer tended to offer lower liquidity amidst lower volume, and thus it was important for portfolio managers to adjust their investments ahead of this quiet season. Forced sales over the summer could yield less than ideal outcomes, and therefore it made sense to pull forward this activity into the second quarter. Companies, too, tended to avoid major announcements during July and August, instead waiting for the fall and into the fourth quarter to share details of new initiatives and to update guidance for the next year.
What we have experienced more recently is that market activity, in terms of volume, has been tied more closely to what is happening in the economy rather than reflecting this perceived historical seasonality. The challenge is that the relative lack of news flow from companies has not changed, and as such, there are fewer positive catalysts which can vault a stock’s price higher. Instead, investors tend to focus more on economic data and geopolitical events during the months of July and August, particularly after the bulk of companies have reported their second quarter earnings.
So what has been the impact of this on market returns? The result is clear – the third quarter has been the worst quarter for the S&P 500 on average over the last 30 years, and the numbers are not even close. One could surmise that digesting this information against a quiet corporate backdrop has resulted in more negative than positive assessments of how these factors will impact revenues and earnings in the coming quarters. The other alternative, and one that is more likely, is that investors are attuned to the cycle of mid-year portfolio reassessment, and that the adage of selling in May is actually borne out over the course of May and June as part of this mid-year rebalancing.
One final observation worth noting. Over the last several years, as volumes have increased during the summer months, the trend of underperformance in the third quarter has not played out, at least in U.S. equities. A change in the wind? Perhaps. Either way, the days of lazy summers for most investors are a thing of the past – in a 24/7 world, capital is always in motion and I will be here making sure our clients’ capital is where it needs to be.
What we’re watching
The threat of inflation on corporate earnings and as a catalyst for the Fed to take its foot off the QE gas pedal dominated the narrative through much of the spring.
The underlying data, however, appears to support the notion that the marked increase in the various measures of inflation are indeed transitory. Companies and consumers should anticipate higher prices that come with stronger economic growth, but after a decade of low growth in the U.S. prior to the pandemic, the Fed will be hesitant to put the brakes on too quickly.
Connect with me on Twitter @ShannonSaccocia