Moderation and a maturing recovery

In short

• With the pandemic entering yet another challenging phase, confidence is likely to take a hit. However, there is little political will to move back into lockdowns in the U.S., economic growth will continue.
• With equities posting stellar returns in 2021, fears of outsized valuations could led to choppiness over the next several months. However, with bond yields still historically low, the appetite for fixed income is likely to remain muted over the coming quarters.
• The U.S. housing market has some fearing that another bust is imminent. However, the recent acceleration in home buying could instead be the beginning of a longer term trend.

The second quarter of 2021 continued the trends of the first quarter, as economic activity –from manufacturing and consumers – accelerated significantly with a return in confidence and a reopening of the services economy globally. While the COVID-19 threat is ever present, the move towards herd immunity appeared to be within our grasp early in the quarter, as vaccinations began in earnest in the developed world and many restrictions were fading into the background. Employment is improving and the supply-demand mismatch is creating higher wages which could boost consumer activity, lower margins, or both. Businesses are coming out of the dark and larger corporations are refocusing their workforce, tech stacks and real estate footprints for the years ahead.

Trouble on the horizon could come in two forms.

One, the Delta variant is hitting the unvaccinated population hard and, as has been documented, spread leads to mutations which can create a much longer tail for the virus. Case counts are rising and it is becoming clear that previously vaccinated individuals will likely need booster shots to maintain immunity. All of this could slow consumer recovery. On the flipside, the drumbeat of inflation, interest rates and the Fed represents the other potential torpedo to the strong returns earned in the equity markets this year. Should the Fed flip to a view that inflation is truly here to stay, tapering will happen faster than anticipated and the rate hikes will come earlier in 2023 rather than later.

Economic data, particularly as it relates to the consumer, picked up steam during the second quarter. Conference Board consumer confidence rose to yet another post-pandemic high, from a revised 120.0 in May to 127.3 in June. This was well ahead of consensus expectations which called for a jump to 119. As evidenced in consumer data, including retail sales, consumers are incredibly confident in their current situation, as this component of the measure rose from 148.7 to 157.7. Even against the backdrop of a COVID-19 case pick up, consumers’ expectations increased from 100.9 to 107.0 in June, a two-month high. July’s reading came in slightly higher than June, at 129.1, as consumers responded that jobs are “plentiful” and the assessment of current business conditions improved to 160.3.

From a consumer perspective, higher prices and a shift to services spending were expected to bring retail sales back down to earth. Instead they came in well above consensus expectations, increasing by +0.6% month-over-month and +18% year-over-year for the month of June.

Leading indicators continue to point to economic growth in the U.S. but the torrid pace of improvement in manufacturing and services may be slowing modestly. This is not necessarily a surprise given that the ISM surveys are generally forward looking by about 12 months. For example, the US ISM non-manufacturing index fell to 60.1 in June from 64 in May, with new export orders, business activity and employment decelerating; imports and backlogs were higher. This is consistent with the decline in the manufacturing survey which fell to 60.6 from 61.2, still marking the thirteenth straight month of expansion. New orders and backlogs were lower, with prices and new export orders higher. In July, the ISM Manufacturing index moderated once again, coming in at 59.5; the decline was attributable to a sharp decline in prices paid and in new orders. Interestingly, while Chinese PMIs are moderating alongside the U.S., PMIs are on the rise in Europe, indicating that the delayed recovery in the euro area could finally be gaining some momentum as lockdowns are finally falling away in the region.

Prices, for their part, are certainly higher, as expected. CPI for June increased +5.4% year-over-year, the largest increase since August 2008, driven by higher used car, housing, food and energy prices. Even core CPI, which strips out the impact of food and energy, was up +4.5% year-over-year, indicating that even if most of the inflation is transitory, there could still be lingering price pressure well after supply chain and demand factors normalize.

The impacts of the pass through of higher prices should be mitigated somewhat by an improving labor market. While April and May brought non-farm payroll disappointments, June non-farm payrolls came in at +850k, well north of the +720k jobs expected as services industries continue to make up a bulk of the jobs added. July’s print was even stronger, as payrolls rose +943k. The unemployment rate fell to 5.4%, with the number of people classified as unemployed falling to 8.7 million. In addition, the May and June prints were revised higher by +31k and +88k respectively. From a demographic perspective, the unemployment rate fell across almost all groups, save teenagers and Asians; from an industry perspective, leisure & hospitality posted the biggest increase, with +380k jobs added in July. Wages were up modestly, but hours worked were essentially unchanged from June, and there was minimal improvement in the number of part-time workers seeking full-time employment. Clearly, the employment situation has improved, but the U.S. economy still has a ways to go to approach the pre-pandemic unemployment rate of 3.5%.

As for market returns in the quarter, as mentioned above, equities continue to post stellar returns. U.S. markets have outperformed through mid-year, with the S&P 500 leading the way in the second quarter, posting an +8.6% return. The index is now up +18% through the end of July. Small cap stocks have performed admirably off the bottom, as is consistent with previous corrections, however, the outperformance has narrowed as of late. In particular, as large cap growth stocks performed well in July on fears of a slowdown in the economic recovery on the back of the Delta variant, capital flowed out of small cap stocks, as well as emerging markets, which were hit hard as the Chinese government ramped up its efforts to reign in private businesses in areas like technology and public education.

Broadly, international and emerging markets names have underperformed year-to-date. However, with the reopening now occurring in Europe and the United Kingdom, it is likely that international developed names will pick up some steam through the back half of the year. Bonds have continued to perform as expected – which is not particularly well – although recent declines in yields as investors become slightly more concerned about COVID-19 could create some near term gains. Real estate and commodities continue to perform well, exhibiting the clear benefits of diversifying into real assets.

In focus: seeking suburbia

The lasting effects of COVID-19 are likely to take years, if not decades to determine and economists and public policy scholars will have the opportunity to create entire courses dedicated to dissecting what we, as a global society, could have done differently during this extraordinary period. One of the potentially lasting positive effects, is the re-acceleration of household formation and more importantly home buying that has occurred during this period in the United States.

Following the dramatic and painful bursting of the housing bubble in 2008 and 2009, the housing market in the U.S. fell out of the narrative as a driving of economic growth. Prices were slow to recover, housing starts failed to recover to annual levels of the early 1990s until 2017, and existing home sales moved sideways from 2013 until 2019. This occurred despite record low interest rates that created opportunities for buyers to lock in homes at levels of affordability which would have been unheard of prior to the housing crisis. However, this was also set against a backdrop of very tight lending standards put in place to mitigate the risks lenders were willing to take on back in 2005, 2006 and 2007 in particular.

The pandemic set the housing market aflame, as demand expanded from core markets such as New York City and San Francisco into secondary and tertiary markets. Renters became would be owners, singles with roommates became couples with dogs, and everyone seemed to want space – overnight. Prices shot higher quickly as supply was unable to meet demand, with all areas of the country experiencing an increase in median selling prices. Housing starts, too, accelerated sharply from their pandemic induced drop, and supply chain disruptions sent lumber prices through the roof. Would-be buyers became frustrated with the lack of inventory, and builders were forced to slow or delay projects due to margin compression and spotty availability of construction materials and finished goods.

As a result, in the first half of the year, the boom appeared to slow, and some have cited a return to more “normal” life coupled with higher prices and lower supply as the cause. Instead, it is likely only a pause. New home supply remains far too low to replace the U.S. housing stock and the shift to later household formation is starting to bear out. Millennials, it turns out, like the suburbs just as much as earlier generations – they just aren’t in as big of a hurry to trade their trucker hats for Little League caps emblazoned with House of Pizza. Moderation of the mania will end up being a positive as it will keep new buyers engaged and ease some of the pricing constraints that builders are facing. Gen Z is ready to have their time in the city sun and will support continued improvement in rents and occupancy in this post-pandemic period. But as Millennials downshift into the suburbs, I can only say – welcome home.

What we’re watching 

While many touted the discovery of effective vaccines as the means to end the COVID-19 pandemic, inconsistent vaccination rates and stronger variants point to a longer tail than originally hoped.

The impact of the Delta variant wave of COVID-19 is not yet fully known. However, it is clear that the approach to this spike will be different than those experienced in 2020. Companies have delayed their return-to-office plans and authorities are taking a localized approach to policies regarding masking and social restrictions. Quantifying the economic impact remains in sharp focus for our team.