ECONOMIC COMMENTARY

Take it to the limit

In short

  • While the economic recovery in the U.S. may prove uneven in the short term, increases in consumer demand will continue to drive strong growth through the rest of the year.
  • Inflation, whether transitory or persistent, is on the rise and stocks, commodities and real estate returns all benefited during the month as a result.
  • With the reopening of the economy picking up steam, some of 2020’s best companies may have lost their shine in the eyes of investors.

One of the biggest challenges for investors and the Fed during the rest of the year is the assessment of the strength of the economic recovery, and the determination that the pressures of a rapid pick-up in growth will lead to outsized inflation. The balancing act of allowing the economy to “run hot” versus the threat of higher prices that turn from transitory to sticky is a real challenge, and the focus on the Fed and its ability to walk this tightrope is warranted. It seems difficult to imagine the world prior to the pandemic, which was marked by concerns of deflation and an inverted yield curve, but now, global investors considering the next several years are wondering where the opportunities and risks will shake out.

In the meantime, there will be plenty of fits and starts along the way. One of the bright spots in the month of April was the leading economic indicators report, which finally jumped into positive territory. All 10 leading indicators were positive for March, up from six out of ten indicators in February, as the six month trailing LEI index is now up +3.8%. The biggest contributors to March’s positive move were the decline in initial jobless claims, the ISM New Orders index, the interest rate spread, and average weekly manufacturing hours.

Creating the foundation for the upswing in the LEI were the ISM Manufacturing and ISM Services surveys, which continue to exhibit the strength of the recovery, even as they softened modestly month-over-month. The ISM Services index for the month of April moderated from the month prior, from 63.7% to 62.7%, but remains close to all-time highs on the back of a meaningful pickup in consumer activity. This marks the 11th straight month of growth for the services economy, coming off of the massive decline in activity last year. Breaking down the report, 17 of 18 industries measured posted gains, and business activity and new orders were particularly strong in entertainment and recreation, as well as wholesale trade. The only industry which softened during the month was agriculture, forestry, fishing & hunting.

On the manufacturing side, the ISM Manufacturing survey for April fell back slightly as well to 60.7% from 64.7% in March. All six of the major industries notched high levels of growth during the month, while prices increased and inventories fell on strong demand. Respondents noted the challenges of filling open positions, a sentiment shared by the services industry; this may point to higher wages across many parts of the economy as we move into the summer months.

With all this momentum, it was hardly surprising that U.S. first quarter GDP was incredibly strong. The economy grew by +6.4% year-over-year in the quarter, and was up +1.6% quarter-over-quarter. Leading the growth were consumer spending and residential investment, and with approximately $4 trillion sitting in savings, the American consumer renaissance may just be getting started. Admittedly, the type of spending may change over the course of the next few quarters, as Americans have been spending more on goods than services during the pandemic period, and that shift may already be occurring. For example, while retail sales for the month of March rose +9.8% month-over-month, well ahead of the +6.1% increase that were expected, sales in April were flat from the month prior. While the moderation from March’s stimulus-fueled jump was not surprising, the slowdown speaks to the fact that the U.S. economy is still very much reliant on stimulus funds, from a monetary and fiscal standpoint.

Evidence of this choppiness was also found in the April non-farm payrolls report. The report indicated non-farm payroll growth was much lower than expected, with economists expecting payrolls to increase by 1 million, and the unemployment rate to fall to 5.8%. Instead, only +266k jobs were added, and the unemployment rate actually increased to 6.1%. The March non-farm payrolls release was revised down as well, from +916k to +770k – further evidence that the Fed is likely to continue its “wait and see” approach.

One area of the U.S. economy that remains hot, perhaps a bit too hot, is the housing market. Home prices rose by +12.0% year-over-year in February, according to the S&P CoreLogic Case-Shiller Index. The year-over-year gain follows gains of +9.5% in November, +10.4% in December, and +11.2% in January. Prices rose in 19 out of 20 cities, with the sharpest increases reported in Phoenix, San Diego, and Seattle. However, higher prices and lower supply are threatening to slow the momentum, and existing home sales in the month of March were also down month-over-month, declining by -3.7% to 6.01 million units. To put these challenges in perspective, supply is -28.2% lower versus March of last year, and low supply will continue to pressure prices higher.

With that said, capital markets continued to move higher in April, although admittedly in the equity space, leadership shifted back to large cap U.S. stocks during the month again. Growth also outperformed value for the month of April, as upward pressure on interest rates eased modestly during the period. In addition, bonds were positive, but only slightly, with riskier high yield issues outperforming safe havens. Assets positively correlated to inflation, namely commodities and real estate, continued their rise – a trend likely to continue in the coming months.

In focus

With the announcement by the Centers for Disease Control that vaccinated Americans can abandon their masks, it is truly beginning to feel like the worst of the global pandemic, at least in the United States, is behind us. Services businesses, in particular restaurants, are struggling to hire employees fast enough to keep up with the sharply rising demand, and the construction boom is creating pockets of steep inflation in inputs such as lumber, as well as a groundswell of opportunity in an industry that was severely hobbled by the 2008-2009 financial crisis. Cyclical areas such as financials, industrials, materials, and energy are performing well, and credit is once again in favor as portfolios shift to a more risk-on posture.

But the turning tide is threatening to leave behind some big boats – namely, some of last year’s darlings. The rapid shift to work-from-home, school-at-home, really everything-at-home allowed companies which offered virtual services to capture the center stage in investors’ portfolios last year – and experienced rapid price appreciation as a result. Now, however, an about face for these companies has occurred, as the combination of very high valuations in a rising interest rate environment along with concerns about the sustainability of their rapid growth have thrust names like Zoom, Teladoc, and Peloton into the recycle bin for many investors.

What is important to keep in mind is that at the height of the pandemic, it was hard to imagine life returning to normal, just as now it is hard for investors to imagine that these companies will play as big a role in our lives over the next 3 years as they have in the last. The answer lies somewhere in the middle. In the case of digitally delivered medicine, for instance, the ability to offer physician and patient flexibility coupled with the greater efficiency of telemedicine has created a foundation for the future of health care – even in a more normalized world. The pandemic has offered consumers a vision of how technology can improve and enhance their lives even further, and it is unlikely that the wheels of change will slow over the next decade. Determining which companies will be able to seize this opportunity and expand on it is more challenging, but should the pressure continue, it might be worth the effort.

What we’re watching

With economic data somewhat uneven, and speculation in areas such as cryptocurrencies demanding attention, the summer could provide some surprises.

The sunset of the first quarter earnings season is now upon us, and without meaningful catalysts to create investor enthusiasm, the markets could drift sideways or even down in the coming weeks. A focus on the long term is warranted, as the opportunities for rebalancing and allocation of new funds are likely to present themselves over this period.

Connect with me on Twitter @ShannonSaccocia

Richard Grasfeder is responsible for economic analysis, portfolio management and strategy, and individual equity analysis. He previously covered the Technology sector and various subsectors in Energy, Industrials, Materials, and Utilities as an Equity Analyst, as well as managed a Technology Sector fund.

Sebastian Leburn has expertise in investment leadership, including portfolio design, strategy and management. Sebastian serves on the firm’s Investment Policy Committee.

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