There was not a lot for investors to complain about in 2Q21, especially when compared to 2Q20. Fueled by rapid progress in vaccinations and re-opening economies, pent-up demand, and continued monetary and fiscal stimulus, consumer sentiment climbed and economic data were broadly positive. This spurred sharp gains in global stock markets, commodities, and real estate. Atypically, bonds were even well-behaved and delivered positive quarterly returns in spite of rising inflation and buoyant economic growth. Markets were seemingly undisturbed by the ongoing debate as to whether recent increases in inflation will be short-lived or not, with most of Wall Street being in the Fed’s “transitory” camp. Investors were also unperturbed by the Fed’s move to a more “hawkish” stance coming out of its recent June meeting (more on both topics later).
According to the Centers for Disease Control, nearly 60% of the U.S. population (ages 18 and over) has been vaccinated (more than 150 million). Aside from the U.K., most developed markets are making slower but steady progress. Japan is an exception. According to the World Health Organization, less than 8% of its population has been vaccinated as it prepares for the Olympics this summer. Japan has faced a shortage of doctors and nurses and, further, has had to import all of its vaccines. Emerging market countries have had mixed success but have generally lagged developed markets.
Consumer demand for goods and services has been robust, spurred by stimulus and months of forced solitude, while supply in some channels has been constrained by labor shortages and other bottlenecks. Real GDP growth in 1Q surged 6.4% (annualized) and some expect growth to exceed 9% in 2Q. The most recent prediction from the Congressional Budget Office was for GDP growth to be 7.4% in 2021, the fastest pace since 1984 and double its forecast of 3.7% issued in February 2021. Under the hood of the headline GDP figure, personal consumption and business investment grew 11.4% and 11.7%.
Manufacturing and services indices remained strong in spite of supply bottlenecks and widespread labor shortages. The July 1 release of the Institute for Supply Management (ISM) Manufacturing Index was 60.6 (above 50 signals expansion) and the prices-paid component jumped to 92.1, the highest since 1979. The Conference Board Consumer Confidence Index reached a 13-month high, and the “jobs gap,” which measures the difference between those indicating that jobs are “easy” versus “hard” to get, reached 43.5%, near an all-time high. Unemployment fell to 5.8% as of the end of May. There are still nearly 10 million people unemployed, yet job openings are at record levels (9.3 million in April according to the Labor Department’s JOLTS report) and labor shortages are widespread. There are a number of theories for this, all of which likely have some element of truth. These range from employees’ fear of returning to the workforce given concerns over the virus, to difficulties finding childcare, to a simple reassessment of priorities (early retirements have accelerated) and quality-of-life considerations (did I really like my job?). Further, continued jobless benefits have likely made the choice possible, though this contributor could be short-lived as federal benefits are slated to expire in September and a number of states have already ended theirs. A mismatch in skill requirements is an issue in some industries as well.
Housing prices have been on a tear. The S&P CoreLogic Case-Shiller U.S. National Home Price Index showed a 14.6% increase over the past year (as of April), the highest reading since data began to be collected more than 30 years ago. Demand for houses has surged throughout the country while inventory has never been lower, and builders have been hampered by high costs and labor shortages. Craig Lazzara, managing director and global head of index investment strategy at S&P DJI, summarized it well, “April’s performance was truly extraordinary…. Housing prices in all 20 cities rose; price gains in all 20 cities accelerated; price gains in all 20 cities were in the top quartile of historical performance. In 15 cities, price gains were in the top decile. Five cities—Charlotte, Cleveland, Dallas, Denver, and Seattle—joined the National Composite in recording their all-time highest 12-month gains.”
The Consumer Price Index (CPI) rose 5.0% over the last 12 months (as of May), exceeding expectations and notching the largest increase since 2008. Core CPI (ex food and energy) was up 3.8% year-over-year, the largest increase since 1992. The Fed’s favored measure, core PCE, climbed 3.9% (3.4% core) for the period, well above its long-term 2% target. While leaving the Fed Funds rate alone at 0.0%-0.25% at its June meeting, the Federal Open Market Committee turned a bit more hawkish. Seven of the 18 committee members see the first hike in 2022 and 13 members expect a hike in 2023. In March, there were four members expecting a 2022 hike and seven expecting a hike in 2023. The Fed also sharply raised its expectation for inflation, measured by the PCE, in 2021 (from 2.4% in March to 3.4%). Asset purchases of $120 billion per month continue, but Chairman Jerome Powell did acknowledge that “tapering” had been a discussion item at the meeting. It would not be a surprise to see asset purchases tempered at some point this year.
A wide-ranging debate around whether inflation increases will be short-lived is ongoing. Supporting arguments for this include:
- Current inflation figures are off of a low pandemic-induced base and thus unsustainable
- Downward price pressures from secular themes such as globalization and an aging workforce will resurface
- Intensity/pace of this economic rebound has created short-term supply-related price pressures that will subside
For those concerned about more stubborn inflation increases, the following points are cited:
- Wage pressures can be expected to climb as workers demand higher compensation
- Price increases have been broad-based (used cars, food, energy, construction, car rentals, airfare, appliances)
- Supply constraints could be longer lasting and lead to “cost-push” inflation
Interestingly, the bond market appears to be unfazed and yields fell steadily throughout the quarter after rising sharply in 1Q. One may wonder what the bond market is seeing that others are missing.
The recent rise in inflation may indeed be transitory, but so may the pace and longevity of the economic recovery. Consumer and investor exuberance may also be transitory, especially when considering base effects (very low one year ago—not so low today!), the potential for the dangerous Delta variant to cause disruption, and a slow-to-heal labor market. On the flipside, inflation increases may prove not to be transitory and rate hikes could be needed sooner than expected. In either scenario, there are a variety of paths that markets could take. Meanwhile, there are few (any?) investment options that can be argued to have “attractive” valuations and thus it is sensible to temper going-forward return expectations. In this vein, it will come as no surprise that Callan continues to advise adherence to a disciplined investment process that includes a well-defined long-term asset allocation policy.