by William Henderson, Vice President / Head of Investments
With second quarter earnings season well under way, last week saw a slight retreat in all three major indexes as stocks sold off a bit from their previous highs. The Dow Jones Industrial Average fell (-0.5%), the S&P 500 Index lost (-1.0%) and the NASDAQ sold off by (-1.9%).  Regardless of last week’s modest sell off, year-to-date returns remain strong across all three indexes.  Year-to-date, the Dow Jones Industrial Average has returned +14.5%, the S&P 500 Index +16.1% and the NASDAQ +12.3%; representing a broad rally across industries and sectors. Bonds continued to be torn between inflation-related news and Federal Reserve Chairman Powell’s commitment to keeping rates lower for longer. Confounding bond bears, yield on the 10-Year U.S. Treasury dropped an additional nine basis points last week to close at 1.25%, a full 49 basis points lower than the 1.74% yield level hit in March of this year. 

Inflation news was all the rage last week when a monthly measure of U.S. consumer prices rose at the fastest pace since 2008. June’s Consumer Price Index rose 5.4% from the same period a year earlier, which surprised most economists who expected the recent spike in inflation to begin to moderate. (See chart below from the Federal Reserve Bank of St. Louis.) 

While the spike in inflation was much larger than expected, breaking down the results revealed that about 1/3 of the increase was due to increases in used-car prices. Inflationary pressures were certainly broadly felt by consumers elsewhere, as food prices increased 0.8% in June and gasoline prices rose by 2.5%. In his report to a U.S. Congressional Panel, Powell repeatedly stated two things: 1) He would not hesitate to raise interest rates if needed to control runaway inflation; and 2) He expects consumer prices to ease later this year. However, Powell firmly believes significant progress in terms of employment and inflation is still needed before short-term interest rates are increased.   

Wall Street analysts are expecting strong earnings results from companies focused on technology, materials, and healthcare as final 2Q results are announced.  Looking beyond 2Q, companies will have to deal with increases in prices of materials and labor and this could certainly impact earnings, especially in firms where their ability to pass on costs to consumers is limited. Conversely, we have seen some modest price declines in materials like copper and lumber. The overall supply/demand mismatch is abating and these factors will assist companies going forward.   

The moves in U.S. Treasury Bond prices as noted above with the 10-year note falling to 1.25% seem to harken back to the early trading patterns when the pandemic first struck in 2020. Surging cases of the new Delta variant of the COVID-19 virus in many parts of the world, including highly vaccinated countries such as the U.K., could be prompting a flight to quality by investors. Lastly, any impediment to a continued re-opening of the global economy will impact future economic growth and concomitant earnings results for equities. Concerns abound and markets are a tricky business. Modest pull backs in equity markets like last weeks and even larger corrections in bull markets are healthy and expected. Equity prices never go straight up, they go up and down and up; generally going from the lower left of a chart to the upper right. Keep focused on long-term trends and a Federal Reserve that is committed to a healthy recovery.

With the first half of 2021 well behind us, the second half started as simply more of the same thing. We saw positive returns across all three market indexes despite concerns about COVID variants and global growth. The Dow Jones Industrial Average rose by +0.7% last week and the S&P 500 Index and the NASDAQ both increased by +1.2%. Solid weekly gains in all three indexes allowed new highs across the board and set up very strong year-to-date gains as well. Year-to-date, the Dow Jones Industrial Average has returned +15.1%, the S&P 500 Index +17.2% and the NASDAQ +14.5%. Further, the earlier rotation between value and growth has abated as markets overall have converged upon similarly strong gains thus far in 2021. Bonds continued to be well bid and the yield on the 10-year U.S. Treasury dropped 10 basis points last week to close at 1.34%, a full 40 basis points lower than the 1.74% yield level hit in March of this year.   

While the labor markets continue to show solid improvement, the pace of job gains has slowed a bit and last week we saw a bit of that slowness in the slight uptick the weekly jobless claims number released by the U.S. Department of Labor Department (see chart below).    

Further, while the unemployment rate continues to fall from a pandemic high of 14.8% in April 2020 to the current 5.9%, a supply of and demand for labor mismatch exists (see chart below from the U.S. Department of Labor).   

One theory around this supply/demand mismatch is that during the pandemic we saw large scale demographic shifts in population as people moved residences; potentially due to COVID-19 reasons, work-from-home flexibility in family employment or simply the need to seek varied employment elsewhere. Regardless of the reasons, we may see an imbalance in worker demand and worker supply for some time and this economic oddity could weigh on the markets for a while. However, recall the Federal Reserve has been consistent in its message about two measures before they raise interest rates: the unemployment rate and inflation. We have seen inflation, transitory or not, in recent CPI numbers, but we have not seen unemployment at or near their target level of 4%, so watch for interest rates to remain low for longer, just as Chairman Jay Powell has stated repeatedly.

As the second half of 2021 unfolds, watch for labor to regain some strength as unemployment benefits begin to expire and workers return to work. With this acceleration in job growth, the unemployment rate will fall.  As we have mentioned frequently, the consumer remains in excellent financial shape with savings rates near recent extremely high levels (see chart below from the Federal Reserve Bank of St. Louis).   

Falling unemployment rates, financially healthy consumers and a cooperative Fed point to a strong economic expansion well into 2022 and certainly for the remainder of 2021. Like all economic indicators, concerns abound and can be impactful such as the emergence of a powerful COVID variant or unseen global unrest. We believe that the Federal Reserve will continue to back-stop the economy especially given an unforeseen global event. 

View/Download PDF version of Q2 Commentary (or read text below)

Stocks
Each of the three major U.S. equity indices – the Dow, S&P 500, and Nasdaq – were up between 12.5-14.4% through 2021’s first six months. The Dow had a quick start to the year while the tech-heavy Nasdaq lagged, but at this point, the performance disparity between any of three indices is immaterial, illustrating the breadth of the market rally.

Generally speaking, companies in the Nasdaq are more rapidly growing but less profitable today. For companies who have the bulk of their profits in the distant future – companies disproportionately located in the Nasdaq – rising interest rates are relatively harmful. This is because all corporate profits must be discounted to the present to derive a company valuation; profits further out are discounted more. By contrast, companies in the Dow are predominantly harvesting their profits in the present moment; thus, they are more immune to rate changes. Interest rates rose sharply to begin the year; as a result of the dynamic just described, this negatively impacted Nasdaq constituents more severely than companies in the Dow. However, rates stabilized – and have even declined – over the past couple of months, during which time the Nasdaq made up ground on its counterpart indices.

Bonds
Interest rates nearly doubled during Q1, as the 10-year treasury bond increased from approximately 0.90% to greater than 1.70% in the three-month span. Bond prices fall as rates rise; thus, major bond indices declined in Q1. In Q2, however, the 10-year fell to a range between 1.40-1.50% by period-end, and bonds were buoyed to end the first half.

The rate environment must be considered both in the context of historical precedents and current inflation expectations. On the former, rates remain extremely low, as the 10-year treasury generally hovered between 4-5% prior to the Great Financial Crisis and its subsequent monetary stimulus. Low rates facilitate economic activity, as consumers and businesses alike are incented to borrow money, spend on goods and services and invest in growth initiatives.

On the other hand, central banks are averse to inflation. Their means of obstructing this insidious force is hiking interest rates. Inflation simply refers to higher prices of goods and services. Prices are driven by supply and demand. Higher rates work to offset demand for goods and services because they encourage consumers to save their money rather than spend it.

The Federal Reserve – the U.S. central bank – holds a long-term inflation target of 2%; however, Jay Powell, Fed Chairman, has stated that he is willing to let run inflation run above this target over the short and medium term in order to facilitate economic growth. In April, inflation was 4.5%, its highest figure in some time; the figure decelerated to 3.5% in May. Chairman Powell believes that the high inflation numbers are the result of pent-up demand being unleashed on a globally constrained supply chain. Powell forecasts that inflation will moderate further over the coming months as supply chain bottlenecks resolve.

Outlook
Historically, strong first-halves in the equity markets portend strong second-halves; per Refinitiv, in every year since 1950 in which the S&P and Dow were up double-digits to start the year, they were positive in the final six months. Economic indicators also suggest a healthy second half of 2021 is forthcoming. The unemployment rate is well within normal range, sitting just below 6%, while the housing economy – represented by home prices and remodeling & renovation activity – is in its strongest condition since the Great Financial Crisis. Crude oil is priced at $75 – a three-year high – as the appetite for travel and mobility are surging. As a result of these trends and more, the International Monetary Fund has increased its projection for U.S. 2021 GDP growth from 4.6% to 7%; should the forecast come to fruition, it would represent one of the strongest years on record.

If there is a risk to the economy – and therefore, possibly the markets – over the coming six months, it is that of overheating. At present, the market is expecting the Fed to hike rates twice in 2023. However, if inflation persists – contrary to Chairman Powell’s forecasts – the U.S. central bank may be forced to take hastier action. Nevertheless, modestly higher rates are unlikely to unhinge the financial markets so long as economic growth remains strong.