As we enter the third quarter of the year, the stock market is at new highs, Treasury rates are historically low and the economy is running hot. Shortages, long delivery times, a glut of service workers, and booming demand for nearly everything will make for an interesting summer.
True to form, stocks are at all-time highs because earnings are at all-time highs. When businesses cut back last year, it wasn’t like in a normal recession; they were trying to survive a pandemic of unknown length and severity. They cut workers and reduced inventories at the fastest pace ever. Government stimulus kept things idling while we waited for resolution. We got multiple vaccines sooner than anyone expected and pent-up demand fell on maximally efficient companies. Hence, the fastest earnings recovery in our lifetime.
Companies are still lean, demand is still strong, and earnings continue to be revised upward. The consumer powers this economy, and the consumer has rarely carried more manageable debt levels relative to disposable income—and has simply never been holding more cash—than they do today. In June, the National Retail Foundation raised its outlook yet again; it now expects retail sales to grow 10.5% to 13.5% (that is, $4.44 trillion to $4.56 trillion) year over year. Just this past month, the retail giant Target raised its dividend by a whopping 32%.
As I said, the economy is running hot. We are still in the midst of an unprecedented experiment in both fiscal and monetary policy and the outcome remains impossible to forecast. The possibility that we’ve overstimulated the economy was highlighted this spring by a significant resurgence in inflation. But Fed Chair Powell and Governor Bullard are aware of this risk and have indicated a readiness to act against it. The markets appear to have believed them, as inflation hedges like gold and oil sold off, stocks pulled back modestly, and the yield on the 10-year U.S. Treasury note fell below 1.3%. I try not to read too much into short-term phenomena like these, except to say that the Fed recognizes its credibility is on the line.
The recent jump in inflation can be tied to temporary supply issues that should fade as the economy moves past a volatile reopening period. COVID was a global economic disruption that we’re still working through, so I think inflation will be hot in the near-term at least. We have a lot of catching up to do with demand so far ahead of supply.
But comparing where we are today to the 1970’s—the last time we had sustained, high inflation—is like comparing apples to oranges. For all practical purposes, we were a closed economy then. The amount of business done outside our borders was miniscule. Today, our biggest and best companies operate more globally than they do in the U.S., and global competition puts limits on pricing pressures. We also have different economic leadership. In the 60’s and 70’s, the leading industry was autos, a slow-moving behemoth with intense labor and capital needs. Now we have an enormous tech sector—a deflationary force if ever there was one—which is light on labor and heavy on innovation. Plus we have aging demographics, rising productivity, slower monetary velocity, and plenty of slack in the labor market.
All that to say that secular deflationary forces may win out against cyclical inflation. That certainly seems to be the narrative reflected in the markets today.
As for our approach, we’re still leaning into the reflation trade, with an emphasis on cyclical, value-oriented equity holdings. Earnings growth in these areas should continue to improve as the real economy improves. Value stocks, small caps, REITs, energy and financials have been strong performers year-to-date. It’s important to note that factors, sectors, and styles move in and out of favor, sometimes quickly. Index-level gains don’t always tell the full story of what’s happening in the market.
Looking at the markets and economy today, I find plenty of reasons for optimism. We have accommodative policymakers, incremental stimulus with the expanded child tax credit, inventories being rebuilt, healthy corporate balance sheets, record earnings, low borrowing rates, plenty of slack in the labor market, massive unspent savings, surging numbers of new household and business formations, record household net worth and the lowest debt-to-income levels for consumers in at least a generation. All of which argue for stronger growth down the road.
I’ll close this commentary by saying that the broader market hasn’t experienced a correction of 10% since the recovery started last spring. If history is any guide, we are overdue. It’s common in the earlier stages of a bull market for prices to consolidate and move sideways for some period of time, even while earnings and fundamentals improve. So although the market has risen rapidly and we have some excesses to work off, our long-term conviction for higher stock prices fueled by a global economic recovery remains intact.
If you have any questions or comments, please let us hear from you.
Wishing you all a great summer
Ashley Vice, CFA, CFP®– Portfolio Manager
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