Markets and Economy Summer 2021

Market Update:
The S&P 500 is in Bull market pattern with the index’s cumulative advance/decline line showing broad market participation confirming it is uptrend. There are more gains ahead as market breadth at the sector level is far from overbought.

Market trading as if inflation is transitory. TIPS Break even yields are way off their March highs, and economic growth is expected to remain strong but decelerate somewhat in coming quarters. I expect Fed to hike sooner than Fed officials say. The FOMC most likely will announce tapering plans as early at the August Jackson Hole meeting. Futures market pricing in a hike in October 2022 sooner than Fed “Dots”.

History shows that stock returns remain robust in the months leading up to and following the first-rate hike. More specifically, over the past four rate hike cycles the S&P 500 gained 9.5% in the twelve months prior to the first hike, and 26.0% over the subsequent 3 years. The real damage from higher rates tends to occur later in the cycle when tighter policy inverts the curve.

With the percentage of the U.S. population having been vaccinated approaching herd immunity, investors have been predicting an explosive reopening of domestic economic activity. The initial rebound has past but the ongoing recovery still has legs. Expectations have been high for such measures as retail sales and industrial production. Bank of America CEO Brian Moynihan says consumer spending is 20% higher this year than 2019. In the past 24 months, total retail sales are up 10% per year, on average, versus a 3.6% growth rate from 2014-2019, supporting the case for strong economic growth, and further earnings growth.

The market’s upside has been driven by earnings (EPS), while multiples have been flat. The earnings recovery continues to set records for both strength and speed. S&P 500 companies have beaten consensus estimates at highest beat rates on record. 2021 consensus EPS continues to drift higher, as analysts underestimate the impact of fiscal and monetary stimulus, and the reopening process. Economic growth and consumer spending should boost corporate earnings over next 12 months. Every 1% increase in nominal GDP drives 3% increase in S&P 500 revenues. Economic forecasts imply higher revenue growth than analysts’ project.

Second quarter is also peak acceleration for earnings growth. The market needs to hear that companies are raising their forward guidance to avoid a sell-off this earning’s season. Over the long run, the stock market depends on earnings growth. Even though earnings growth rate peaks this quarter, earnings are projected to continue to grow by 12% in 2022 - 5% greater than the long-term average earnings growth.
S&P 500 valuation peaked last September and is declining as earnings set new records. Valuations are historically rich; however, ultra-low yields support richer valuations. When Fed starts hiking rates valuations will matter.

Where will the market likely go from here? Strong first halves for the stock market historically bode well for the remainder of the year. Whenever there has been a double-digit gain in the first half, the S&P 500 have never ended that year with an annual decline, according to Refinitiv data going back to 1950. What is more, the S&P 500 is up more than 12.5% to start the year, the second half has a median gain of 9.7%, according to LPL Financial data going back to the 1950s.

The third quarter is typically the weakest quarter for the markets. Big draw downs are most likely during the months of August and September. The stock market has been experiencing ongoing rolling corrections among its sectors which may help avert a full market correction anytime soon. Based on seasonal weakness, and markets progress so far, and valuations, I think the stock market is likely to hit a high in July and consolidate for the rest of the quarter.

Economic Update:

The International Monetary Fund expects the world economy to grow by 6%, and the United States set to expand by 6.6% in 2021. The U.S. economy is expected to grow at the fastest pace in nearly four decades this year. U.S. economic growth is projected to grow at 4.3% for 2022, above trend line expansionary growth, according to TD Economics.

The global composite PMI, a timely proxy for global GDP growth, has peaked and receded. Yet the latest reading is historically consistent with 6.5% annual global real GDP growth. I expect growth to continue to remain above trend line as pent-up demand is unleashed, before leveling off in the new year. The OECD U.S. Composite Leading Indicator points to continued recovery ahead, it also suggests that the pace of the rebound will likely moderate, as fiscal stimulus wanes while demand/supply imbalances take longer to work out.

The Conference Board’s Leading Economic Index point to continued fast growth in the US. Lagging, Coincident, and leading indicators are consistent with strong growth, and suggest continued fast economic expansion in 2H 2021.

The ISM Manufacturing PMI pulled back in June. While this is off its peak in March, it is still near its highest level since February 2018, and consistent with above-trend growth in manufacturing output. The ISM estimates that the latest PMI corresponds to 5.0% real GDP annualized growth, which is more than double the pace in 2019, before the pandemic struck. Most economic indicators show slowing but still growth ahead the above trend line that historically supported above average earnings growth.

I think the recent decline in bond yields is signaling that the inflation burst is transitory, and that the Delta variant will temporarily slow global growth. I think bond yields are not a reliable signal because of automatic bond purchases by the Fed, Foreigners, and Pension funds are not an economic bet. I think the most recent decline in yields is due to technical issues related to liquidity and forced buying. A dramatic softening in economic activity is not what bond market is signaling. Credit market spreads, a more reliable economic signal then Ten-Years Treasury yield, supports my view.

The unemployment rate unexpectedly rose to 5.9% in June. The current unemployment rate suggest that the recovery still had a long way to go. Job growth in June rose as businesses looked to keep up with a rapidly recovering economy -- which is a positive sign for the second half and the recovery -- but not so much that it would trigger an accelerated timeline for the Federal Reserve to start tapering.

The U.S. has a record number of jobs available—over 9 million. People are earning more staying home than if they go back to work. With this many jobs open, unemployment rate should be below 5%. Moreover, layoffs are at record lows! Fed Chair says strong job creation coming this Fall. The end to extra unemployment benefits could boost employment by two million workers according to Jeffries research. School re-openings will help people on unemployment return to work. Unemployment rate should decline further putting more pressure on the Fed to start tapering sooner.

Inflation is everywhere: commodities, housing, wages, energy, etc. Fed’s best inflation gauge, Core PCE, is way above its 2% goal at 6.6% YOY! Headline inflation is up 5.4% year-over-year. The biggest gain since August 2008. Inflation seems to have peaked in March but will remain elevated as long there are shortages and rising wages. Wages were up 3.6% year over year. Wage inflation tends to stick. It cannot be taken back. The percentage of businesses reporting inflation as the biggest problem surged to the highest level in over a decade in June’s NFIB survey. Besides wage pressures, if velocity of money increases this Fall, a lot more money being lent and spent, then inflation pressure will persist.

President Biden agreed to a bipartisan framework for an infrastructure that will not increase country’s debt and taxes and at last address the country’s aging infrastructure. The infrastructure plan seeks to improve the nation’s roads, bridges, and broadband. The framework will include $579 billion in new spending. If the Progressives in Congress do not vote for it then there may not be any infrastructure spending any time soon.

Next year, Fiscal and Monetary policy which is a tailwind for the U.S. economy and stock market will turn into a headwind.