CIO Rob Edel takes an in-depth look at the economic recovery during the pandemic for the second half of 2021 below.
Highlights this Month
- Returns in equities and commodities show the economy is strong, but a few things are unsettling.
- The Fed will let the economy run hotter in hopes inflation will exceed their target.
- Supply-demand imbalances have led to prices increasing well above pre-pandemic levels.
- The Delta variant is proving to be a more formidable foe.
- The pandemic has amplified inequality.
- Taking recent market returns and projecting them into the future long-term is unrealistic.
June in Review
Independence Day in the US, and Canada Day north of the border are opportunities to celebrate the founding of our respective countries. For the markets, it also marks the end of the second quarter and brings trading to a close for the first half of 2021. A perfect opportunity to reflect on what has transpired over the last six months, including the pandemic, and what to expect for the rest of the year.
For the equity markets, we are left with many fond memories, with the S&P/TSX having its best six-month start to the year since the Financial Crisis. For US markets, other than 2019 when the S&P 500 gained 18.5%, it’s been the best start since 1998.
This is compared to Bonds, which with the exception of high yield, are in the red year to date. However, the second half of 2021 is going to be more challenging. Markets are expensive with most of the good news already discounted in the markets. Timing a correction is exceedingly difficult, however, and will be heavily dependent on the Fed, inflation, fiscal policy, and maybe even the pandemic.
This month we will look at the market action year to date in more detail before exploring what matters for markets, the inflation outlook and how the Federal Reserve may react to it. We end the commentary with a bit of a reality check, and maybe a hint of a rant, about future returns, and the difficulty in forecasting in today’s uncertain environment.
For the second quarter, Canadian equities more than held their own.
Last month was another fine month for stock investors, with the S&P/TSX up 2.2% (C$ terms) and the S&P 500 +2.3% (US$ terms). Because the Canadian dollar declined against the greenback last month, the S&P/TSX translated into US$ terms (what a US investor would have returned on their S&P/TSX Canadian equity investment) was actually down 0.3%. For the second quarter, Canadian equities more than held their own. In local currency terms (C$), the S&P/TSX gained 8.5%, but in US$ terms returned just under 10% versus +8.5% for the S&P 500. Only Brazil and Latin American stocks did better. It was much the same for the first six months of the year.
The S&P/TSX led the way gaining 20.7% in US$ terms and 17.3% in local currency (C$), while the S&P gained a respectable, but lower, 15.2%. Globally, Canadian large-cap equities were the top performers in the first half of 2021, compared to other equity markets. Commodities provided the best overall returns, with the CRB index up 27% year to date. WTI oil gained 51%, while Natural Gas was up 44% and Copper up 22%.
Returns in equities and commodities show the economy is strong, but a few things are unsettling.
Returns in equities and commodities are conveying that the economy is strong, and growth continues to recover. Even compared to the rally of the 1982 and 2009 bear market lows, the current bull market is impressive in its duration and magnitude. And yet, reading between the lines, there are aspects of this rally we find a little unsettling, especially last month.
First, as growth accelerates, it would be expected that value stocks should outperform growth stocks, which up until last month was the case. In June, however, growth stocks regained their leadership over the more cyclically biased value stocks. The Nasdaq, which has an abundance of growth and tech exposure, had been losing ground against the more economically sensitive Dow but regained its leadership position in June after outperforming the Dow over the past couple of months.
Also falling behind were inflation-proxy stocks, which tend to outperform when inflation moves higher, and the re-opening stocks, namely hotels and airlines. Nonetheless, investor’s lack of interest in the re-opening and reflation trades didn’t mean they were becoming more defensive. The Consumer Staple and Utilities sectors have failed to gain much attention for months. As pointed out by Strategas, Consumer Staples (think household products) have underperformed Consumer Discretionary (think retailers), while Utilities have continued to lose ground relative to the S&P 500.
The market action in Utilities is particularly interesting given what bond yields have been doing. 10-year US Treasury yields fell 13 basis points in June and 27 basis points during the second quarter, flattening the yield curve. The resulting decline in yields also pushed real rates further into negative territory, with 10-year inflation-adjusted yields approaching minus 1% in early July. The safe and consistent dividends that Utilities pay are generally considered a good bond alternative, with positive real dividend yields, but investors haven’t been interested in what Utility companies have been selling. The decline in yields can perhaps be explained by signs that economic growth may have peaked and this is as good as it gets.
According to the Citi Economic Surprise index, for the first time in a year, US economic data is no longer surprising to the upside. The June ISM Services index declined to 60.1 versus 64.0 in June, still well above 50 and thus indicative of an expanding services industry, but lower than expected, with a negative rate of change. While we concede the second derivative of growth may indeed be declining, growth is still positive, and we believe the re-opening trade has further to run.
Monetary Policy and Inflation will continue to drive the markets.
According to a recent RBC poll of institutional investors, slowing growth is not something that keeps them up at night or even makes them nervous. In fact, you have to go pretty far down the list before anything related to economic growth, like jobs or consumer confidence, is mentioned. The top two risks or worries given are Monetary Policy and Inflation. Not only do we agree with this, but we believe this was driving the markets last month, and last quarter, and will be the major driver until a clearer path for inflation and monetary policy are determined.
The Fed will let the economy run hotter in hopes inflation will exceed their target.
Regarding monetary policy, the Federal Reserve took its first step towards tightening last month by signalling that they were considering thinking about tapering their $120 billion a month bond and mortgage buying program. Remember, in the first step of the tightening process, they start thinking about tapering (which they have now done), then they officially talk about it, announce a date, actually start tapering, before finally raising rates.
Goldman still believes a formal tapering announcement won’t happen until December and the actual tapering process will take all of 2022 to unwind before any rate hikes happen in 2023. Perhaps the bigger news was the shift in the infamous Fed dot plot, whereby each dot signifies where an FOMC member expects rates to be in the future. Prior to the June meeting, it was expected rates would be unchanged through 2023. After the June meeting, the median dot plot now indicates two rate hikes by the end of 2023.
The Fed has firmly maintained they will let the economy run hotter in hopes inflation will exceed their 2% target to compensate for the extended time it has been below target. The market’s interpretation of the Fed’s new guidance is they are perhaps getting cold feet given that their assessment of inflation risks might have shifted materially higher over the past few meetings.
The flattening of the yield curve has proved more durable.
The market’s initial reaction to the shift in the Fed’s view was to sell equities and inflation-protected Treasury notes. If rates were going higher, the discount factor in which future cash flows are valued increases, thus lowering the value of equities. As for inflation-protected notes, if the Fed starts taking the inflation risk seriously by tightening monetary policy, there would be less need for them.
Less demand means lower prices, which results in lower breakeven inflation rates. The impact of both proved fleeting, however, with both the S&P 500 and 5-year breakeven rates back to where they were, previous to the Fed news, in under a week. While it could be concluded that the reaction of stocks and breakeven rates was an over-reaction by the market, the flattening of the yield curve has proved more durable.
Although it might seem counterintuitive that tapering would lead to a flatter yield curve, it is consistent with past central bank tapering and likely a result of the market’s expectation of slower future growth and inflation. Still, it appears the market is jumping the gun a little this time given no definitive tapering announcement has even been given yet. The Fed’s still just thinking about it.
Supply-demand imbalances have led to prices increasing well above pre-pandemic levels.
What’s likely going to make up their mind is the future path of inflation. The Fed maintains the present inflationary pressures are transitory, but their conviction now appears less resolute. From a supply-demand perspective, imbalances have led to prices increasing well above pre-pandemic levels, pushing Core PCE inflation above the Fed’s comfort zone. Though according to Goldman Sachs, the impact from these supply-constrained categories, which they estimate at over 1% presently, should dissipate over the next year or so. By the end of 2022, Goldman estimates the contribution of these categories to inflation will shift to -0.5%.
Unfortunately for the Fed, the inflation story doesn’t end there. According to the trimmed-mean inflation rate, which excludes the top and bottom 8% of extreme price moves, inflation is still nearly 5%. Also, the Atlanta Fed’s sticky price inflation index, which measures a basket of items that change price relatively slowly, has started to move higher. If higher inflation is due to a select group of goods being bid higher due to supply constraints, the transitory argument makes sense. If inflation starts bleeding into a broader group of categories, it becomes harder for the Fed to ignore.
Housing is also a potential catalyst for higher future inflation. Housing is a large component of CPI but is not based on the change in house prices, which have been very strong, yet rather on what is termed “owner’s equivalent rent”, namely the rate homeowners believe they could rent their house. While owner’s equivalent rent has been trending down, over the longer term it tracks house prices and thus could cause CPI to increase in the future as rents catch up to house prices.
For the time being, the market appears to be buying into the Fed’s transitory argument that inflation won’t cannonball the economy. According to a Bank of America Fund Manager Survey, 72% of investors believe the Fed that inflation will be transitory versus permanent.
Influencing investor’s views has been the commodity market.
After strong moves earlier in the year, commodity prices have started to correct, with copper, corn and lumber all coming off their highs. Still, copper is up over 22% year to date and lumber is up over 100% from its pandemic low of last year. Oil, which has probably the biggest impact on inflation, has continued to push higher.
There remains a mystifying mismatch in the pandemic between workers looking for a job and job openings, with an abundance of both.
Wages are likely to be the largest determinant of whether inflation pressures are indeed transitory, and as with many aspects of the current economy, the status of the job market is in flux. There remains a mystifying mismatch between workers looking for a job and job openings, with an abundance of both. Despite adding 850,000 jobs last month, the US economy is still short 6.8 million positions versus February 2020 and the unemployment rate of 5.8% is well above its pre-pandemic level of 3.5%.
Employers, however, are finding it hard to hire workers, and at 6%, the job opening rate is the highest it’s been in decades. More workers are also quitting, with 3.95 million people, or 2.7% of total employment, voluntarily leaving their jobs in April. Some have retired and are likely never coming back. According to the Dallas Fed, an estimated 1.5 million more workers than would normally be expected retired during the pandemic.
The retail, leisure, and hospitality industries are seeing the highest quit rates. This fact is not surprising given they are also low-paying and the industries hit the hardest by the pandemic lockdowns. Rather than go back to their jobs, many are deciding to choose another career, despite being enticed with higher wages from employers desperate for workers. Generous unemployment benefits, however, have afforded workers the luxury of being choosy, but with the remaining 70% of these benefits set to expire by early September, power could shift back to employers.
According to the Labor Department, States that ended supplemental unemployment benefits early saw lower jobless rates in May than those planning to end benefits in September. There is undeniably some friction in the labour market, but we’ll need to wait a few more months to see whether that friction will result in a meaningful and lasting increase in wage growth and inflation.
The Delta variant is proving to be a more formidable foe.
Apart from inflation, the pandemic also remains a consideration for the Fed, particularly with the more infectious Delta variant gaining dominance globally. Markets have largely been ignoring the pandemic since the success of the vaccine rollout increased visibility around the re-opening of the economy and removed much of the left tail risk from market forecasts.
The Delta variant, however, is proving to be a more formidable foe. Estimated to be 40% to 80% (let’s call it 60%) more transmissible than the Alpha variant, which itself is believed to be 50% more transmissible than the original COVID-19 virus, Delta is spreading rapidly throughout many economies globally. Bernstein estimates that the Delta variant is now 25% of all new COVID cases globally, and growing. A higher infection rate means a larger percentage of the population will need to become immune, either through prior infection or vaccination, to reach herd immunity. Goldman Sachs, in fact, recently raised their herd immunity bar to 85% of the population.
Rising new COVID-19 cases in the United Kingdom, a leader in vaccinations, has validated concerns that the Delta variants could slow re-opening plans and lower economic growth forecasts. Although the key is that while new cases have ramped higher, hospitalizations and fatalities have not.
Vaccine efficacy varies, but in general two doses of a vaccine are still believed to be highly effective against the Delta variant. Using the Pfizer/BioNTech vaccine as an example, one dose provides just over 30% protection against symptomatic infection, while two doses boost efficacy, depending on the study, to between 60% to 80%. Protection against hospitalization is closer to 90%.
Controlling hospitalization levels has always been the key motivation to lockdowns, not new cases. Concern that the pandemic would overload the healthcare system was the driver behind draconian lockdown measures, and according to Goldman Sachs, the Delta variant poses a manageable risk to hospitals in countries with high vaccination rates. Using the UK and Israel as an example, consumer mobility might edge down slightly, but the government won’t impose more lockdowns if hospitalization rates remain under control.
Canada is leading the world in vaccinations during the pandemic, the US? Not so much.
Canada is leading the world in terms of administering first doses and quickly gaining ground in terms of fully vaccinating our population. We are slightly more concerned about the US. According to Bloomberg, as of June 22, 482 US counties had fully vaccinated less than 25% of their population. Fortunately, even in US states with low vaccination rates, the more vulnerable elderly population is much more protected.
In England, most Delta outbreaks have been concentrated amongst the younger unvaccinated population, and while they might get sick, they are less like to need hospital care. Studies have shown the Delta variant is more infectious, but there is no conclusive evidence it makes you sicker. What the Delta variant can do to younger people, is motivate them to get vaccinated during the pandemic, which is what has been happening in Portugal, Israel, and the US.
The pandemic has amplified inequality.
One of the negative longer-term legacies of the pandemic is it has accelerated one of the most important issues confronting developed economies, the growing gap between the haves and have nots. The pandemic has made inequality even worse, as most job losses were in lower-paying professions, and the rally we have seen in investment markets has benefited the rich more than the poor.
Typically, a recession brings lower investment returns, but S&P 500 returns one year after the start of the COVID-19 recession are up nearly 30%. Who holds most of the financial assets that are benefitting? The top 20% of income earners, of course, due to their larger exposure to equities, real estate, and pension.
A feeling amongst the public that everyone is making money but them.
Strong returns are starting to draw in smaller investors, with retail trading as a share of total US equity volume in Q1 2021 reaching 24% and cumulative daily equity ETF flows reaching record levels, despite it being only early July!
As highlighted on the cover of a recent issue of Bloomberg Businessweek, there is a feeling amongst the public that everyone is making money but them, which isn’t surprising, given the plethora of assets that appear to be soaring in price. According to a recent Natixis Investment Management survey of 750 US individual investors, the average after-inflation return they expect to earn this year is 17.3%. Not unreasonable given the S&P 500 is up nearly that much so far this year and was up more than that last year.
Investors participating in the Natixis survey, however, expect an even higher 17.5% return longer term, which is extraordinarily rich given after inflation returns since 1926 have averaged only 7.1% according to Morningstar. Investors might be getting a little greedy, given the same survey in 2019 showed investor expectations of only 10.9%.
Taking recent market returns and projecting them into the future long-term is unrealistic.
Investors don’t lack confidence, but they may lack some common sense and perspective. According to YouGov, 6% of Americans believe they could beat a grizzly bear in a fight, bare-handed (pardon the pun), without any weaponry. A grizzly bear! It puts the 17.5% long-term investment return projection in perspective. Yes, Leonardo DiCaprio out-duelled a Grizzly in the Revenant, but he had a knife, and it was just a movie. The average investor has no chance against a grizzly and has no chance of attaining a 17.5% real long-term return. Taking recent market returns and projecting them into the future long-term is unrealistic.
For one, there are just too many unforecastable variables surrounding the post-pandemic world. How quickly will consumer behaviour revert to its pre-pandemic norms, if at all? For the markets, three unknowns we believe are key include: inflation, monetary policy, and the growing influence of fiscal policy. Low bond yields appear to signal markets are trusting central banks that inflation will be transitory and controllable. The problem with this is that central banks like the Federal Reserve are not static, their members or constituents change, as do their policies. We have no idea how they will deal with inflation in the future. Many believe fiscal policy and the potential to drive economic growth beyond full capacity is what will eventually cause inflationary expectations to rise and inflation not to be transitory.
Fiscal policy is set to become a headwind to GDP growth next year.
According to JP Morgan, fiscal policy is set to become a headwind to GDP growth next year, even if the Democrats pass their $4 trillion 10-year infrastructure and social spending package. It’s just math, $2 trillion being spent in the short term has a greater impact than $4 trillion spent over a longer 10-year period. It’s still a lot of money, however, and should help economic growth. The question is how much? There are a lot of moving parts to analyze when forecasting what happens in Washington, and the magnitude and impact of spending is challenging, especially with mid-term elections in 2022.
Next comes the question of how to pay for it. We will likely see some tax increases but continued support from the Fed in keeping interest rates low and inflation high will be essential. It all comes down to policy decisions, which are very hard to forecast, especially longer-term.
We tip our hats to US officials commenting on recently de-classified UFO reports, admitting they had no idea what they were and that the aerial phenomena defied worldly explanations. Some days we feel the same about the markets. We are not sure what those objects are in the sky, and we struggle to understand why 10-year bond yields keep falling. What we are more certain about is that we don’t want anything to do with any grizzlies, and after-inflation long-term investment returns won’t be 17.5%.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities’ commissions.