At the midway point of the year, it has clearly been one for the record books, but not always for obvious reasons.
To see how far we have come, it is helpful to see how bad things were when we started. In 2Q 2020, U.S. GDP fell by $2 trillion. The unemployment rate jumped more than 10 points, to 14.7%, the biggest one month increase in the history of the data. Covid cases and Covid-related deaths were soaring in the U.S. and around the world.
But the recovery has been nearly as dramatic. While the big jump in GDP came in last year’s third quarter – up 38% – the economy has continued to expand well above trend, notching back-to-back quarters of 6.4% growth. The unemployment rate fell to 5.8% in May, with 559,000 new jobs added in the month. Investors who stayed the course through the pandemic have been rewarded, nearly doubling their money with the S&P 500 Index up over 96% from last year’s low through the end of June.
As we’ve previously noted, $1 trillion now seems to be the price of entry in the federal government spending sweepstakes. In March, $1.9 trillion in new stimulus spending was approved. As Q2 drew to a close, Congress appeared to be close to agreement on a new infrastructure deal that could weighing in at as much as $2 trillion, including $580 billion in new spending. Finally, the Biden Budget proposal remained before congress, pegged at $6 trillion.
Massive spending, near-zero interest rates, and an economy springing back to life on the back of widespread vaccinations. That, at least, was the first half story and that was enough to propel the S&P 500 to its 32nd new high for the year on June 28. The Nasdaq reached its 18th new high that same day.
While the trend for 1H has been mostly up, there have been a few sharp drops, as the Fed shifted its language around interest rates and the spread of a new Covid variant began to emerge. On June 16, the Fed announced that it would begin to lift rates at the end of 2023, not exactly imminent but earlier than expected sending stocks reeling on the day. That setback turned out to be temporary though, and stocks ended the quarter on the front foot, with the S&P 500 up 14%, the Dow climbing 13%, and the Nasdaq returning 12.6%. Bonds generally went nowhere, with the yield on the 10-year bouncing around from 1.5% to 1.6% before ending the quarter at 1.443%.
As I anticipated in my 2021 outlook, assets have continued to pour into ETFs, new debuts have continued at a healthy pace, and liquidations have slowed. ESG is still top of mind for many managers and investors, and we’re seeing an expansion of new socially responsible strategies, notably in fixed income. Active nontransparent ETFs have also been gaining traction and some large asset managers have made headlines by converting previously existing mutual funds into active ETFs, using the nontransparent approaches now on offer. I expect we’ll see more such conversions in the months to come.
This year’s worries
Covid has not gone away, and the world is currently grappling with a new surge of infections attributed to the Delta variant. Most of these have been among the unvaccinated, but as the Bloomberg vaccination map reminds us, that’s still about half the U.S. population (as of July 21). Globally, the percentage of those vaccinated is much lower. These concerns have weighed on the outlook for the economic recovery going into the second half of the year.
Inflation numbers have been an on again, off again cause for worry, as have market valuations. The rate of inflation went up in 1H as growth accelerated and shortages turned up in the supply chain. The most recent print on the core Personal Consumption Expenditures Price Index (PCE), the Fed’s favorite gauge, had May prices climbing 3.4% year over year, the highest annual rate since 1992.
The semiconductor shortage has made headlines, but for those in the building trades the spike in lumber prices to an all-time high of $1,700 per thousand board feet has been just as worrisome. Houses traded hands at record levels, with the median house price topping $350,000 for the first time in 2Q, potentially suppressing demand. The Bloomberg Commodities Spot Index, which captures the prices of 22 raw materials, was up 78% from its March 2020 low at the end of June. For his part, Federal Reserve chairman Powell has generally professed to be unperturbed by all this, time and again using the word “transitory” to describe the current jump in price levels.
If lumber is a leading indicator, Powell’s view may turn out to be the correct one. Following its historic rise, lumber prices fell sharply, declining to around $800 per thousand board feet. More to the point, the Fed seems to be more closely focused on jobs than price levels and there are still about 8 million fewer of those than before the pandemic. In the most recent statement from the Federal Reserve Open Market Committee (FOMC) Chairman Powell et al confirmed the commitment to keeping interest rates low until “substantial further progress has been made toward the Committee's maximum employment and price stability goals.”
Equity valuations are no doubt high based on historical comparisons. The question before the market is whether or not earnings will grow fast enough to justify these levels. That will become clearer as 2Q earnings continue to roll in.
Is there a next act?
It’s been a good run, but is there a second act? Certainly, the economy appears sound. The Atlanta Fed’s GDP Now series had 2Q GDP coming in at 7.6% as of July 20, down from an earlier forecast of 9.7% but still strong. For the year, the Fed itself projects GDP growth of 7%, up from an earlier estimate of 6.5%. Indicators are generally supportive. The preliminary June Purchasing Managers Index (PMI) came in at 62.1, pointing to continued robust expansion in manufacturing. Other data points are similarly indicative of above trend growth.
As to earnings, the dramatic comparisons are now mostly behind us. The second derivative – the rate of change – is unquestionably slowing. For 2022 and 2023, the Fed is predicting GDP growth of 3.3% and 2.4%, respectively – more like pre-Pandemic experience but a big step down from the current numbers.
Globally, the pace of reopening has been uneven. As a result, economic and market projections carry a higher level of uncertainty than usual, circumstances that could result in an uptick in volatility as we head into 2H. Clearly, there are lots of reasons to be optimistic. Near-term, the expansion seems likely to continue and possibly even accelerate outside the U.S.; as to the transitory nature of inflation, that remains to be seen. A quarter-ending headline in The Wall Street Journal put it this way, “Stock Markets Cruise to Record Highs in First Half, but Investors Grow Uneasy.”
That seems about right.