Q2 Market Commentary
The second quarter under the Biden administration saw the economy continue to recover as vaccination rates continue toward an aspirational rate of getting at least 1 dose of coronavirus vaccine to 70 percent of adults by July 4th. With the Q1 passing of the $1.9 Trillion-dollar COVID bill, growth in U.S. government spending has now been met by GDP growth such that the Total Public Debt to GDP ratio has stabilized at 127% coming off a high of 135% reached in April 2020.
The most recent Federal Open Market Committee 2-day policy meeting brought a change in their interest rate policy language and median projection as officials see lifting their benchmark rate to .6% from near 0% by the end of 2023. In March, the Federal Reserve vowed to keep interest rates low through 2023. The Federal Reserve also discussed an eventual reduction, or tapering, of the central bank’s bond buying program but the timing of such a move remains uncertain according to Chairman Powell. Our feeling is that the hawkish tone in the most recent fed speak is an acknowledgement that the fed is surprised by the amount of inflation creeping into the economy, but they are willing to get in front of it with early action to keep inflation from embedding north of 2% longer term. This remains bullish for equities and the massive fiscal and monetary stimulus tailwind should keep the equity markets in positive territory in the intermediate term.
The main observation of the second quarter has been the start of a shift in consumer spending habits. The Institute of Supply Management reported that its May read of the services index rose to 64.0 in from 62.7 in April, marking the highest level ever recorded in the history of the index. Looking at the details of the report, all 18 of the services industries surveyed reported growth on the current pace of business, new orders, and employment. As the vaccination rates continue to climb and consumers feel more comfortable getting out of the house for office visits, haircuts and family gatherings, the demand for services could climb even higher. This continues to be a catalyst for the YTD 2021 broadening out of the market expansion into value sectors.
Looking at the combined ISM Manufacturing and Services Index charts below, you can see that much of the recent expansion in the demand for services has come at the expense of demand for manufactured goods.
Any prolonged increase in demand for services at the expense of manufactured goods could mark a “shift” in consumer behavior.
Should consumer demand shift longer term from the manufactured goods sector, which dominated the COVID pandemic, to the services sector in the post-COVID era; we could be looking at a profound shift in consumption patterns. If consumer spending shifts to the services sector it could take pressure off commodity prices and start the valuation contraction of cyclical stocks. Growth stocks would be the obvious beneficiary of any decline in commodity prices as this would be an indicator that inflation may be more transitory versus embedded for the long term. Our systems and procedures remain the same and the portfolio was adjusted throughout the quarter per our portfolio construction process.
IN SUMMARY, OUR PROCESS BLENDS TWO SCHOOLS OF THOUGHT
One is what we call Focused Tactical Allocation (FTA) utilizing ETF’s, and the other is a focused individual stock strategy we call Focused Growth. The result is a dynamic, global, all cap, go anywhere portfolio built for all market conditions.
The blended portfolio looks for companies which have had strong historical performance and continue to have prospects for sustainable performance in several key value drivers, i.e., return on invested capital, growth, cash flows, and valuations. In addition to fundamental analysis, technical analysis is used to help identify price momentum as well as aid in execution decisions. At any given time, the portfolio strategy may contain securities in various sectors, or it may contain concentrated sector allocations as well as various or concentrated market capitalizations. Although the portfolio is tactically responsive to immediate market movements and trends, it deploys a strategic overlay and trades at the end of each month and on a lagged quarterly basis.
During the quarter, we rebalanced the portfolio and continued to reduce our exposure to high beta names accompanied with negative earnings and negative earnings revisions. We maintained a positive outlook for the large cap tech names in the portfolio and our patience is now being rewarded as the rate of change on 10 year settles down driven by commodity price abatement as consumer demand begins to shift between high priced goods to services. Additionally, interest rate stability brought bullish technical signals throughout the quarter. As a result, we reduced our cash position from the beginning of the quarter to take advantage of the opportunity.
SHIFT IN CONSUMER SPENDING HABITS
Overall, we believe the start of a shift in consumer spending habits from goods to services will continue to broaden the recovery through Q4 of 2021. We expect the stock market to continue its upward momentum until U.S. economic growth expectations begin to taper or we begin seeing more evidence that inflation is embedding itself into the economy longer term. A reduction in the U.S. economic growth forecast will be met with a broader PE multiple contraction as economic models are revised downward to reflect slower growth expectations. The largest risk facing the economy is a policy misstep by the Federal Reserve in their anticipation of inflation. To date, most investors and strategists are all in agreement with the Fed that inflation will be “transitory” in nature.
While we agree that current supply chain issues coupled with the reopening demand lend support for the transitory inflation argument, we remain vigilant of the fact that most Inflation Index Surprise charts are measuring greater than +2 Standard Deviations away from the mean consensus forecasts for the latest reads on inflation. Looking at the 20-year Citi Inflation Surprise Index chart below, you can see that both investors and economists alike have been caught off guard in 2021 when it comes to actual inflation measures running hotter than forecast.
These are some of the largest inflationary surprises in history and makes us question the degree to which the Federal Reserve, investors and economists can effectively anticipate and forecast inflation in this post-COVID environment.
Here are the 3 key metrics we are tracking to determine if inflation is embedding itself longer-term into the economy:
- Worker Compensation – The labor force embeds inflation through pay raises. The supply of workers remains constrained as it is now, wages will continue to rise. Those same workers have more money to spend so prices for goods and services rise. The cycle of pay raises and rising prices for goods and services continues and embed inflation long-term.
- Consumer Demand – It is no surprise that consumers came out of lockdown with record savings, flush with cash and ready to spend. IHS Markit showed new orders across the entire economy at the highest rate ever recorded during the month of May. We have never witnessed household income improve in a recession the way it did post COVID. Current rates of spending have triggered an increase in demand for all goods and services and prices are on the rise as a result. We will be watching both savings rates and consumer spending in the coming months and quarters for any sign of embedding inflation.
- Inflationary Expectations – Inflationary expectations can become self-fulfilling because if workers, consumers and businesses believe that inflation will get worse, they will bid up prices and wages in anticipation of inflation thereby fueling the flames of inflation they were originally fearing! According to a recent University of Michigan survey, one-year consumer inflation expectations are 4.6% in May, this is the highest read since the China commodity boom of 2011 post Great Recession. 2013 was the last time we had 3% long-run inflation expectation; until recently, it had been less than 3% since 2013. We will continue to monitor inflationary expectations as a sign of embedding inflation.
By Q4 we will need to reevaluate our stance on fiscal policies, inflation, rates, corporate margins and earnings, labor force participation, unemployment and regional/national gauges of manufacturing and service level activities.
Published June 23, 2021
Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA
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