Economic Commentary – Q2 2021

Quarter in Review

• Equity markets continue to establish new records as corporate earnings and consumer confidence recover.
• The Fed has begun discussing when and how to begin pulling back on stimulus but it will be a long process.
• Supply constraints due to the pandemic are straining many industries and elongating delivery times. These problems are also leading to higher prices in many cases. All of this bears close scrutiny for its impact on inflation.

Commentary

Financial market gains piled up high in the second quarter as the economy displayed numerous signs of robust growth. The global pandemic inflicted serious pain to the service sector, and this is the area that has displayed some of the most eye-popping growth rates. As we have mentioned, the magnitude of the swings in many of the economic reports are simply without context, but the general trend provides a favorable backdrop for investors. In a reversal of the first quarter trend, growth outperformed value and small stocks lagged their larger brethren. In terms of the leading sectors, real estate, technology, and energy were the clear winners. Energy owes its rebound to higher prices for both oil and natural gas.

Meanwhile, fixed income markets turned in positive results even though the widely expected higher inflation reports proved higher than expected. During the early part of the year when market yields on bonds increased, there was much speculation that the Fed may shift their policy to a more aggressive stance due to this higher inflation. There was also speculation that the Fed may be losing the confidence of the markets with its tolerance of higher inflation, which the Fed expects will be transitory due to the supply constraints of the economic re-opening. All of these fears proved erroneous: the yield on the 10-year Treasury fell by 27 basis points during the quarter. Yields on shorter term notes increased a bit since the Fed did, in fact, bring forward its expectations of when policy changes would take place.

The economic recovery is being hampered by numerous supply constraints, and among the most notable is that of labor. With so many thrown out of work last year, it may seem surprising to some that companies are finding it difficult to fill jobs, but the issue is incredibly complex and multifaceted. For example, higher real estate prices make it difficult for job-seekers to relocate, and those with the necessary skills may not be located near the jobs. Other factors include the lower immigration rates of the last several years which impacts agriculture, leisure and hospitality, and construction industries dramatically. The pandemic may have also influenced some to change careers, which may leave jobs with evening or weekend hours with fewer candidates to choose from. Or perhaps the shortage of childcare options may still be hampering a return to the job market for those with young children. In any event, there is a labor shortage affecting all kinds of businesses in various places around the country which is making a full recovery more challenging.

Other supply-side constraints include a shortage of microchips, partly due to huge demand from cryptocurrency miners, as well as shortages of certain commodities like industrial metals. China has taken the unusual step of releasing some of their metal stockpiles to the market in an attempt to alleviate some of the pressure. The uneven nature of the vaccination process and economic recovery across the globe is still another factor in explaining supply constraints, but it will simply take time for most of these to recede.

We focus a great deal of attention on the labor market because the Fed seeks “substantial further progress” in labor market conditions before it will pull back on loose monetary policy. The labor force participation rate fell by a large 1.7 percentage points during the pandemic, or 2.7 million people, and this is a major impediment in preventing many small businesses from returning to normal. Higher participation rates and improving wages are critical for economic growth, helping support the 70% or so of the economy that is consumption, and should rebound at least partially once the fear of the disease has dissipated, enhanced unemployment benefits end, and school returns to normal.

Regardless of the supply constraints impacting the economy, corporate earnings have risen strongly, and margins are at or near all-time highs. This fundamental earnings backdrop is an important driver of equity markets: equity prices are essentially discounting future earnings in perpetuity. The powerful price performance of equities has also likely been impacted by the low interest rate environment, and we do not believe that will change materially in the near term.

Equity markets have enjoyed phenomenal returns since the difficult days of early 2020 and much good news is already reflected in security prices. While further gains can continue, they may be more muted and more hard-fought than the recent past. Still, if earnings momentum continues due to healthy demand from consumers and businesses alike, financial markets can continue to reward investors who are patient and selective. As always, our security selection process continues to focus on high quality securities with a full market cycle investment horizon.