The Pause That Refreshes
The second quarter of 2021 might best be characterized as “the pause that refreshes”. After a chaotic first quarter – and certainly 2020 – the past three months felt mostly “normal”, if we can use that word these days. There were no elections or political riots. The pandemic is waning, at least in the U.S. Day-to-day life is taking on more of an ordinary feel. On the investing front, global equities are sitting near record highs and bond yields near historic lows. If nothing else, the quarter offered an opportunity for investors to catch their breath and take stock of where things stand.
So, Where Do Things Stand?
With nearly 50% of the U.S. population now fully vaccinated, the economy has revved back into gear. Bars and restaurants are buzzing, storefronts are coming back to life, and people are venturing out on long overdue vacations. “Help wanted” signs are everywhere and retailers are scrambling to keep shelves stocked. The world’s largest economy was at a standstill a year ago. Now, there is talk of a new “Roaring 20s”, a reference to the post-World War I boom in the 1920s, which was marked by widespread prosperity and significant leaps in innovation. U.S. GDP grew 6.4% in the first quarter of 2021 and is forecasted to land near 8% for the second quarter. Full-year GDP is projected to grow 6-7%+ year-over-year, the largest increase in decades. Aiding the economic recovery is abundant government support, with child tax credit payments beginning to arrive for a large swath of American families and millions of stimulus checks still hitting bank accounts. There is also growing optimism that a $1.2 trillion infrastructure spending plan is on the way.
Stocks have responded in-kind, with the S&P 500 setting 36 new record highs this year. Investor sentiment is largely “risk-on”. However, there are two key questions right now: 1) Can the economy maintain its breakneck pace of growth? 2) Will inflation rear its ugly head?
As it pertains to the economy, there is no playbook for coming off a once-in-a-generation global pandemic. Pent-up consumer demand for goods and services is clearly driving accelerated growth at the moment, but is it sustainable? Stocks are currently valued on the higher end of the spectrum. If the economy returns to a more normalized growth rate and corporate earnings growth stalls, present stock prices may be difficult to justify. On the other hand, a “Roaring 20s”-type environment would obviously bode well.
Perhaps more importantly, the world’s largest economy doesn’t flip back on with a switch. It takes time to get the economic machine cranking full-speed. Enter the most pressing concern of the moment: inflation. Prices are up across the board. The Consumer Price Index (CPI), which measures the change in prices paid by consumers for goods and services, showed a 5.4% increase in June, the biggest spike since 2008. A trip to any grocery store or retailer confirms this. Have you tried buying a car recently? How about a home appliance? Or a home itself? Labor shortages, a dearth of raw materials (think lumber), and other supply chain constraints are all contributing factors. Add-in consumers ready to spend after being stuck at home for over a year and it makes sense there are inflationary pressures.
The question is whether price spikes are permanent or transitory (Federal Reserve speak for “temporary”). Will expiring unemployment benefits bring more workers into the labor market to meet the growing demand? Will supply constraints diminish as factories come back online? Will consumers tolerate higher prices? An argument could be made that consumers are stomaching higher prices right now after being cooped-up for a year. They’ll pay anything to go to a restaurant or take a vacation. They may be less forgiving as the pandemic fades from the rear-view mirror. Government stimulus will also subside.
While there are many unanswered questions, the bond market is offering some clues on inflation. There was a meaningful spike in interest rates in the first quarter, with the 10-year Treasury yield surging from approximately 0.9% to 1.7%. Rate increases tend to occur when there are concerns over rising inflation because bond investors require greater compensation to account for the erosion of their future returns. Interestingly, this benchmark yield has recently fallen back to around 1.4%, an indication the bond market believes inflation may be transitory. The Fed mostly agrees with that assessment and continues to strike an accommodative tone.
So, What Does This All Mean?
Transitory inflation, an improving economy, continued government stimulus and spending, and a supportive Federal Reserve would appear to place the stock market in a desirable spot. However, as we noted last quarter, this mix is also creating pockets of froth that bear watching. The most recent example is AMC Entertainment Holdings, whose stock skyrocketed during the second quarter. Last April, the movie theater chain was priced for bankruptcy, with a total market value of just over $200 million. Today, the company is valued at well over $20 billion! Movie theaters aren’t exactly a great business these days.
While up and down swings in stocks like AMC have negligible impact on diversified investors, they are nonetheless important to monitor. From GameStop to Dogecoin, bizarre occurrences in the markets are seemingly more prevalent at this juncture. Some blame the Fed. Others point the finger at government stimulus or the gamification of investing through apps like Robinhood.
Whatever the reason, our job is to separate rampant speculation from long-term, thoughtful investing. The question we hear often is, “are these pockets of froth indicative of a broader market bubble?” Given the current state of the economy, it is much more likely pockets of the market are a bubble versus the entire market itself being overinflated. That said, stock valuations are on the higher end and it would behoove investors not to extrapolate the market’s recent past into the future. It’s highly unlikely returns experienced over the next twelve months will look anything like the impressive gains witnessed since the March 2020 low.
Take a Breath and Assess
Last quarter, we said: “Optimism for a strong economic rebound and an accommodative Fed is typically a healthy combination for stocks”. That proved true during the second quarter and the recent string of record highs has offered no reason to think otherwise. We also said: “The potential for meaningful inflation and further rising rates are risks that could ultimately put a dent in stocks and cause further damage to bonds.” Obviously, the jury is still out on this.
So, what is “the pause that refreshes”? This wasn’t a reference to a pause in the upward climb for stocks that might then springboard higher. Instead, the second quarter offered a pause from the firehose of wild headlines and events we’ve all experienced over the past year and a half. Investors had an opportunity to clear their heads, return to some semblance of normalcy in their daily lives, and evaluate their portfolios without massive fluctuations in the markets. As is always the case, chaos will return to the markets at some point, making now a perfect time to assess current and future financial goals. We are here to help.