The economic recovery is moving ahead at a strong pace, but important headwinds remain. Recent challenges include the “delta” variant of COVID-19 that threatens the speed of economic reopening as well as rising inflation. Stimulus packages have helped to strengthen consumer demand, and the personal savings rate is well above average. The demand for goods has outpaced the demand for services, leading to inflationary pressures in some areas of the economy. Consumer behavior appears to be normalizing as restaurants and bars are nearing pre-pandemic levels.
Summary of Q2 2021
The economy continued to recover during the second quarter as stimulus checks and COVID-19 vaccinations boosted economic activity. Consumers have been directing their buying toward goods, as the services and entertainment sectors have yet to fully recover. Global manufacturing and purchasing data have been strong. Unemployment has improved but is still above target. Meanwhile, the framework of an infrastructure spending bill has been agreed upon and is making its way through Congress.
The stock market has remained consistently above fair value; earnings and valuations continue trying to “catch up” to stock prices. U.S. equities remain strong. International equities are showing signs of strength as well, although they continue to lag U.S. equities due to a slower pace of recovery from the pandemic in several regions. Commodities have felt the impact of increased demand from economic reopening. The U.S. Treasury yield curve, which reflects investors’ expectations about short-term and long-term interest rates, is upward-sloping; this is generally indicative of a growing economy. The U.S. Federal Reserve (the “Fed”), which targets an annual inflation rate of 2%, has publicly stated that it will allow inflation to grow; the U.S. central bank contends that inflation is transitory and has been too low for too long.
We believe that the Fed may be playing with fire by allowing inflation to run hotter than usual. Inflation is already on the rise; the latest inflation data published by the U.S. Bureau of Labor Statistics show an inflation rate of 4.99%. Last year, inflation was just 0.12%. History has taught us that spikes in inflation shouldn’t be taken lightly.
A notable inflationary episode occurred in the early 1980s during a recession. The inflation rate went as high as 14.93%, causing the Fed and then-chairman Paul Volcker to take dramatic steps to rein it in. Today, the same basic laws of economics are still at play. Debt financed largely by central banks along with fiscal policy stimulus are at unprecedented levels, causing a dramatic increase in the money supply. This money must go somewhere. Given that the economy is still not at full capacity, the increasing money supply has temporarily found a home in personal savings rates, which are unusually high. This means a lot of unspent money is waiting on the sidelines; this pent-up demand should eventually spur further inflation.
In the near term, we expect the stock market to continue to rise. Inflation typically has been supportive of stocks, at least to an extent. But investors focused on the bigger picture—especially investors with sizeable bond allocations—shouldn’t welcome rising inflation. A big reason for this has to do with the dynamic between inflation and interest rates, which are the main tool that the Fed employs to deal with inflation. As inflation rises, the Fed eventually increases interest rates to keep inflation in check. Higher interest rates translate into higher bond yields, and as bond yields increase, bond prices go down. Just as importantly, rising interest rates can serve as a headwind to economic activity, which can in turn hurt stock markets.
Looking ahead, we will be closely monitoring how the Fed deals with this situation. We agree with the Fed that inflation is likely transitory, but we are concerned that a high degree of government spending and stimulus could exacerbate an already tenuous inflationary situation.
Until next quarter,
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