Second Quarter 2021 Market Recap Read
We almost never think of the present, and if we do think of it, it is only to see what light it throws on our plans for the future. The present is never our end. The past and the present are our means, the future alone our end. Thus we never actually live, but hope to live, and since we are always planning how to be happy, it is inevitable that we should never be so. (Blaise Pascal 1670)
It is hard not to be impressed by the resiliency of the US economy and the speed of its recovery. US GDP growth clocked in at 6.4% on an annualized basis in the first quarter, while forecasts for the second quarter are between 9% and 10%. It is now almost certain that US GDP in total dollars exceeded pre-pandemic levels at the end of the second quarter. This is also true of the G-20 countries in aggregate. There is no doubt the keys to our success were the rapid development and deployment of multiple effective COVID-19 vaccines and effective countermeasures through monetary and fiscal stimulus. At the same time, companies and individuals adapted with a panoply of innovative technologies. Think Zoom, Slack and DoorDash!
While the economy is bouncing back rapidly, adjusting to new post-pandemic concerns will take longer. There remains a spirited debate among economists and market participants about the nature of current inflation – essentially, how long will it last and what effect will it have on the markets? A year ago, US inflation had fallen to 0.1% and the predominant concern was deflation. Today, inflation pressures are mounting as: consumers unleash pent-up demand on an economy still reeling from supply chain disruptions; the Fed continues to maintain a zero-interest-rate policy and large-scale monthly debt purchases; trillions in fiscal stimulus work through the economy; and soaring stock markets and real estate prices create wealth effects. A challenge for investors is to strip out the ‘base effects’ and temporary supply bottlenecks from more enduring drivers.
One of the more likely of these enduring drivers will be demography. According to a new book called The Great Demographic Reversal, aging populations in Developed Markets and China will have significant impacts on inflation and savings. The authors Charles Goodhart and Manoj Pradhan assert that prior decades saw the greatest positive labor supply shock in history principally as China and other emerging economies added enormous capacity to the world’s output. This increase kept wages in check and allowed for the long decline in real interest rates. These once favorable relationships are worsening quickly and inexorably. Adjustment to these ratios will play out slowly, but likely with less favorable outcomes – slower growth, higher interest rates and higher inflation. Perhaps the mantra should be to find happiness in the present moment.
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I think that you will all agree that we are living in most interesting times. I never remember myself a time in which our history was so full, in which day by day brought us new objects of interest, and, let me say also, new objects for anxiety. (Joseph Chamberlain, British statesman, 1898)
How was the quarter? : The rollout of COVID-19 vaccines, continuing large-scale fiscal stimulus, and central banks’ highly accommodative monetary policies have bolstered investors’ confidence in a rapid economic recovery and led to market gains. There was some rotation away from 2020 winners like tech into value and small cap stocks. As evidence of this new twist, the tech-heavy NASDAQ 100 only returned 1.8% while the Dow Jones Industrials, dividend stocks (Vanguard High Dividend Stock ETF) and small cap stocks (Russell 2000) earned 8.5%, 11.2% and 12.7%, respectively.
Objects of interest: SPACs, Reddit, Robinhood, GameStop, Bitcoin and Archegos all made for captivating headlines. Economically speaking, the March jobs report blew past expectations as payrolls rose by 916,000, while the latest report on U.S. manufacturing gave the highest reading since 1983. GDP is closing in on its pre-pandemic high and growth is expected to exceed 6% in 2021, while corporate profits are set to rise more than 20%. Consumers, who have been biding their time during the pandemic, have accumulated excess savings of an estimated $1.5 trillion that could release a wave of pent-up demand later this year. If air travel is any indication, in March 2021 the TSA screened the highest number of passengers in a single day since March 2020.
Objects of anxiety: One object of anxiety is not new – recent market exuberance. There are legitimate questions regarding whether it has been rational or irrational. The market’s recovery since last year is supported by the factors mentioned above. However, other metrics such as the cyclically adjusted PE ratio (CAPE) and the Buffett Indicator (market value to GDP) show the S&P 500 at levels equal to or exceeding those of the tech bubble. A second and newer object of anxiety is inflation. With massive government stimulus, easy monetary policies, and substantial economic growth, the prospect of higher inflation is rising. Unchecked inflation erodes purchasing power and leads to countermeasures that can be recessionary.
What to do?: Investors should gird for a more challenging year ahead, while acknowledging that asset price cycles are inevitable. In fixed income, investors should consider keeping duration at the low end of target ranges and holding some inflation-protected bonds. On the equity side, one should balance growth with value and consider commodity-based equities, liquid alternatives, and private equity to sidestep any potential short-term speed bumps.