The economy has gained considerable momentum this spring, as a larger share of the population has been vaccinated and daily new COVID-19 infections have plummeted. With the threat from COVID diminishing, restrictions on business operations have also loosened. Real GDP has grown at an astonishing 10.0% annual rate during the second quarter.
However, the economy’s recovery has continued to be uneven. Hiring gains have lagged GDP growth as millions of workers remained sidelined due to factors such as expanded unemployment benefits, increased child-care responsibilities, and fear of COVID-19. Consumer prices also surged in May from a year earlier, fueling concerns that the Federal Reserve will not raise interest rates soon enough to contain inflationary pressures.
With pandemic restrictions fading, consumers have begun spending more on services, which have not been captured in the retail sales report other than restaurants and bars. Retail spending fell 1.3% in May. Supply-chain disruptions and business re-openings have triggered a consumer spending shift from goods to services.
This spring's economic boom has also been accompanied by some growing pains. Shortages have cropped up and intensified for a wide array of input materials due to the sudden resurgence in demand amid lean inventories and severely disrupted supply chains. Businesses have also struggled to find the workers they need. These supply-side constraints notwithstanding, a robust 7.0% rise in U.S. GDP in 2021 should reflect the revival in economic activity. If realized, this would mark the nation's fastest economic growth since 1951.
The U.S. economy has outperformed most expectations in the first half of the year. Thanks to two rounds of fiscal stimulus and a quick ramp-up in vaccinations, real GDP sprinted out of the starting blocks in the first quarter at 6.4% (annualized). The consumer has been the biggest part of that story as spending surged by 11% in the first quarter.
Business investment in equipment and intellectual property products also continued its impressive growth (+15%). The consumer's “freedom-induced demand spurt" will likely continue through the next quarter, spurred forward by the latest round of $1,400 payments. Additionally, advance payments from changes to the Child Tax Credit beginning July 15 will provide additional cash in 2021; many families would have had to wait until 2022 to receive the payments after they filed their 2021 income tax return. We expect GDP growth in the third quarter to be about equal to the second quarter with a greater tilt towards services rather than goods as people resume more normal socially engaging economic activity. Households have built up over $2 trillion in excess savings through March and are well placed to keep spending as the economy reopens.
While the economy has already partially rebounded from the deep contraction in the first half of 2020, a variety of factors will determine the way forward. Key variables include a) the deployment and effectiveness of COVID-19 vaccines; b) the impact of fiscal and monetary support; c) the status of labor markets and household consumption; and d) the pace at which mobility and travel restrictions are lifted.
Supported by the distribution of COVID-19 vaccines, U.S. equities produced solid returns during the second quarter. Stock prices were also boosted by strong corporate earnings. The FOMC’s June meeting brought no policy changes, but Fed projections suggest that interest rates could rise as soon as 2023. Economic data has mostly been encouraging, with consumption indicators being especially strong. Inflation data continues to generate headlines. In May, core inflation posted its largest year-over-year increase since 1992. The second quarter also featured significant fiscal policy developments. The Biden administration appears to have secured a deal on a $1 trillion infrastructure package. The S&P 500 closed Q2 at an all-time high.
Overseas, equity markets produced positive gains but underperformed their U.S. counterparts. In Europe, share prices rose as the pace of the vaccine rollout accelerated. First-quarter corporate earnings were generally very robust. In Japan, stocks produced a negative result for the quarter as a persistent increase in COVID cases led the government to delay lifting its declared state of emergency. The nation also has struggled to efficiently distribute COVID vaccines. Emerging markets generated solid equity returns during the second quarter. Amongst the BRICs (Brazil, Russia, India, China, and South Africa), Brazil led the way with returns boosted by currency strength. Russian stocks also delivered double-digit gains as oil prices rose, while Indian stocks increased nearly 7% despite the country’s surge in COVID-19 cases. Chinese equities lagged the broader emerging markets index for the quarter.
Broad bond market indexes generated positive results during the second quarter as U.S. Treasury yields fell. June’s FOMC policy statement noted higher expected inflation this year and brought forward the time frame on when the Fed will raise interest rates. The headline inflation expectation was raised to 3.4%, while rate hikes could come as soon as 2023. Discussions about when to pull back the Fed’s $120 billion in monthly bond purchases also commenced. In the U.S., corporate bonds outperformed government issues. European bond results lagged the U.S. amid growing optimism about the region’s recovery and accelerating vaccination effort. Emerging market bonds had a strong quarter, led by high yield issues.
Driven by increased vaccination rates, massive fiscal stimulus programs, accommodative monetary policies, and solid corporate earnings, global equity markets have rallied aggressively following Pfizer’s late 2020 COVID-19 vaccine announcement. In the U.S., pent-up consumer demand provides a tailwind for cyclical stocks in hard-hit areas of the market. Cyclical names should continue to show strength in the intermediate term. Meeting earnings expectations is important as equities appear somewhat expensive. Several risks to the market are worth monitoring. Of chief concern is inflation, and whether recently rising prices in some areas of the economy are transitory or the beginning of something more enduring. An inflation spike that persists could trigger a more hawkish tone from the Fed, while fears of inflation may be enough to generate additional volatility. Tax policy may also produce volatility as U.S. lawmakers are likely to debate various tax law changes in the fourth quarter through the budget reconciliation process. See our recent blog post on the potential estate, gift and income tax changes under the Biden administration here. Additionally, the G20 is currently negotiating global tax rules that could have a significant impact on the net-after-tax earnings of the world’s largest multinational companies – which is certainly a scenario that could introduce volatility in the equity markets. Finally, pandemic-related concerns remain, particularly in the form of COVID-19 variants.
Developed international equities appear relatively attractive. Given the economic cycle, cyclical stocks are expected to show near-term strength. And relative to the U.S., international stock indexes are overweight cyclicals. In Europe, the vaccine rollout is gaining momentum, and a more sustained reopening of economies is on track for the second half of the year. The fiscal boost from the European Union’s recovery fund should help maintain the region’s economic rebound. In Japan, the recovery has been constrained by localized outbreaks of COVID-19, which have led to renewed lockdowns of metro areas. However, a solid economic recovery is expected through the back half of the year, boosted by strong global capital expenditure spending and the return of domestic service activity. In the U.K., a rebound is expected in both GDP and corporate profits as the market recovers from the dual headwinds of Brexit and the pandemic. Broadly speaking, valuations overseas are attractive, with the MSCI All Country World index excluding the U.S. forward price-to-earnings ratio trading at a significant discount to that of the S&P 500.
Many emerging markets continue to struggle with the pandemic. Unlike the developed economies, the U.S. and U.K. in particular, vaccine rollout remains low. Vaccine hesitancy is a challenge, as is vaccine supply and the logistical difficulties in distribution. Consequently, the COVID-19 virus continues to mutate, and caseloads and hospitalizations remain high. On a positive note, first-quarter economic output exceeded expectations in most developing nations. Emerging market equities have been laggards since the announced development of a vaccine. These trends should start to reverse later in the year as vaccines become more available. U.S. dollar weakness will also be supportive of emerging markets. The dollar is expected to weaken as investors fully price in Fed tightening expectations and the global recovery becomes more entrenched.
For fixed-income investors, current bond yields do not appear to be consistent with the likelihood of continued strong economic growth and the risk of higher inflation. Thus, rising bond yields in the second half of the year would not be surprising. Anchored by Fed policy, short-term rates should remain close to zero, but the 10-year Treasury yield may rise to the 2.0% to 2.5% range. Given this environment, investors may want to keep the average duration in their portfolios below their benchmark. Expansive fiscal policy and improving economic growth support the credit quality of corporate bonds. Municipal bond fundamentals have seen significantly improved fundamentals, boosted by more than $1 trillion of stimulus. High-quality core bonds should continue to serve as a ballast in equity-heavy portfolios.
We will continue to monitor the markets and communicate how any proposed tax law changes, if enacted, may impact your financial situation. If you have any questions, we encourage you to contact your GW & Wade Counselor or you can reach us at email@example.com.
Based on the S&P 500 trailing twelve-month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading at the 4th percentile January 1957 to July 12, 2021.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers a May 2021 reading at the 97th percentile from January 1979 to May 2021.
The equity valuation and economic activity gauges have been reviewed by GW & Wade and are consistent with the firm’s near-term outlook.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well-established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
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