Market Commentary - July 2021

Monthly Update

Another month and another rally in the S&P 500. Extending its streak to 6 straight months, the index rallied by 2.3% in July[1]. The NASDAQ was up too, but broad equity market performance was much more mixed. The Russell 2000 index of small cap stocks closed the month down by -3.7% and broke a 9 month winning streak[2]. The mid cap index was about flat. A lot of cross currents continued to swirl with the Delta Covid variant along with the inflationary environment we now find ourselves in.

Overseas markets were mixed with the Euro STOXX 600 rallying by 2% while the Shanghai composite was lower by -5.4% and the Nikkei was down by -5.2% to name a few[3]. I will get more into the China situation below.

While the ‘reopening’ theme was a main driver of markets in the first half of 2021, some bumps in the road have occurred. One being the Delta variant I mentioned, but we have also seen some economic moderation driven by the rise in inflation. This creates some stagflationary situations in housing, manufacturing and parts of the service sector. These concerns were reflected in the 10 yr note yield which closed July at 1.22%, down from 1.47% in the month prior[4]. That is the lowest level since January. Overall for bonds year to date, the Barclays US aggregate bond index closed July down by .5%[5]. For many investors, all of their total return has come from the equity side.

My thought on the much more contagious Delta form of Covid is that the world has no choice but to power through it without shutting down. We have seen tremendous benefits from the vaccines where almost every single hospitalization is among those who were not vaccinated. Yes, there are now vaccine breakthroughs but with very low risk of hospitalization and death. The challenge has been much greater in emerging markets where vaccination rates are still very low. The glass half full of the fast spread of Delta, and I’m not meaning to sound callous at all, is that it will quicken the pace to herd immunity.

The other risk, inflation, is real and it is here. The only question is how long it lasts. I wrote this in the June letter and the exact same thing applies with some modest tweaks from me: “On the supply side, supply chains have been splintered due to lack of parts and labor and in response to the high cost of raw materials and transportation. On the demand side, the world is coming back (albeit now in fits and starts). And in the US too, very generous government transfer payments have replaced Covid related wage and income losses and thus maintaining a level of demand that wouldn’t have happened otherwise.”

This all filters down to Federal Reserve policy and how they will react to all these moving pieces. In the July FOMC meeting, Jay Powell basically punted to future meetings the possibility of them announcing the beginning of a trimming of asset purchases. I believe they have already well over stayed their welcome with easing to the point they are now hurting the US economy by running things too hot. At least in housing and autos, we are now beginning to flame out because price increases have been so aggressive that consumers are finally saying ‘I can’t afford this.’

Inflation

The word ‘stagflation’ was coined in the 1970’s and was meant to describe a period of slower growth, higher unemployment and inflation. While I am not comparing the two time periods, we are currently experiencing some stagflationary situations. With respect to housing, the most interest rate sensitive part of the US economy, price gains as of May ran at a 17% y/o/y pace according to S&P CoreLogic[6]. This level of appreciation has more than offset any benefits of low mortgage rates and we are also now pricing the first time home buyer out of the market. With respect to the construction of new homes, builders are being crunched by supply shortages of materials, labor and lots. This is a perfect example of too much inflation slowing growth. In the automobile sector, the lack of semiconductors has reduced the supply of new cars, leading to massive price gains of used cars and rentals and all of this is turning off the customer. With respect to the service side of the economy, particularly in leisure and hospitality, there is a shortage of workers which is resulting in reduced hours for restaurants (if they can open at all) and not enough people to clean and service hotels leading to lower availability of rooms.

Federal Reserve

These inflation pressures are putting a lot of pressure on the Fed to reduce the extreme level of their monetary accommodation. The reason why we have not seen it yet is because many on the committee, most importantly the Chair Jay Powell, believe the inflation spike is ‘temporary’ and are thus willing to ride it out on the hope it soon moderates. The risk of course is what if they are wrong and it is more sustainable? It could lead to a quicker pace of monetary tightening which would then be negative for the economy and markets. It is a tough situation that they are in, even though they did put themselves in it. How they maneuver through in coming quarters and years might just be the main factor in where asset prices and the economy go from here.

I’m of the opinion that inflation will be more persistent, but what I think doesn’t matter. The Fed will wait as long as they can before pulling back on QE. That said, I expect the beginning of the tapering of asset purchases no later than November.

Interest Rates

After a very sharp increase in interest rates in Q1, they’ve since been bleeding lower, particularly since mid-June when the Fed said they began talking about talking about (not written twice by mistake) tapering asset purchases. Throw in worries about stagflation and the Delta variant and we have a drop in interest rates to the lowest since January and a coincident flattening of the yield curve.

Essentially, I believe, long end interest rates are in a tug of war between worries about rising rates and the potential slowdown implications of inflation, with Delta concerns mixed on top. At the same time, the pile of negatively yielding securities overseas is growing again. At the end of July, that amount totaled $16.2 Trillion, up from $13.4 Trillion at the beginning of the month[7].

The Economy

The US economy grew by 6.5% on a real basis in the 2^nd quarter after a 6.3% increase in Q1[8]. This was below the Bloomberg consensus forecast of 8.4%. Part of this was a higher inflation read but there was also a bigger than expected inventory drawdown. Inventories are getting drawn down because there is a shortage of so many things. Currently the Atlanta Fed’s GDPNow Q3 forecast is for growth of 6.3% but I believe the pace of inflation will be a key determinant as supply remains a challenge and demand is impacted by higher prices.

Growth in Europe is rebounding too as the pace of vaccinations has been very good, particularly in the UK. GDP in Q2 rose by 2% q/o/q which was better than the Bloomberg consensus estimate of up 1.5%. This follows a contraction of .3% in Q1[9]. Asia has been more of a mixed bag because of varying degrees of Covid spread and selective restrictions we are seeing as outside of China and Singapore where many countries have lower rates of vaccination. I am confident that the pace of vaccinations will increase sharply in the coming months and along with natural immunity, the global recovery will continue.

China

After halting the ability of Ant Financial from going public months ago, the Chinese government turned its attention to the broader tech sector and alerted all that they must abide by data and cyber security regulations. Hit in particular was Didi Global, the Uber of China, who chose to list their IPO in New York only with no co-listing in Hong Kong. That was met harshly by China who was not happy with that. Imagine if Uber listed only Hong Kong and not on the NYSE? Lastly, for now, Chinese authorities turned their attention to the private education sector as they were not happy with some well to do families paying for private tutoring that others did not have access to. The question is whether all of this is China trying to create some guard rails in which businesses can participate in, or if it is something broader where they can literally wipe out the value of an entire industry like they did to ‘for profit’ education. I am hoping and believing in the former as the latter would preclude them becoming an economic powerhouse on the same stage as the US.

Conclusion 

If the year ended today, we’d all be very happy with the year to date equity returns. As stated earlier, it has been all stocks as fixed income has been much more mixed due to the rise in interest rates since December. At the same time, we are currently living through the most intense inflation situation since the 1970’s, as interest rates around the world are microscopic and asset price valuations are very high. How long this lasts will be crucial to both the economy and markets when looking out to the coming quarters.

Either way, whatever the outcome will be, it remains vital that investors have a plan that suits their short term liquidity needs over the next 2-3 years. Knowing that period of time is covered can help separate the balance of one’s portfolio from what I believe will continue to be a choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and these markets.

Disclaimer

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The market and economic data is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. The information in this report has been prepared from data believed to be reliable, but no representation is being made as to its accuracy and completeness.

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