Market Commentary - May 2021

Monthly Update

After a strong start to the year, US stocks took a rest in May with a very mixed performance. Looking at some of the key indices we saw the S&P 500 up .6%, the NASDAQ down by 1.5%, and the Russell 2000 higher by a slight .1%[1]. Overseas markets put on a better performance, particularly in Europe. The STOXX 600 European stock index was up 2.1%[2]. Asian markets were more mixed with the Shanghai composite higher by almost 5%, while the Japanese Nikkei was flat[3]. The South Korean Kospi rallied for the 7^th straight month and was up 1.8% in May[4].

There were a lot of cross currents flowing through the investing dynamic in the month with a wider reopening in some countries, and COVID challenges in others, like in India and selective restrictions in Japan and Singapore. Also, the demand for manufactured products is rising sharply, but the ability to deliver the quantity needed and on time is hindered. In addition, the service side of the economy is seeing a sharp rebound, not surprisingly, with the success of the vaccine rollouts in the US and Europe as leisure, travel, and hospitality are the key beneficiaries. Lastly, central banks around the world remain very easy, but we’re soon reaching a point where the foot might soon slowly lift off the pedal. We finally saw hints of that in May.

With respect to interest rates, which have been a key story in 2021, they leveled off in the US and Asia but continued higher in Europe. While the attention has shifted to the economic rebound, it is coming with intensifying inflation pressures. Everything from higher commodity prices, ever rising transportations costs, tight labor markets, and a literal shortage of goods lead to the debate on whether this is temporary or not. I believe it is not so temporary. The US 10 yr yield after rising from .84% in November 2020 to 1.74% at the month end in March, fell back to 1.60% at the end of May[5]. Though the German 10 yr yield was less negative at -.19% and that is up for the 6^th month in the past 7[6]. Most yields elsewhere in the Euro region finally have a plus sign in front of them. After seeing a dramatic increase in yields in Australia in January and February, they backed off for the 3^rd straight month, but are still up sharply from last year.

The Full Reopening

The COVID restrictions are just a short bit away from fully ending, with California recently announcing that all physical distancing and capacity rules will go away on June 15^th. While herd immunity is still in front of us and COVID will likely still be a battle to be fought, the success of the vaccines, along with the natural immunity of many people, have rendered COVID essentially over in my opinion. Countries like India and Brazil have had a brutal time of late with 2^nd waves, but we’re seeing signs that the spread is topping out there and the vaccine rollouts will only continue.

A global economy that is finally getting its legs back means a rush of demand for many things, both services and goods. The latter certainly saw robust buying over the past year, as people renovated parts of their homes, added exercise equipment, bought RV’s, and bought more laptops, phones, and other electronic products with the shift to work and learn from home. The question is, then, how sustainable will this spending be on goods in 2021, as spending shifts to going back out again. Also goosing the US economy has been the large amount of fiscal spending that resulted in more money in more people’s pockets, to the point where government transfer payments has more than offset the lost wages due to COVID.

Inflation

As mentioned, inflation is here in every single good that is produced in the world and that inflation is now spreading into services. It is important to break down inflation between these two different influences as service inflation is rarely transitory, while pressure on goods prices is usually standard. For example, over the past 20 years services inflation ex energy has averaged 2.7% per year, but core goods price gains have averaged zero over the same 20 yr time frame[7]. Higher service prices are thus persistent led by higher rental costs, medical costs, insurance, tuition, and the list goes on. Technology and production efficiency has kept a lid on goods prices, but now we have higher goods prices along with a rebound in services inflation after the 2020 moderation.

Here is a quote from the Institute of Supply Management in their May report, which highlights the factors pushing manufactured prices higher: “Business Survey Committee panelists reported that their companies and suppliers continue to struggle to meet increasing levels of demand. Record long lead times, wide scale shortages of critical basic materials, rising commodities prices and difficulties in transporting products are continuing to affect all segments of the manufacturing economy.” On the labor market side, “Worker absenteeism, short term shutdowns due to part shortages, and difficulties in filling open positions continue to be issues that limit manufacturing growth potential.”

With respect to service inflation, Markit said this in their purchasing manager’s report for May: “Inflationary pressures continued to mount in May, as rates of increase in input prices and output charges quickened to the steepest on record. Companies commonly noted efforts to pass through soaring costs to clients, with prices of oil, PPE and transportation often cited as fueling the uptick in expenses.”

Inflation Expectations

Along with the inflation reality on the ground, inflation expectations have been rising both in market based measures in the TIPS (Treasury Inflation Protected Securities) market as well as in consumer sentiment surveys. The implied inflation rate in the 5 year TIP was little changed in May but at 2.60%, that compares with 1.60% in the week leading up to the November 9^th 2020 Pfizer vaccine approval[8]. Looking at the 10 yr inflation breakeven, it has risen by 75 basis points from last October to the end of May to 2.45%[9].

Within the University of Michigan monthly consumer confidence survey, one year inflation expectations in May rose to 4.6% from 3.4% in April[10]. That matches the highest since 2008, when crude oil was approaching $150 a barrel. The Conference Board’s consumer confidence index has its one year inflation expectations component at 6.5%, one tenth off a 10 year high[11].

Central Banks

The vaccine driven economic rebound, along with the inflation pressures, begs the question of, “When do central bankers start taking away the punch bowl?” After the Bank of Canada said they were trimming its QE program in April, the Bank of England reiterated in May that theirs will end at year end. There is now chatter that the ECB will discuss tapering their Pandemic Emergency Purchase Program at the June 10^th meeting. That leaves the Federal Reserve and the pressure is clearly building on them to at least begin discussing slowing the pace of asset purchases, although they still remain very afraid of upsetting the apple cart.

Looking at the 2^nd half of 2020, we have to acknowledge that the behavior of central banks possibly slowing the pace of their easing may be a key factor in where markets go. I believe the direction of inflation, interest rates, and central bank policy will be the main determinants of where stocks go from here. With valuations on just about everything in the US still very elevated, there is little room for error.

Stocks

The US stock market remains very rotational between value and growth with one day one side is up and the other down. Much has depended on the direction of interest rates with growth underperforming on days rates rise (valuation compression), and outperforming when they fall (valuation expansion). I don’t expect this to change anytime soon. Thus, tell me where rates will be and I’ll render a good guess as to where stocks will trade. I mentioned the high valuations of US stocks, but that is not the case globally. After years of value underperformance, many markets in Europe and Asia are cheaper. With respect to credit though, with low rates globally and still below zero in Europe and Japan, there is little value to be had.

Conclusion

As we are currently experiencing the most intense inflation story since the 1970’s, with interest rates around the world microscopic, and central banks that are still mostly pushing the monetary pedal to the metal. This inflation challenge is either transitory or not, and answering that question is now central to understanding the tenor of the investing landscape as we look to the back half of 2020. I believe what we are seeing is not transitory, and think that interest rates will resume their trend higher, with central bankers badly lagging in pulling back their money printing.

Either way, 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 be a continued choppy time for the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on these markets.

Disclaimer