In the first half of 2021, the US economy rebounded nearly to its pre-pandemic peak, signaling the transition from recovery phase to the start of a new economic expansion.
In the second quarter of 2020, US gross domestic product (GDP) shrank an eye-popping -31.4% on a quarter-over-quarter annualized rate. That was followed by a significant rebound of +33.4% in the third quarter of 2020, then more moderate growth of +4.3% in the fourth quarter of 2020 and +6.4% in the first quarter of 2021.
Growth in the second quarter of 2021 is forecasted to jump +9.4% as the economy continues to reopen. Consensus estimates suggest that the second quarter will be followed by steadily descending—but still positive—growth rates in the next two quarters. This pattern marks the sharpest economic “V” in history, given the deep recession and rapid recovery both contained within only five quarters.
Contributing to this dramatic expansion is that companies became lean very quickly in the early days of the pandemic, and now they’re benefitting from those aggressive cost-cutting measures and operating leverage as the economy reopens. Additionally, robust consumption has been driven largely by pent-up demand and record monetary and fiscal stimulus, which has left both corporations and families with ample cash.
Here, we cover the main factors affecting the market in Q2, including strong earnings, increased inflation, and lifting international restrictions.
Key Contributors as the US Economy Rebounds
Second-quarter earnings strongly beat consensus-analyst estimates and mostly conservative company guidance. According to Factset, the bottom-up consensus for second-quarter S&P 500 earnings per share (EPS) increased by 7.3% from $41.97 to $45.03 over the course of the quarter. This represents the largest increase in the bottom-up S&P 500 EPS estimate since FactSet began tracking it in 2002.
Bond yields have fallen in recent months, shrugging off:
- Wide swings in economic data
- Hotter-than-expected inflation data
- Uncertainty about the direction of fiscal and monetary policy
The surprising retreat of bond yields has given renewed support to growth stocks, which languished in the face of rising rates in the first part of the year.
Late in the second quarter, US Treasury Bond prices rallied while yields dropped despite hotter-than-expected inflation numbers. In the face of spiking inflation, the seemingly counterintuitive lower US Treasury rates have left many investors scratching their head.
Several factors have been cited for the move lower in bond yields, with much of the narrative revolving around the notion that inflation worries may have peaked. The Federal Reserve (Fed) has received a lot of the credit regarding the consensus messaging around its transitory view of current price pressures.
Consumer Price Index (CPI)
The heavily anticipated headline CPI print in May 2021 rose 5% year over year—the biggest increase since June 2008. Core prices, on the other hand, rose 3.8%—the biggest increase since June 1992. Like the April CPI report, economists flagged the following takeaways:
- Base effects
- Reopening momentum
- Supply-chain pressures
Airfares, parking fees, apparel, and hotel lodging were among the reopening categories that saw upward pressure. Semi-conductor shortages led to a 7.3% increase in used car prices following a 10% surge in April.
The Fed’s Transitory Messaging
Economists have noted that these trends all fit with the Fed's transitory messaging—though there continues to be debate about whether transitory may be longer than expected. For example, the rally in the bond market may be signaling it is—at least for now—more worried about growth than inflation.
The Fed has indicated it would be willing to let inflation run a little hot in the short term to catch up to inflation, which has been—in their view—too low for too long. At the most recent Fed meeting, it noted it’ll give advance notice before announcing a decision on tapering and that timing will depend on the progress of economic recovery.
“It’s not yet time to have a conversation about tapering,” said Powell in a press conference following the Fed’s announcement. “We’re 8.5 million jobs below where we were in February of 2020.”
In addition to confidence in the Fed’s ability to rein in inflation should it become troublesome, there has been a decade of major secular trends—including technology innovation and demographics—that have kept inflation stubbornly under the Fed’s target. The secular theme of productivity advancements driven by technology hasn’t changed in our view. If anything, it has become accelerated by the pandemic.
We support the notion that inflationary pressures are likely transitory as supply-demand issues ultimately sort themselves out through market forces.
Equities have historically performed well in an environment of higher inflation. Pricing power does, after all, generate profit. Some equity sectors may do better than others, however. Historically good inflation hedges include the following:
- Real estate
- Emerging-market securities
Other developed countries, including Europe, are only now starting to ease their restrictions on economic activity—just as Europe’s largest-ever stimulus plan is about to be deployed. This suggests eurozone growth still has some way to go, which means eurozone stocks may still deliver further gains into the second half of the year.
Meanwhile, continued solid growth combined with signs that inflationary pressure may be transitory could ease concerns that central banks will tighten policy prematurely—a fear that weighed on emerging market stocks in the first half of the year.
We continue to guide our clients towards geographic and sector diversification when appropriate. A hybrid approach with an eye toward sustainable growth at reasonable valuations—as well as quality factors like balance sheet strength—has seen success this year.
Additionally, while accounting for risk tolerance and investment objectives, we continue to advise clients to stay the course. A diversified portfolio and long-time horizon can give comfort in the midst of short-term volatility.
We’re Here to Help
For specific questions about diversifying your portfolio in the face of short-term volatility, contact your Moss Adams advisor.