Economic Monitor: A Troublesome Wall
BY: Mark Drachenberg
One of the interesting things about economics and market machinations is that good news is sometimes bad, and bad news is sometimes good. Investors sometimes talk about “climbing a wall of worry,” where the markets are resilient and move higher even considering troublesome economic news. Then, just when you think you have that figured out, they turn on a dime and head south with the next batch of less-than-stellar economic data. Are we climbing a wall of worry now, or is the economic data such that the markets' gains are fundamentally justified?
Sometimes the answer involves looking to the past to determine what our future course should be, but are there historical examples that mirror our present circumstances? The answer to that, mostly, is no; we're living in near-unprecedented times. Even if that weren't the case, is our current situation too fluid to use the past as a guide for the future anyway? What might the “worries” be in the wall we are climbing? And finally, what are we to do with the conclusions we reach? Let's dive in.
We kicked off the second half of the year on a positive note, as both the equity and fixed income markets generally moved higher. The Dow Jones Industrial Average gained 1.34% in July, while the S&P 500 gained 2.38%. Small-cap stocks lagged, as the S&P 600 index fell 2.39% during the month. The tech-heavy NASDAQ added 1.19%, the EAFE gained 0.70%, and the Barclays US Aggregate Bond Index made it three straight months of gains, adding 1.12% in July.
Quarterly earnings started to come in by the end of the month, and generally, they were quite strong. Unfortunately, future guidance was a bit of a mixed bag, and that hindered some stocks. Earnings have been solid recently, but they are coming off last year’s lows, and it can be hard to discern what's truly indicative of growth and what's just a rebound in a corporation’s fortunes. If earnings do continue to grow at this rapid pace, that should help reduce elevated valuations somewhat, if prices do not react as strongly. But, as discussed last month, that is where the TINA (there is no alternative) principle comes into play. If there is nowhere else to invest, then dollars will continue to flood into the equity markets and push prices higher, both because of strong earnings and because equities are viewed as the only game in town.
The economic data will help us determine if the wall we're climbing is made up of worries or solid, positive information. The first element to look at is GDP: second-quarter GDP was expected to come in somewhere between 8% and 11% annualized. Unfortunately, the initial numbers put the figure at “just” 6.5%. Not quite what was expected, but still very strong. In fact, the economy is now bigger than what it was prior to the COVID-19 recession.
What kept the economy from growing as fast as expected? Several factors likely played a role, including productivity (think computer chips), shipping and transportation , and ongoing employment issues. Some businesses are thriving, even considering these concerns, while others are struggling to meet the strong demand expected of them. For example, one recent Sunday , my wife and I went out to lunch, only to be told that it would be a long wait due to staff shortages. We left, as there were more people waiting to be seated than actually were seated. Our next choice was no better, so we ended up at a deli that had plenty of employees, but offered less “service” than the first two locations.
The good news, however, is that we're seeing strong productivity numbers from manufacturers; inventories have been somewhat depleted, which may hurt short-term sales, but should provide incentive for continued manufacturing growth and the jobs that go with that. Additional good news is in regard to the COVID-19 recession. New data shows that the recession lasted only two months and ended in April 2020. It didn’t necessary feel like it for many (and perhaps still doesn’t), but officially, it’s over.
Longer-term, estimates have remained strong for economic growth, and that should come to fruition unless other outside influences (e.g., potential for higher taxes & higher inflation, worsening spread of COVID variants) hold us back. For now, the markets can climb a wall of positive economic news.
Last month, I noted that the Fed tends to “waffle” in its commentary, and discussed how that waffling makes it hard for economists and investors to predict how the Fed’s actions (or lack thereof) could impact the economy and markets. There really isn’t anything new to report on this month: The Fed continues to buy bonds and keep rates steady. There are, perhaps, some more hints that a tapering process may begin sometime this year, but no definite schedule has been released.
The one thing that seems to have changed is the tone from economists and market observers. There is a growing frustration with the Fed and its lack of action, and a fear that it is going to cause disruptions down the road. Those disruptions could include bubbles in housing and other markets, higher and stickier (i.e., longer-lasting) inflation, and limited ability to fight the next recession, whenever it may occur. The Fed is sticking to its guns by maintaining its desire to get back to full employment before substantially changing its stance on its easy-money policies.
Our best guess is that the Fed will begin tapering before the end of 2021, and start raising rates in late 2022 or sometime in 2023. Certainly, that timetable will adjust as new data comes out. This wall the markets are climbing may be changing from one of strength to one of worry, but in any event, the climb continues.
No changes here – "steady as she goes" remains our outlook. We recommend staying diversified, somewhat defensive-minded, and ready to act if it appears that the economy and markets head in a different-than-expected direction. From a market perspective, we continue to stress that a correction sometime over the next six to 12 months is likely (and perhaps overdue). Getting rid of the froth is a normal market condition and could be what the market needs to move substantially higher.
In the meantime, look for areas where valuations may improve (e.g., value and international stocks) or that may provide some protection (e.g., floating rate bond funds). Just be prepared for the hangover, whenever it may occur.
To discuss your portfolio, or any other issue you may have, please call our Wealth Management Division at (608) 826-3570, or send me an email. We look forward to speaking with you!