Stocks continued to move higher last week, once again driven by good economic news. 10-year Treasury bond yields continued to trend lower, further adding to the gains.
Last week started earnings season. While only a few companies reported, trends were obvious. The pace of recovery in recent weeks has escalated despite a renewed rise in Covid-19 cases. About half of U.S. adults have now received vaccinations and over a quarter have received second shots. Liberated by the declining risk of getting the disease, Americans are itching to get out and about. The data is clearly showing that. At the low point of the pandemic about a year ago, airline passenger counts were down 80% from peak levels. Today, they are down by about a third. Hotel reservations are picking up rapidly. Summer rentals are already hard to get.
But not all is perfect. If you look closely at the airline statistics, you will see weekly trends that show the heaviest traffic is over weekends, peak periods for leisure travel. Midweek numbers are weaker, a sure sign that business travel is still markedly lower than pre-pandemic levels.
The rate of rise in demand is also creating its own set of disruptions. Restaurants are filling up as they reopen. But getting wait staff and line workers to return has been difficult. Restaurants are offering higher wages, retention bonuses, and even in a few cases new benefit plans for those who stay longer, unheard of a year or two ago. The rapid recovery has caused other disruptions as well. Ketchup packets are hard to get, for instance. Auto lots are empty and used car prices are rising.
So far, these anecdotal trends haven’t shown up in inflation data. That has kept bond yields down, but data usually lags reality. In addition, the key components of inflation are wages and rents. Although demand of homes for purchase is skyrocketing amid a historic shortage of homes for sale, rents have remained subdued to date. That won’t last forever, but for now rents are staying stable, even falling in some urban centers. As for wages, the aforementioned story regarding difficulty finding restaurant workers may be a harbinger of things to come, but workers used to modest annual wage increases are not pushing too hard yet. With unemployment back below 6% and new jobs being added at a pace of over a million per month, it is only a matter of months before labor markets tighten to the point where wage pressures will rise. Economically, higher wages can be offset by an increase in output per man hour worked, what we call productivity. The use of new technology (e.g., kiosks taking fast food orders rather than humans) helps to drive productivity. Time will tell whether productivity can offset rising inflationary pressures.
With all that said, the canary in the coal mine about the economic recovery might well be the size of loan reserve recoveries banks are taking this quarter. Before 2020 banks made a quarterly judgement of the adequacy of their reserves for bad loans based on economic conditions at the moment. Thus, when times were bad, they escalated reserves. It would seem more logical to reserve money before bad times arrived, not after. Therefore, regulations were changed requiring banks to make reserve judgments earlier in a cycle. When the pandemic hit last year, banks no longer waited for loans to default, they established reserves on the presumption that a certain percentage of loans would be unpaid, especially if the pandemic continued for a significant period of time.
As it happened, despite the obvious human cost of the pandemic and the advances of medical science, the economic pain wasn’t as severe as many thought last spring. Business began to reopen around mid-year and escalated sharply in recent months as more people were vaccinated. The reserves put in place a year ago turned out to be far larger than needed. Accounting rules required a readjustment to current reality. As a result, many banks lowered reserves this quarter, resulting in much larger than expected earnings.
Investors, however, didn’t reward banks for the better-than-expected loan experience. For one, it was obvious to most that the economic pain wasn’t as bad as originally expected. The reserve reversals were anticipated and already priced in. Investors in bank stocks are more interested in net interest margin spreads and loan demand. The former is starting to rise. But loan demand at the moment is anemic. Businesses are either flush with cash or already have more debt on their books than they want. In addition, inventories are depleted, requiring less bank financing.
While early earnings reports don’t tell the whole story, the trends suggest a very robust season. The heaviest period for earnings reports is this week and next. Obviously, recent market strength suggests high expectations. How companies perform relative to those expectations will determine the course of stock prices over the near term.
There are two other events to watch this week. The trial of Derrick Chauvin will come to a close. Depending on the outcome, widespread civil unrest could follow an unpopular verdict. Normally, non-economic events like this have no market impact. But this one could cause a wobble under an adverse set of circumstances and is worth noting.
Second, the FDA is likely to decide whether to allow the continued use of the Johnson & Johnson# Covid-19 vaccine. The pace of vaccinations in the U.S. and around the world will depend on whether the use of this vaccine is allowed to continue and under what circumstances. Most experts expect its use will be allowed, but it could be limited and there could be label warnings attached. The media is full of concerns about the impact on herd immunity, etc. But the likely reality is that the worst of Covid-19 is behind us and life will continue its path back to normalcy.
Today, actress Kate Hudson is 42. Ashley Judd is 53.
James M. Meyer, CFA 610-260-2220