Stocks finished higher yesterday, although the NASDAQ Composite fell. There was clear rotation from the growth names toward the cyclical stocks. Banks, energy companies and industrials were notable leaders. The 10-year Treasury continued its week-long rally. It has risen over 20 basis points since ADP issued what turned out to be a weak and inaccurate forecast of July job creation.
The other factor in the economic mix is the impact of the Delta variant of Covid-19. The lead story every day on the evening news and on the front page of major newspapers has been the rapid surge of the variant, particularly in the South and within those states where vaccination rates are below the national average. As schools get ready to reopen, precautions are being put into place. Companies that planned to reopen offices in September are either deferring their decisions or requiring vaccinations. But the net result is that there has been much more muted economic impact during this surge than amid prior outbreaks. Schools are going to reopen in person. A few might limit class days and spread out students more, but those requirements will likely last only until there is a meaningful decrease in the latest surge. While it doesn’t seem likely that this surge will even end, if you listen the media each day, any review of prior outbreaks or a look overseas at the patterns in the U.K. and Israel, which saw their Delta surges before us, suggest that the U.S. is at or near a peak for this outbreak. By Labor Day, case counts, especially in states that saw surges early, will start to fall. Once that happens, it is likely that the fall will be as rapid as the ascent. At least that has been the pattern for surges ever since the pandemic began.
Stocks look ahead. The rotation from growth to cyclicals has two catalysts. The first is the one I just alluded to, that the Delta variant surge will peak in the coming weeks with minimal economic impact. Yes, there may be some hesitancy to fly or eat indoors. Movie theatre attendance may fall or stall for a few weeks, but overall, business will go on as normal even if it takes a bit longer to get workers back into their desk chairs at company headquarters. The second factor relates to last Friday’s employment report and this week’s pending inflation data. The jobs numbers suggest ongoing economic strength. The JOLTS reports on job listings out Monday topped 10 million for the first time. If you want to work, there is a job waiting for you. More jobs mean more money which means higher earnings and GDP. The inflation data puts grave doubt into the Fed’s assertion that price increases are transitory. While supply/demand mismatches coming out of the pandemic created some price spikes that indeed will prove temporary, companies today have their greatest pricing power in almost a decade. Rents are starting to surge; they are the biggest component of the consumer price index (CPI). Wages are rising at ever faster rates. The average starting wage is now at or above $15 per hour. So much for the need for a mandated $15 per hour minimum wage! Free markets work and do a better job than the politicians.
The combination of ongoing economic strength and higher more persistent inflation suggests strongly that the Fed will start its process of tapering bond purchases sooner, perhaps as early as Thanksgiving. While this will help to dissipate the tailwind associated with easy monetary policy, it works in favor of keeping the rate of inflation under some level of control. Some might argue this point and note the Fed is always too late when it comes to dampening inflation. They may prove to be right. But we won’t know for at least another year. Meanwhile, easing steps already taken will take another 12-18 months to work through the economy. The economic impact of easy monetary policy will help promote above average growth for at least another year or two.
A few weeks ago, as interest rates were closing in on 1% for 10-year Treasuries, concerns rose that slower growth together with fears associated with the Delta variant might lead to a more rapid economic deceleration than had been expected. Furthermore, managements in their second quarter conference calls warned that margins could be squeezed by rising input costs. While that raises concerns, the fact that so many more businesses have pricing power today than just a year ago, suggests that rather than letting margins get squeezed, companies are likely to respond with price increases.
All this plays well for cyclical companies. Banks will benefit from rising rates and a steeper yield curve. Industrials will benefit from resurgent demand and their ability to pass along cost increases. More economic activity will lead to more energy consumption. Electric cars may be coming but they are only 3% of sales today and comprise a much smaller fraction of vehicles on the road. Oil companies may have a cloudy future, but their near-term prospects appear solid. Retail sales are spiking. Online sales are torrid and malls are filling up. There is room for both.
As I noted Monday, a lessening tailwind, associated with fewer central bank bond purchases, isn’t a headwind. Higher interest rates will be a headwind for stock prices over time, but strong earnings continue to be a powerful tailwind. Neither the economy nor the stock market moves in a straight line. At least for this week, the mood is rosier. Earnings season is behind us, the Fed should lay out its tapering plans within a month, and we can begin to see past the worst of the Delta variant, even as the evening news remains stuck on the present. I expect a much slower ascent for stock prices in the months ahead with more bumps in the road, especially if there are short-term spikes in interest rates. But if I had to choose between stocks and bonds today, I still would favor equities.
Today, Terry Bollea, better known as Hulk Hogan, is 68. Steve Wozniak, co-founder of Apple, turns 71.
James M. Meyer, CFA 610-260-2220