Stocks rallied Friday cutting the losses for the week. While there were some favorable earnings reports from retailers, most of the news last week was negative. Afghanistan turmoil, slowing retail sales affected by increases in Covid-19 infections, persistent inflation, and a falling 10-year bond yield all combined to impact financial markets.
As I have noted many times, markets have difficult times dealing with transitions. The Fed is on the cusp of tapering its pace of bond purchases. The timing and pace are likely to come out no later than the September FOMC meeting, but the tapering won’t begin until late fall at the earliest. While traders may whipsaw markets fussing over the exact timing, in the long run, whether tapering begins in November or January isn’t all that relevant. What is relevant are earnings and inflation.
Earnings continue to increase as the economy gets back to normal. Normal is 2-3% real growth. There are still parts of the economy functioning at a less than normal pace. It may take another year to fully normalize, and that assumes the winding down of Covid-19. What will change is the rate of growth. Earnings rose by more than 80% in the second quarter on a year-over-year basis. That pace will slow dramatically not because of anything wrong, but because the second half of 2020 was markedly better than the first half. Comparisons get tougher. Closer to normal. But not normal quite yet.
As for inflation, some of the spikes have stopped. Frantic buyers chasing homes has slowed. Used car prices, which were rising 10% or more in sequential months, have flattened out. Gasoline and lumber prices are in decline, but rents are rising and likely will continue to rise. Wages are also increasing as businesses are forced to pay more for workers.
The Covid surge is delaying the return to offices. As the virus fades, workers will return, maybe not 100%, but a substantial portion. There is no substitution for collaborative work other than in person. The surge is also impacting other economic sectors including travel and restaurants. Supply chains remain disrupted. Spikes in prices for everything from ground beef to selected seafood are forcing restaurants to raise menu prices or make menu substitutions. Businesses are contending with shortages of key components as well. Just-in-time inventory management only works well when low inventories can be replaced quickly. When they can’t, you see the disruptions we all seem to face every day.
All these disruptions add up. Last week several leading economists cut their growth forecasts for the second half of 2021. While that would make a long-term difference if the disruptions were temporary, some will prove to be long lasting. I suspect finding the right employee to fill vacant positions is going to be an ongoing problem.
Academic studies have shown that it takes about a decade to recover from a financial crisis. Ten years after the Great Recession took us to late 2019, a time when unemployment rates were near all-time lows and excess supply was finally getting absorbed. The only true excess was money, as demonstrated by record low interest rates, and a steady decline in monetary velocity. Then Covid-19 hit. The economy stopped. Excesses reappeared. Businesses once again hoarded money. The recession was non-traditional in every sense. It lasted only weeks. It wasn’t an economic event as much as a reaction to a medical disaster. Once the devil was contained, life got back to normal relatively quickly aided by enormous Federal spending and a flood of money poured into the economy by central banks. As the economy recovery, central banks continued to flood markets with even more money. That won’t stop until the tapering process ends, at least a year away. President Biden wants to spend another $5 trillion, not all of which will be paid for by new revenue sources. Do we really need to grease an economic inferno? The Fed is finally talking about closing the faucet. What happens next is still unknown.
As the Fed tapers, the economic growth rate subsides, inflationary pressures persist, and supply chain disruptions continue, the choppiness we saw last week is likely to continue. Choppy doesn’t mean down it means volatile. There will be weeks dominated by negative news and there will be weeks that highlight the economy’s ongoing strength. Given the huge earnings surge so far this year, P/E ratios are actually going down even as the stock market hits record highs. The one key to watch when tapering finally begins, is what happens to long-term interest rates. Does slowing growth and negative rates overseas contain any rise in rates in the U.S. or will enduring inflationary pressures and less bond buying lead to a move higher for long-term bond yields? Answer that question and you will be able to define the direction of financial markets over the next year. Clearly, since the Great Recession, all asset values have benefited from a flood of money. One could argue that the excesses abetted the surge in speculative assets from SPACs to cryptocurrencies.
We are entering unchartered waters. We all have ideas where we are headed but unchartered waters always carry a unique set of risks. That is why more volatility can be expected. For the next several weeks, until we get to third quarter earnings season, an absence of hard news increases the chances of heightened volatility.
Today, Seth Curry is 31. Barbara Eden turns 90.
James M. Meyer, CFA 610-260-2220