Stocks are on track for their best monthly performance this year with gains of over 5% up to today, the final trading day of the quarter. The catalysts were better-than-expected economic growth, flat interest rates, and a nice earnings tailwind with no interest rate headwind.
As noted on Monday, we are at peak growth rates with peak inflation. That inflation should dissipate in the months ahead as supply catches up with demand. Higher prices in the interim will bring more production while reducing demand. That is the cardinal rule in the supply/demand equation. On Friday, the Government will issue its June employment report. It should be quite positive. Employment trends are likely to continue throughout the Fall as extended unemployment claims wane, students return to school, and offices continue to reopen. There are over 9 million jobs available, more than the current number of unemployed Americans.
Earnings reports for Q2 start in a few weeks. They will be outstanding. Year-over-year gains may exceed 50%. But that’s history. Investors are forward looking. They want to know what growth rates will look like in the future. Economic predictions suggest that growth, currently close to 10%, may be cut by two-thirds before the end of 2022. The drop will be uneven. Industries most hurt by the pandemic, like airlines and restaurants, are just beginning to recover. Others, where demand was swollen by the pandemic, will revert to normal growth rates soon. Still others, currently impacted by component shortages and supply chain disruptions, will see growth supercharged for several quarters as inventories are rebuilt. By the end of 2022, for most companies, year-over-year comparisons may return to some semblance of normal.
All this is going on amid massive ongoing fiscal and monetary stimulus. The Fed talks of pulling back, first by tapering bond purchases and later (probably much later) starting to increase interest rates. But the Fed has to act amid declining growth and rising inflation. It cannot sustain a growth economy if interest rates are allowed to get too high. Most observers still see real rates at or below zero through 2022 and perhaps quite a bit longer. That leads to distortions in financial markets and investment spending. Excess investment in many areas (think commercial real estate, for instance) have kept prices low and inflation in check. Certainly, investors haven’t been hurt by rising asset prices.
None of the Fed planning incorporates legislation that hasn’t passed. The Biden administration proposes as much as $6 trillion in added spending this decade. Even half that much would add about 1.4% per year to GDP. Of course, it might not get anything passed. The recent bi-partisan agreement on infrastructure lies in limbo as Democratic leadership in both the House and Senate wants to hold up the bill until they can get a 100% partisan package passed that includes as much of its progressive agenda passed as possible. However, getting Senators Manchin and Sanders to agree on a budget package won’t be easy. Democratic leadership will point to the Republicans for failure to support their ideas, but they are choosing to go it alone. To get there, they will need 100% support among Democrats in both chambers. Until that happens, the Fed will operate on the basis of today’s status quo.
Even without more fiscal stimulus, our economy is humming. It will continue to grow at above-average rates over the next 18 months. Ultimately, demographics and productivity will drive growth. History suggests that sustaining growth above 3% for any period of time will be particularly difficult. 2% is more likely. Even that requires that rates stay low and inflation in check. For the past 15 years, Fed actions have been fighting disinflation, not inflation. Massive stimulus can create some inflation, but it can’t be sustained once stimulus is withdrawn. We are following the path set by Japan in the 1980s when massive borrowing led to explosive growth only to fall apart in the late 1980s amid excessive speculation. Japan has never recovered. Of course, Japan’s demographics are much worse than ours and it lost its technological leadership along the way. Thus, while Japan’s growth has meandered either side of zero with deflation as prevalent over time as inflation, the U.S. should fare a bit better. Hopes of sustaining growth near 3% or greater will require ongoing massive government stimulus. Congress is certainly trying, but whether it can get across the finish line remains questionable. The Fed wants to ease, first by tapering bond purchases, but whether it can get there depends on whether long-duration rates stay low (3% or lower).
Markets at the moment see a soft landing, slower growth and very low interest rates, but that could change quickly. We will learn more from managements’ forward looking statements as they release second quarter earnings. For now, the outlook is good. How long momentum can be sustained remains an open question. We will look for hints in the coming earnings statements.
Today, Olympic swimmer Michael Phelps is 36. Mike Tyson turns 55.
James M. Meyer, CFA 610-260-2220