With the economy continuing to rebound markets remain at all-time highs. However, the resurgence of COVID and a recent deceleration in data has brought markets to an inflection point. On one hand, strong corporate earnings, a decline in interest rates, and an imminent infrastructure deal have created a fundamental backdrop for continued gains. On the flipside, the threat of the Delta variant, friction in labor markets, and a slowdown in data has markets wondering whether we’ve already reached “peak growth”. This could set the stage for a correction as the economy shifts to a mid-cycle phase of expansion and markets readjust forward-looking expectations.
With market indices up over +15% YTD it’s clear that the positives have been winning so far. Corporate earnings in particular continue strong with nearly 90% of companies in the S&P 500 topping estimates so far in the 2nd quarter. Earnings actually are posting their fastest growth rate since 2009. This continues a tailwind from prior quarters and is helping to bring down valuations, with the forward P/E multiple lower by nearly 20% YTD. This means that in relation to expected earnings stocks are actually cheaper now than on January 1st, even with the market up.
While inflationary pressures remain a major source of concern, the corporate sector so far has broadly absorbed these costs without it affecting the bottom line. This has largely been due to the major productivity gains achieved in the last year due to the adoption of new technologies, as well as cost reductions in key areas such as real estate. Additionally, as more of the economy goes digital, these increases in input costs are having less of an impact on the overall GDP as they would have previously. Indeed, the share of overall market capitalization within technology and technology-enabled sectors has just continued to grow, with COVID only amplifying that trend. So even though inflation is pinching certain sectors greatly its having less of an effect on the overall market than you might expect.
Labor markets remain a key source of concern however, as a record number of jobs go unfilled even as the unemployment rate remains elevated, a reflection of both jobless benefits as well as a structural mismatch in skills. As companies are forced to increase wages to retain workers, more of these costs could start to flow through to both profits and consumers. While these pressures have thus far been mainly limited to the most pandemic-impacted sectors, this warrants close attention. As we have discussed previously, the Fed is watching the evolution of these data closely as it signals its intentions on monetary policy. To the extent that these pressures begin appearing more persistent than anticipated, the Fed may need to tighten policy faster than expected. This would likely cause some volatility given that the market right now is largely buying the Fed’s narrative that much of this is “transitory” in nature.
Indeed, over the last month treasury yields have continued their decline with the 10-year yield dipping below 1.3%, from a high of nearly 1.8% earlier this year. These movements suggest markets are discounting these pressures to some degree, in line with the Fed’s thinking, and moderating their expectations for growth. And it hasn’t just been limited to the US, with bond yields dropping in developed markets globally. This seeming disconnect between record stock prices and lower yields warrants attention, as it suggests bond investors are becoming more pessimistic than stock investors are.
However, one plausible interpretation is that the Delta variant may simply “take the froth off the top”, rather than trigger a deeper economic pullback. The slowdown in job gains also supports the notion that the Fed might delay in tightening, which all things equal is better for both stock and bond investors in the short-run. This would explain why the stock market doesn’t seem to be worried while at the same time tempering growth enough to delay sudden rate hikes that would hurt bond investors.
Nevertheless, the longer this divergence continues the greater the likelihood of volatility, as it leaves little room for surprises in either direction. Despite their mixed signals, payrolls do continue to improve, with the unemployment rate down to 5.4% before the Delta variant took hold. Markets could be caught off guard if labor tightness suddenly accelerates. And from a purely technical perspective, stocks are somewhat due for a pullback, as it’s now been over 190 days since the last 5% decline, as compared to a historical average of 97 days. That stocks have performed as strongly as they have in the face of these uncertainties speaks soundly to the underlying resiliency of earnings right now and the greater efficiencies being achieved in the economy.
Looking forward into the Fall we remain very constructive on the market while also remaining vigilant for opportunities to add value in portfolios when volatility arises. This “tug-of-war” between positive and negative factors in the stock market is likely to continue into year end, with the constant stream of new data helping markets to continually reassess. Importantly, all eyes will be on the Fed to see how these data change monetary policy. We will be watching closely.