With the economic recovery firing on all cylinders, markets have charged ahead to new all-time highs, as the uptake of vaccines and relaxing of restrictions have brought life somewhat “back to normal.”
Indeed, in the last few months we’ve seen a surge of economic activity as the third COVID stimulus hit Americans’ pocket books and the services side of the economy roared back after a year of depressed activity. Restaurants are full, workers are returning to the office and two-thirds of Americans are planning a summer vacation, double the normal rate. This sudden increase in activity has driven sharp rebounds in various economic indicators such as GDP growth, retail sales, building permits, and manufacturing demand. Most importantly for the stock market, corporate profits are rebounding strongly as well, with over 80% of companies in the S&P 500 beating their earnings estimates in the 1st quarter, continuing a trend from the end of last year. This earnings strength is helping the market “grow into” its valuation, as higher stock prices become more fairly valued versus actual profits.
Despite this strength, the stock market has sputtered a bit in recent weeks, with the impressive beats failing to drive further gains. This reflects the fact that with the market up over 10% year to date, much of this enthusiasm was already priced in. Talks of higher capital gains have caused some jitters as well. This “buy the rumor, sell the news” dynamic is typical and with the market moving so quickly in such a short period of time a little volatility is to be expected. However, this is a natural phenomenon in the course of a bull market, and with earnings continuing their momentum, the market is finding its base of support moving higher as well. Therefore, we believe any volatility in the short-run represents an opportunity to add value in portfolios.
As we wrote in our recent white paper, the shock of suddenly turning the economy “back on” overnight will cause some growing pains in the short run. We are already seeing it now in places like semiconductors, restaurant staffing, rental cars, and raw materials such as lumber and copper, all of which either cut capacity during the pandemic or re-routed supply chains to adjust to the drop in demand. This is going to take some time to work through, and accordingly, the economy is likely to see a near-term spike in inflation as it works to rebalance itself.
However, these price increases will largely be driven by the once-in-a-lifetime nature of the pandemic, which caused global supply chains and consumption patterns to change on a dime, and not just once but twice. This is a very different scenario from prior periods such as the 1970s, where the economy was chronically sluggish and a combination of a dollar devaluation and monetary expansion drove double digit inflation. In contrast, the current economy has a supply side that is slowly “catching up” with demand, but just needs time. Government officials, most prominently Fed chair Jay Powell, see significant slack in labor markets as well, which means as wages increase, people who left the workforce last year will be drawn back in. Indeed, the unemployment rate is still double its pre-COVID value, with the prospect of government childcare assistance likely to further expand the workforce. While inflation will likely spike over the next couple years and drive some market volatility, we believe it will eventually give way to various long-term forces that were dominant before the pandemic, which rendered it manageable.
We will be watching these developments closely in the coming months and will be prepared to act on opportunities as they arise. Portfolios are currently benefitting from being exposed to both the immediate cyclical rebound as well as playing the long game in areas that will drive value in the future. While many areas of life are returning to back to their pre-COVID normal, many of the shifts we saw last year appear likely to continue. We believe maintaining this balance will be critical to long term performance, even as the market twists and turns with the themes of the day.