With the economy roaring back after a year of reduced demand, markets are again trading at all-time highs, with most indices up double digits year to date. While we’re not completely out of the woods, the rollout of COVID vaccines has been sufficient to allow for a broad return to pre-pandemic norms. Service sectors in particular have picked up dramatically in recent months with people again filling restaurants and booking a well-deserved vacation, which in turn is driving up the prices of food, fuel, and flights. The sudden surge in activity has caused some hiccups as supply chains and hiring struggle to keep up with demand. In fact, much of the market volatility we saw in the second quarter was driven by concerns the economy is doing “too good”.
With the Federal Reserve holding firm on its easy monetary policy, markets have been holding the spotlight on Chair Jay Powell and his view that these inflation pressures are mostly temporary. In particular, markets are watching closely to see if the rise in prices causes the Fed to shift forward the end of the current easy monetary policy. Thus far, however, the data has broadly supported his view, with the majority of pressure happening in areas that were most hit last year. These sectors, such as hotels, car rentals, and restaurants, had the most drastic cuts last year in prices and staffing, and as a result are simply returning now to pre-pandemic levels. Other areas of froth have likewise started to correct, with lumber prices down over 50% in 8 weeks and the housing market showing signs of slowing. As a result, markets so far appear to be going along with the Fed’s point of view, as the recent move lower in treasury yields attests. Likewise, we’ve seen technology and other growth stocks recover lost ground as future expectations of inflation moderate.
Despite this cautious optimism expressed in the market, there is still the potential for some volatility as more data is released and the Fed’s signaling solidifies. The longer the current pace of growth continues the greater chance the Fed moves forward its initial rate hike, which in turn could put some pressure on the stock market. Congress is nearing passage of a $1tn infrastructure bill, which if passed, could stimulate growth for years to come. Likewise, consumers are now starting to spend the extra savings they’ve built up after a year of deferring purchases. To the extent that these stimulative factors happen gradually and in tandem with a normalization of supply chains and labor markets, then the market should take these in stride. But to the extent they precede them then that ironically poses a risk to the market as it could cause the Fed to intervene.
One strong tailwind helping markets though is the surge in corporate earnings, which is helping to bring down valuations and limit the downside in a market correction. Despite increasing costs, companies are continuing to increase their profits through a combination of strong top-line growth and productivity gains. While this needs to be closely monitored it seems that last year’s surge of technological adoption and reallocation of resources in labor and real estate have helped to offset other cost increases and protect margins. In our view, this is part of the reason that a staggering 85% of companies in the S&P 500 beat earnings estimates in the first quarter, and another reason we continue to be cautiously optimistic looking into the second half of the year. We will continue to monitor market developments closely and stand ready to act in portfolios when opportunities arise.
As always, thank you for your continued trust and confidence in our firm. We wish you and your family the best and welcome any comments or questions you have.