Fire Capital Market Update - 2Q 2021

“NOBODY GOES THERE ANYMORE. IT’S TOO CROWDED.”

– YOGI BERRA

As we head into the second quarter of this year, it seemed apropos to reflect on the parallels of the upcoming season with our current outlook. Spring is a time of growth, new beginnings, and emergence after remaining dormant during Winter. In referring to what is often a turbulent transition to springtime, the saying goes, “if it comes in like a lion, it will go out like a lamb.” In much of the same way, the global economy is entering a similar stage. Having spent much of the last twelve months hunkered down by the long “COVID Winter,” businesses and consumers are broadly resuming activity in a resounding way.

In terms of new beginnings, job growth continues to improve as demonstrated by the lowest level of weekly initial unemployment claims in over a year coupled with the latest monthly jobs report soundly beating expectations. Subsequently, the International Monetary Fund (IMF) now forecasts global economic growth in 2021 to be higher than we have seen in the last decade.

Consumers Lead the Way for Global Economic Growth

Remaining at the forefront of the global recovery, the U.S. and China reign supreme among peers. As the first to contend with, and emerge from the pandemic, China has regained form as the world’s second largest economy. Economic activity is expanding as suppliers feverishly work to restore supply chain disruptions and the resulting backlogs. But China is not simply an export driven economy any longer. Much the like the U.S., the Chinese consumer is a significant contributor to the recovery and future expansion.

Returning to the U.S., consumers stand poised to spend away pent-up demand. The $1,400 deposits are still making their way to the 150 million individuals expected to receive the latest stimulus. The previous stimulus package resulted in a massive increase in savings that ultimately found its way to consumer spending. As people continue to adapt to working remotely, and boosted by low rates, housing prices have achieved all-time highs. Further, indicators of consumer sentiment have moved higher as the economy reopens and employment rates improve.

To meet this demand, businesses are ramping up activity to the highest level seen in multiple decades. In the latest monthly Purchasing Manager Index (PMI) survey, both manufacturing & non-manufacturing (services) sectors achieved a score above 63, beyond the 50 benchmark that marks a state of expansion. Worth monitoring, companies and suppliers continue to report challenges to meet increasing demand.

Not Out of the Woods but Headed in the Right Direction

The key to sustainably reopening the economy is maintaining low rates of infection and deaths related to COVID-19.  Vaccine distribution in the U.S. has increased and now stands at nearly 170 million doses administered. President Biden has announced that vaccines will be available to all adults by the end of May. Pfizer recently announced that their vaccine was 100% effective on children ages 12-15. While still awaiting FDA approval for children, this represents a major tailwind to allow schools to return to in-person sessions by the start of next school (trials have already been initiated for children ages 6-11).

Relatedly, the workforce participation rate has been reduced disproportionately for women during the pandemic. Impromptu childcare providers’ ability to rejoin the workforce in the Fall should run parallel with the expiration of the extra unemployment benefits provided from the most recent federal relief package.

Coupled with reopening protocols and relaxed standards in nearly every state in the U.S., we have the ingredients for a material near term pick-up in GDP. The travel & leisure industry, among the hardest hit in this recession, is likely the largest benefactor. We have already seen the evidence of crowds on Miami Beach, Florida, and the pace of booking of cruise ships is already outpacing pre-pandemic levels.

The airline industry is responding to expectations of rising demand as well. On the heels of Boeing’s 737 Max being cleared to recommence operations, Southwest Airlines increased their previous purchase order for the next decade by 100 additional planes. Even the NFL is making plans to operate games at full capacity this Fall.

Federal Economic Plan Unveiled

Further plans for longer-term economic support from the Biden administration are beginning to take shape. Announced as the “American Jobs Plan,” the proposal consists of a $2.7 trillion package* deployed over eight years aimed at broad areas, from transportation to technological R&D. The proposed spending can be broken apart into five categories: clean energy and power ($674 billion), traditional infrastructure ($658 billion), R&D/manufacturing/workforce ($610 billion), safety net spending ($400 billion), and non-traditional  infrastructure ($368 billion).

Because this plan affects budgetary concerns, the congressional reconciliation process is in play. Keenly, future expenditures must be offset with revenues which naturally lends itself to tax increases. The current proposal largely targets corporations. Raising the corporate tax rate from the current 21%, provided by the 2017 Tax Cuts and Jobs Act (TCJA), to 28%, re-establishes one of the highest corporate tax regimes in the developed world. The sentiment for higher corporate tax worldwide may be gaining traction as the U.S. Secretary of the Treasury, Janet Yellen, called on G20 countries to agree on a global corporate minimum tax rate to end a “thirty-year race to the bottom on corporate tax rates.”

The policies that are most likely to be ineligible for consideration in a reconciliation package are non-budgetary/regulatory provisions, such as policies that would increase competition for broadband delivery, allow for collective bargaining, repeal the subminimum wage, or otherwise change regulations designed to promote or mandate buying or shipping American.

Over the long term, if the execution of the plan is successful and spending leads to a stronger labor market, improved competitiveness, technological advances, and productivity gains, the proposal could help sustain above-average levels of growth and provide significant benefits to the economy.

Inflation Expectations Rising

Accompanying this spending spree are expectations for an increase in inflation.  Concerns regarding inflation typically occur late in an economic cycle. As we have discussed previously, this is because the labor market would be presumed to have achieved maximum employment and wage pressures would rise.  But we are at the very early onset of this cycle, so what gives? Simply put, a dramatic increase in the money supply. We also observe further evidence of rising inflation expectations through the yield spread between Treasuries and Treasury Inflation Protected Securities (TIPS) known as the break-even rate.

Complicating matters further, in the near term, shortages of key supplies across many industries hamper production and place further upward pressure on prices. Critical inputs to meet demand, such as lumber, battery components, silicon computer processors, etc., are in short supply. Even with the massive container ship, “Ever Given,” no longer blocking the Suez Canal, dozens of similar ships are anchored off the coast of California awaiting clearance of the bottleneck to begin unloading their cargo. As a result, the typical wait time for an order from Asia has turned from weeks into months. The supply chain disruption is clearly still being felt and certain business are faced with the difficult decisions as to how to pass on added costs to their customers.

The Federal Reserve has acknowledged near-term inflationary pressure but attributes it as merely transitory. They have reiterated that they expect to remain accommodative for the foreseeable future as the labor market recovers. An important component in their assessment is that the slack in the labor market provides a buffer against sustained excessive inflation. This tempers steeply rising wages as workers are drawn back into the labor market as the economy expands.

As the economy recovers towards maximum employment, the Federal Reserve must balance the benefit of marginal job increases versus the destructive forces of runaway inflation expectations. In our view, a material risk to slowing the economic expansion is the Federal Reserve being forced to contend with excess liquidity by tightening monetary policy and raising interest rates.

Markets are Adjusting to Higher Growth Expectations

In terms of market performance, fixed income instruments, such as bonds, do not fare as well as stocks during times of rising inflation. This is due to the simple fact that the payment the bondholder expects to receive is worth less in the future. While treasury yields have risen dramatically in recent weeks, they are still relatively low and below pre-pandemic levels.  Moreover, much of the yield curve still reflects negative real rates which has historically been a boost for equity market valuations.

Much of the volatility we have experienced to start the year may be a consequence of investors’ appreciation for sectors of the economy most sensitive to economic expansion. Energy, Financials, and Industrials have outperformed, while Technology and consumer-oriented sectors have lagged. For Q1 2021, the consensus estimated earnings growth rate for the S&P 500 is nearly 24%.  We have not seen forecasts for growth rates this high in a very long time.  Despite the recent volatility, all 11 sectors of the S&P 500 finished the first quarter in positive territory as the index reached a record high.      

Overall, we are enthused to witness the return of robust activity as we emerge from the pandemic to begin anew. Much in the same way as we welcome the Spring, we observe strong expectations for future growth met with budding opportunities. While not without its share of challenges, the upcoming quarter is shaping up to deliver plenty of upside potential. Consumers within the world’s two largest economies are well positioned and activity is buzzing. With any luck, pretty soon we’ll be planning our next evening out and think to ourselves, “Nobody goes there anymore. It’s too crowded!”

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