Fire Capital Market Update - 3Q 2021

THE TIMES THEY ARE A-CHANGIN’

As we cross the halfway point of this year, many of us find things to be in a state of transition. While the world continues to contend with a return to some form of normalcy, reopening the economy has not come without tradeoffs. These tradeoffs are showcased with Japan’s spectator ban for the upcoming Summer Olympic Games.  

On the positive side, economic growth is rebounding significantly. Outpacing the global average, the annualized growth rate exceeded 6% for the U.S. economy in the first quarter of this year. Consensus estimates reflect even stronger growth through the second quarter of 2021. This underscores the fact that should the spread of COVID-19 remain controlled, the U.S. is on track for its strongest rate of annual growth in decades.

Alas, the COVID-19 global pandemic is not over. Many countries are facing difficult decisions in their efforts to contend with increases in new COVID-19 cases. In particular, the, “Delta” variant has emerged as a menacing threat to the gains we have made thus far. Indeed, developed economies are largely the benefactors of greater access to vaccines and healthcare. In the U.S. the virus appears controlled to the point where nearly all states and territories are fully open to business activity. Broad measures of the U.S. economy reflect an aggressive expansion already underway. As a result, mobility continues to increase towards pre-pandemic levels. The July 4th weekend saw nearly fifty million vacationers, with air travel rebounding strongly from early pandemic days.

Yet key areas of the economy remain understaffed to meet the demand, contributing to the debate on current and future inflation.  Job growth has not recovered commensurate with the vigorous business activity. The additional weekly benefits provided through the Federal Pandemic Unemployment Compensation (FPUC) are set to expire in September, but nearly half of the states have already withdrawn from the program to bring workers back to the workplace.

In the private sector, some employers are raising wages and resorting to signing bonuses to attract the help needed to meet customer demand. Others are utilizing technology by way of automation to manage rising unit labor costs. Typically, wages are thought of as “sticky,” meaning that once they come up, they don’t easily come back down. The current dynamic of high unemployment and wage growth has a direct, and potentially enduring, effect on the inflationary picture throughout the economy.

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.

But rising wages are not the sole determinant of inflation expectations. More flexible Work From Home (WFH) arrangements, coupled with the prevailing low-interest rate environment, has dramatically impacted the demand for housing. In many markets, the current supply of single-family homes cannot keep pace with demand and a national home price composite index reflects soaring price levels. Further illustrating the large demand imbalance, building materials such as lumber have experienced dramatic and volatile price movements. As the movement of goods through global supply chains continues to play catch-up, many normally available goods are still in short supply. For example, Automobiles continue to be impacted by supply constraints and these constraints have resulted in higher and more volatile prices throughout this year.

As production in the U.S. ramps up, we are starting to see signs of price stabilization, however, the June Consumer Price Index (CPI) reading of over 5% is worth noting. While this is the largest reading since 2008, fears of experiencing inflation like the spiraling inflation of the 1970s should be tamed when considering the current level of productivity which has averaged over 4% over the past year. Productivity certainly won’t remain that high indefinitely but, as companies restructure and reorganize their workplace, it does serve as the foundation for higher potential GDP without concerns of overheating the economy.

Additionally, the Federal Reserve (Fed) has been steadfast in their assessment that these inflationary pressures are acute and transitory in nature. Moreover, the Fed remains committed to an accommodative monetary posture as the labor market continues to heal from the effects of the pandemic. Looking at the latest unemployment data, we are encouraged by a modest improvement in the prime working age segment but note that further improvement will be required for the Fed to reach their employment targets.

We will likely see further improvement if states follow the Center for Disease Control’s recent guidance that schools reopen this fall. This additional push to a return to normalcy increases the prospects of a robust labor market improvement in the latter half of the year. However, sustained progress toward containing COVID-19 outbreaks and minimizing new cases will be vital to this proposition.      

The recent fall in interest rates and further flattening of the yield curve likely reflect the market’s appreciation for the Fed’s perspective. However, some are speculating that this signals forthcoming economic weakness. Our experience suggests that if economic weakness was directly ahead, the decreases in interest rates would also be accompanied by a widening of credit spreads and a tightening of financial conditions.

On the contrary, at present we see the opposite occurring. In fact, there is evidence that a handoff between government stimulus and the private sector is emerging. This handoff is fueled by labor market improvement, healthy consumer balance sheets, accommodative lending standards, and a functioning credit market.

With this as a healthy backdrop, it’s not surprising that record levels in U.S. equity markets are supported by increased earnings expectations. Heading into the second quarter earnings season, year-over-year earnings growth forecasts is greater than 60%. For perspective, profitability estimates have not reached this level since the first quarter of 2010. Contrary to recent years, this rally is not merely the product of share buybacks and multiple expansions. While traditional value and growth style factors have each had their time to shine this year, well-managed companies who are willing to invest in themselves and their people are likely to come out on top. To that end, we are encouraged by the amount of capital expenditure deployed by businesses that has accompanied the economic recovery.

Overall, the U.S. remains at the forefront of global growth as well as the reopening story. However, sustainable progress is highly contingent upon successful containment of COVID-19 variants. Meanwhile, many of us are taking advantage of more flexible work arrangements while adjusting to higher levels of productivity. Further, the U.S. labor market has sufficient slack to mitigate near-term inflationary pressures, allowing the Fed to remain accommodative while they pursue their policy goals. In a perverse way, the right amount of uncertainty related to new COVID-19 variant may extend the Fed’s easing timeline further than the market expects. As markets adjust to inflation and growth expectations not seen in recent memory, market volatility will likely persist for the balance of this year. However, consumers and businesses are primed to support further expansion. Indeed, the times are changing, but growth requires change, and we stand ready to capitalize on whatever lies ahead!

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