August Private Client Letter
/The Economic Recovery Is Not Peaking
Economists and analysts began the year with relatively muted expectations for the U.S. economy. Emergency use authorizations for COVID-19 vaccines were just being issued and there was much uncertainty surrounding their availability and efficacy. Understandably, most forecasts for the reopening of the economy were cautious, if not grim. At the beginning of the year our country was still very much in lockdown mode and while hopeful, true optimism was hard to come by.
Clearwater Capital published something of a differentiated view in our Outlook 2021 report (January). We made a strong case for daily vaccination rates approaching 2.5 to 3.0 million per day. That, along the natural immunity that people who had recovered from the virus would have, put us on course for the economy to begin “reopening” around Memorial Day.
We believed then, and continue to believe today, that this reopening would be the leading economic story for 2021 and the surprises would be on the upside. As we approached early summer our differentiated view was becoming something of a consensus view. However, the dominant narrative calls for “peak” growth in the third quarter. In other words, most commentators believe economic activity would lose steam following a brief surge in growth.
Once again, Clearwater Capital has a different view of where things stand. We do not believe the economy is “peaking” at this time, rather we believe the pundits are vastly underestimating the momentum and breadth of the reopening story. Importantly, recent data appears to support our forecast that economic activity will remain well above the trendline well into 2022, and possibly 2023.
The U.S. economy advanced an annualized 6.5% in the second quarter of 2021 with personal consumption expenditures growing at 11.8%. Retail sales rose 0.6% in June coming in much higher than the consensus expected decline of 0.3%. Overall sales are up a robust 18.0% from a year ago, and sales are up 18.2% versus February 2020, which was pre-COVID.
Some analysts have commented that the GDP number should have been stronger. What they miss is the surprising decrease in inventories. In other words, firms didn't have enough stuff to sell. When companies increase inventories, it registers as an add to GDP, and when they sell more than they replenish, it causes a drag. In the second quarter, contracting inventories subtracted about 1.1 percentage points from total GDP growth (Source: Business Insider).
Even so, real GDP surpassed its previous high from before the pandemic struck, in the final quarter of 2019, and was one of the fastest quarterly growth rates in the last 18 years.
The recent GDP report also included a sizeable upward revision in corporate profits, with corporate profits in first quarter 8.6% above the prior estimate. This supports our view that equities represent an attractive asset class, even as prices continue to rise.
Corporate earnings have consistently come in above estimates throughout the year. The second quarter reports are showing companies beating on both revenue and profits. Revenues are up 21% year over year – marking a new record for revenue growth. Earnings are up 86%, the highest since the fourth quarter 2009, and are running about 18% above expectations (Source: CNBC).
Most analysts have underestimated the last several quarters by a wide margin and are now scrambling to raise estimates for the second half and even 2022. There appears to be an emerging realization that the economy is running much stronger than expected.
Our view remains very constructive when it comes to how long the above average growth rates will last. We believe the “peak” in economic activity is further out than many currently understand. There is an extraordinary level of pent-up consumer demand throughout our economy and there is an astonishing level of liquidity in our system. The M-2 money supply exploded during the crisis, and it is now estimated that excess savings could total as much as $2.3 trillion. In other words, there is a lot of real money in real people’s hands, and these consumers are eager to re-engage.
As is always the case, there are things that could go wrong relative to our optimistic expectations. Inflation is currently running well above trend. In fact, annual inflation rate in the US accelerated to 5.4% in June of 2021 from 5% in May, hitting a fresh high since August of 2008, and well above forecasts of 4.9%. Biggest price increases were recorded for used cars and trucks (45.2%), gasoline (45.1%), fuel oil (44.5), utility gas service (15.6%) and transportation services (10.4%). These are big numbers.
We believe inflation will be much less “transient” than the Fed suggests it will be. We think the Fed is falling behind the curve on inflation and the risks of a policy mistake are rising. Eventually the Fed will need to begin “tapering” their quantitative easing activities (i.e., lowering or eliminating their monthly bond purchases). How the markets react to this shift will depend on the fact pattern at that time. We are now expecting a taper announcement by the end of the summer, possibly at the Jackson Hole meeting.
Near-term, we are aware of high valuations and the potential for some seasonal weakness (the next several months have historically been weak). We are currently trading at about 20 times earnings estimates for 2022, however as observed above, profit estimates are rising. While we expect periods of elevated volatility in the second half of the year, we believe the magnitude of economic growth going forward indicates investors should remain fully invested.
In closing, thank you!! We are grateful to be your partner on this fascinating journey. We will rise to the challenges ahead as we work hard every day to bring clarity to a complex world.
