June Private Client Letter
/Discounting Near-Term Uncertainty
U.S. equities continue to grind higher as we move into the summer months. Following a minor pullback of about 4% for the S&P 500 (and nearly 7% for the NASDAQ) early in May, stocks have been broadly rebounding. As June begins, the U.S. equity markets stand within striking distance of reaching new all-time highs.
Optimism over much better COVID-19 data, the reopening of our economy and the anticipated wave of activity in the second half of the year, continues to support stock prices. While recent economic readings have been mixed, consumer sentiment remains strong and both industrial production and manufacturing activity are now up substantially from a year ago.
We continue to expect an acceleration in economic activity to levels well above current consensus estimates. The trade deficit report from late May came in much lower than expected, which raises the likelihood that second quarter GDP growth will be much stronger than originally anticipated. If the trend for growth maintains its current trajectory, we could soon see economic activity surpassing what we had before the COVID-19 pandemic hit. GDP should also see further support as millions of unemployed workers find their way back into the workforce later this year.
While we do expect a very robust recovery, we understand there will be setbacks and volatility along the way. In the coming months, the data will be noisy, and equities will experience a bumpy ride. Last month forecasters had predicted one million new jobs had been created in April when payrolls increased by only 266,000 for the month. The Federal Reserve’s vice-chair, Richard Clarida, referred to this as the “biggest miss in history”. Now all eyes will be on the May employment report with expectations calling for about 600,000 new jobs.
The point is that a wide variety of macroeconomic imbalances still exist, and it will take time for these imbalances to be worked out. The global economy is not something that can simply turned off and turned back on according to government edict without serious repercussions. We feel it is wise to look past the near-term uncertainty and focus important decisions on what the economy will look like going into 2022.
We also think it is important to understand that this recovery will look very different when compared to the last one. The COVID-19 pandemic acted as a significant shock to our economy as opposed to the systemic meltdown, we experienced in 2008-2009. Almost all the COVID-19 government stimulus has gone directly to consumers whereas much of the liquidity flooding the banking system after the financial crisis was held in bank reserves. This time around consumers have control of massive amounts of liquidity as the M-2 money supply surged by almost 27% during the pandemic.
Eventually, this enormous liquidity and record fiscal spending will pass their peak levels and fundamentals will again become the primary consideration. Economic activity will eventually moderate and new challenges will emerge because of the unprecedented conditions created in our battle with a global pandemic. Higher interest rates and higher inflation are two important challenges coming our way and investors must think differently as we move through the next several years.
Higher input prices and wage costs will eventually pressure profit margins for many U.S. sectors. Higher levels of profitability will be difficult to achieve as margins are impacted by these shifting conditions. Companies having limited pricing power will be especially hard hit. Higher inflation will also steepen the yield curve and net free cash flow will become an important variable in identifying attractive equity opportunities.
The next 18 to 24 months will likely be defined by a stronger-than-expected surge in economic activity and corporate profits; that is the easy part and investment strategy should be positioned accordingly. It is the next 18 to 24 months that will present challenges we have never seen, or at best have not had to navigate for many decades.
All of this will play out as an unprecedented cross section of discontinuous technologies converge to transform nearly every area of our lives. How we shop, work, learn, communicate, recreate, commute will become unrecognizable when compared to the way things were just ten years ago. Advances in the biosciences will change healthcare and medicine in ways few can fully appreciate today. Our world is becoming increasingly virtual with data, computer learning, and artificial intelligence poised to disrupt even the most entrenched players.
Innovation and disintermediation will become household words as all of us adopt faster, cheaper, and better ways to do all sorts of things. Businesses will adapt, invest, and transform, or they will sink into irrelevancy as the world accelerates forward. The opportunities are as exciting as the risks are formidable.
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. Please do not hesitate to reach out to us should you have any questions or concerns.
John E. Chapman
June 2021
