The Economy and Market from Here... at Hills Quarter 3 2021

The Economy and Market from Here... at Hills Quarter 3 2021

July 2, 2021

Tagged As: Wealth Management

Global stock markets continued their advance as subsiding cases and a growing number of vaccinated individuals allowed economies to further open. Consumers eagerly ramped up spending across the board but most notably on travel and lodging. The S&P 500 gained 8.55% in the second quarter and is up 15.24% year-to-date. International stocks are higher with the MSCI EAFE Index adding 5.35% for the quarter and up 9.21% year-to-date. Interest rates, somewhat surprisingly, have declined over the last three months despite expectations for higher GDP growth and inflation. The 10-year Treasury ended June at 1.44% down from 1.75% at the end of March.

As U.S. and global economic activity gathers momentum, the economy faces its biggest inflationary threat in four decades. The headline Consumer Price Index (CPI) jumped 5% year-over-year in May. This is primarily driven by a higher demand for goods and services that utilize major commodities. Factories and mines were severely disrupted by COVID-19 where inventories have been depleted. These supply chain disruptions have contributed to shortages of inputs and delays. Raw materials, such as aluminum, copper, oil, iron ore and lumber have all been in short supply in recent months, and their prices have hit record highs. Copper, a metal closely linked to global growth, has soared while lumber futures more than tripled at their peak last month. Producers are taking a hit on their margins from higher prices and are under increasing pressure to pass the burden on to consumers.

The Federal Reserve Open Market Committee (FOMC), led by Chair Jerome Powell, still communicates the belief that these inflationary pressures will be transitory, or temporary. In a press conference following the June FOMC meeting, Powell cited an anticipated drop in used car prices along with lumber prices coming off their peaks in June as key examples for this argument. The FOMC operates under a dual mandate and inflation is just one part, the second part is maximum employment. Currently unemployment sits at 5.8% and labor force participation (the number of individuals actively seeking employment) is still well below its pre-pandemic level. Though the unemployment rate is well below the 15% peak recorded in April of 2020, the labor market still has more ground to retrace. As people reenter the workforce, the normalization of the labor supply could play a key role in resumption of major supply-chains and the easing of inflationary pressures. The FOMC members have noted many times that near term inflation may run above their stated target in an effort to return to full employment – which is achieved by bringing the unemployment rate to somewhere between 3% and 4%.

The FOMC meeting in late June saw much discussion around tapering, or slowly reducing, the $120bn in asset purchases per month, otherwise known as quantitative easing (QE). The Fed faces this dilemma whenever the economy emerges from recession. How do they maintain credibility with those worried about inflation while also sticking to policy guidance? There are clear economic milestones that will allow them to remove accommodation, however Chair Powell has also made time-sensitive policy pledges, such as waiting until 2024 until implementing any rate hikes. The Fed cannot accelerate the beginning of policy tightening without breaking (or at least bending) these promises. As we have previously witnessed, the taper tantrum of 2013 saw the Fed chairmen of the time, Ben Bernanke, break some of his accommodative promises, resulting in a surprise spike in interest rates that frightened many investors. However, it seems that Powell’s comments following the June meeting struck the right balance, as the Fed took small steps toward tightening and away from calendar-dependent guidance.

Looking Forward
With the U.S. economy roaring back to life, concerns about overheating have dominated our conversations and news-headlines for the past several months. While many of the price movements could prove temporary, not everyone has accepted that explanation. With a selection of products getting more expensive and labor in short supply, more persistent inflation is certainly possible.

However, given the continuing resilience and the recent decline in Treasury yields, investors would seem to be in agreement with the Fed in sensing that we are either at or near a peak in inflation. The next few months will be pivotal as new economic and inflation reports are issued. Should the lead bank be proven correct and the recent upward spike in inflation subside, the bull market likely would continue. If a more sustained rise in inflation ensues, stocks may come under pressure as long-term rates will likely move higher.

Despite scattered labor shortages, continued declines in weekly jobless filings, a rebound in consumer sentiment, and rising industrial production, economic strength should help produce a solid rate of GDP growth this quarter. Therefore, we have allowed equity allocations to drift 2-3% above the policy target midpoints. Our investment committee remains cautiously aware of inflationary threats and is ready at any point to execute rebalances to reduce risk should these threats turn out to be more sustained than predicted.

We are here to answer your questions and make sure your current asset allocation is still appropriate for your circumstances. If it has been a while since you have visited with us, please do not hesitate to call or email and set up a meeting with your Hills Bank Trust and Wealth Management Officer.

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