“Let the Good Times Roll” or Not
After an intentional shutdown of the U.S. economy in 2020 and unprecedented monetary and fiscal policy designed to provide economic support to weather the COVID storm, we are experiencing a resurgence in economic activity that has few historical parallels. The Federal Reserve is charged with balancing healthy economic growth with the potential adverse impacts of long‑term inflation. Given the unusual circumstances, it is no wonder why Federal Reserve members are becoming increasingly divided concerning the path forward. Should they follow the advice of the 80s band The Cars and “Let the Good Times Roll” or take a more pre‑emptive approach to inflation and begin to tap the brakes on economic activity?
The mid‑month announcement was the first indication that the brakes will begin to be applied, albeit in 2023. The announcement was likely driven by mounting inflation data, and the debate over whether the recent trend is sustainable or more transitory in nature. While the consensus among Fed members remains in the camp of transitory, it is not unanimous. More hawkish members are sending up warning signals over concerns about the long‑term impacts of excessively accommodative policy. Investor reaction was swift as interest rates at the long end of the yield curve dropped sharply. After the announcement, 10‑ and 30‑year yields dropped by 15 and 18 basis points, respectively. Since the meeting, generally dovish comments from various Fed Governors have pushed yields higher and back toward pre‑announcement levels.
We believe the rising inflation data is a function of pent‑up demand in both the consumer and business sectors coupled with supply chain issues in the form of both raw material and labor shortages. The duration of the imbalance and elevated prices cannot be known, but we expect a normalization of prices in the months to come. We have already seen lumber prices begin to decline and expect more normalization across the economy. One sector where prices will likely remain elevated is Energy. Changes is U.S. policy related to energy production will likely continue to constrain supply coming out of the U.S and hence keep prices elevated. With respect to possible policy changes at the Federal Reserve, we continue to believe that an increase in short‑term rates will likely follow a reduction in Federal Reserve bond purchases that have kept long‑term rates low during the pandemic.
|Market Index Returns||June 2021||YTD 2021|
|S&P 500 Index||2.3%||15.2%|
|Russell 2000 Index||1.9%||17.5%|
|MSCI EAFE Index||-1.1%||8.8%|
|Barclays US Agg. Bond Index||0.7%||-1.6%|
|FTSE 3 Mo. T‑Bill Index||0.0%||0.0%|
Stock Market Review & Outlook
Investors Quickly Shook Off Federal Reserve Red Flag
Prior to the Fed meeting, equity markets continued to trend steadily higher, then fell four straight days following the Fed announcement, only to recover quickly. The S&P 500 closed the month with a gain of 2.3%, while posting an all‑time high to close the month.
With the month of June in the books, the S&P 500 has now posted positive returns for five successive months. During periods of such strong equity performance, we are often asked “is the market too high” or “when will the market sell off?”
We all know markets move up and down for a variety of reasons, some quantifiable and others emotional. And while we also know that predicting short‑term market movements is folly for any serious investor, we do look to various pieces of data to help frame our short‑term and long‑term outlooks.
To provide some context, one major factor we consider is the earnings generated by the companies in the S&P 500 Index. Generally, the S&P 500 Index trades at between 18 and 20x the earnings its constituents generate over the prior 12‑month period. As of June 30th, the index was trading at 30.7x earnings. All things being equal, one of two things would need to happen to put this valuation metric in line with historical averages. One, we would need to see very strong earnings growth and for markets to not increase or decrease in price. Or two, we would need to see the price of the index decline or sell off.
Based on what we’ve seen so far in 2021 in terms of quarterly earnings, and our belief that strong economic activity for the remainder of the year will foster an environment of further earnings growth, we anticipate markets to trade within a close range of the current level in the coming quarters. Should our view of the economy change and become less favorable, the possibility of a market correction would increase proportionately.
|S&P 500 Sector Returns||June 2021||YTD 2021|
Economic Review & Outlook
How Much Stimulus is Too Much?
There are several levers the government has used to maintain both capital market stability and economic activity. Monetary policy involves keeping interest rates low and high levels of liquidity in markets which both ensures funds are available in the system and at very low or attractive borrowing costs. There are several mechanisms the Federal Reserve has implemented to achieve this goal. The other tool governments use is fiscal policy, or more simply put, spending. To date there have been five COVID stimulus packages and several executive orders to support individuals, businesses, and municipal governments amounting to more than $4.6 trillion in cash pumped into the economy. At this writing, another infrastructure bill is being negotiated. While the exact amount is unknown at this time, we can expect that it will be above $1 trillion.
To be sure, a combination of these policies over the past 18 months has been instrumental in creating the V‑shaped recovery from the pandemic, and the growth we are currently experiencing. However, it does come at a cost ... rising government debt. The Federal Deficit continued to march higher, closing the month at $28.5 trillion. While U.S. deficit levels are lower than most developed countries, we continue to run annual deficits. The long‑term implications of these policies and the subsequent rising deficits are unknown. But the rising deficit does present a potential future risk to both economic activity and the government’s fiscal flexibility to deal with another crisis that may emerge in the future.
Chart of the Month
Total Public Debt Outstanding
With more than ample liquidity in the financial system and strength in major economic areas such as housing, manufacturing, employment, and consumption, we anticipate strong quarterly economic growth through the end of the year. This elevated level of activity should continue to support corporate earnings growth, which will support stock market valuations.
We expect interest rates to stay within a tight trading range and for the yield curve shape to remain steep, as the Federal Reserve’s policy will continue to keep short‑term rates low. Longer term rates could once again move modestly higher should the Fed announce a reduction in Quantitative Easing (buying bonds to inject liquidity into the system) or inflation concerns begin to percolate.