A Market in Flux Equity Investment Outlook Third Quarter
During the second quarter of 2021 the stock market moved higher, propelled by strong post-pandemic economic growth coupled with robust monetary and fiscal stimulus. While inflation did increase as pent-up demand for goods overwhelmed production and transportation capabilities, the Federal Reserve (Fed) and the markets remained convinced that these supply/demand imbalances were temporary and any pickup in inflation transitory. Whether this view is correct is the $64,000 question.
We believe that economic growth will remain quite strong as we recover from the Covid-induced shutdowns. The consumer is generally in good shape financially and eager to go out and spend. Businesses are hiring in order to re-open or expand. Many employers report difficulty finding enough qualified workers. Wages in many industries are rising. High single-digit GDP growth should persist for another couple of quarters. Thereafter, growth will probably revert to a more moderate, but sustainable, low single-digit pace.
As we pointed out above, the current surge in demand exceeds the ability of producers to supply and transport many goods. As a result, prices for commodities and certain finished goods have risen, pushing inflation higher. For instance, lumber prices tripled, but since peaking have fallen 56%. Likewise, copper rose from $3.52 to $4.80 per pound but has since pulled back. Once businesses are operating at full capacity, we expect supply/demand to rebalance and prices to normalize. But this is not entirely a given.
In the meantime, the market appears befuddled by questions around the transitory nature of inflation, how long the strong rebound will persist, and whether a resurgence of Covid threatens the recovery. As a result, the average stock has traded flat since the first quarter earnings season, with the most recent market advance coming from a flight to safety in large-cap tech stocks as bond yields have fallen. More interestingly to us, we see high daily volatility between small and large caps, and growth and value. This suggests a lack of market consensus about the next stop for the economy – is our destination a return to low growth and low inflation, which is favorable for higher multiple secular growers, or structurally higher inflation and a long duration cyclical recovery, which favors value and cyclicals? While we think this is one of the most important questions in the market today, the ultimate answer is likely a number of quarters in the future. With respect to Covid, the success of the vaccines suggests to us that any Covid-driven setback in the recovery would be temporary.
One school of thought foresees persistent labor shortages and long-term upward pressure on wages, reversing trends of the last 20-30 years. Since roughly the mid-1980s, the twin forces of globalization and technology have conspired to keep labor costs down. Globalization allowed the U.S. and other developed countries to tap into nearly limitless Chinese and other developing economies’ low-cost labor pools. High-paying U.S. manufacturing jobs were shipped overseas. Union membership declined. Domestic wages stagnated.