July 2021: Economic & Financial Market Outlook

The Economic Recovery Remains Strong

The economic recovery that began this past spring has remained on track through the early weeks of the summer driven by a successful vaccination effort and an accelerating re-opening of the U.S. economy.

At this writing, nearly half of the U.S. population has been vaccinated and new COVID-19 cases are at the lowest levels since the early days of the pandemic. While the recent vaccination rate has been a bit slower than anticipated earlier in the year, still close to a million people per day are getting vaccinated and by now the most vulnerable populations are largely covered. There remain some concerns regarding new strains of the virus and the relatively low vaccination rates overseas, but for now the COVID-19 pandemic appears at least to be manageable.

The success of the vaccination effort has instilled confidence in the public and people appear increasingly comfortable re-engaging in the economy. Pent-up demand fueled in part by fiscal stimulus money has helped boost spending across multiple sectors. For example, retail and auto sales are spiking to well above pre-pandemic levels. New and existing home sales are the best in over a decade with home prices up double digits from this time last year. And durable goods orders that include items such as appliances and computers have reached all-time highs.

The U.S. National Recovery Tracker examines six dimensions relative to their pre-COVID-19 state. Each index is calculated as the equal-weighted average of multiple high-frequency indicators. For example, the “Health” dimension is a function of ICU utilization rates, new COVID-19 cases per million residents, and the weekly average positive COVID-19 tests.
All dimensions are indexed to 100 in the week ended 1/31/2020. The chart shows rising positive indicators this summer across all dimensions including health, demand, employment, production, mobility and financial with several returning to pre-COVID-19 levels.

Employment has picked up although job growth remains somewhat sluggish for this stage of recovery. The lag may be due to a variety of factors keeping people from returning to work including residual COVID-19 fears, extended unemployment support, or the search for better jobs. However, job openings are spiking. They now number over 9 million, the highest on record, up from about 7 million openings pre-COVID-19. Driven by opportunity and need, we expect people to continue to return to the workforce helping the economy to maintain positive momentum.

In summary, the strength of the recovery appears strong, supporting our expectation of a robust 6.5% to 7.0% GDP growth for the full year of 2021. This would be the highest growth rate since the mid-eighties.

The Expanding Role of the Government and Inflation Fears

Over the longer term, economic vitality may be buttressed by additional rounds of government spending. Negotiations are ongoing in Washington on a massive infrastructure bill and bipartisan agreement has been reached on approximately $1 trillion in new allocations to roads, bridges, transit, broadband, water, and electric vehicles. President Biden and the Democrats are proposing even more generous outlays with some plans at price tags as high as $6 trillion. These broader plans would tack on targeted spending in areas such as childcare, education, climate change, health care, and housing.

Although massive in size, the proposed infrastructure spending will likely extend over several years and, therefore, pack less of a one-time punch for economic growth than recent stimulus measures. Nevertheless, these plans could stabilize longer-term growth and dramatically increase government influence over several areas of the U.S. economy, not to mention having an impact on tax policy and interest rates.

When the economy heats up and government spending rises, inflation often becomes a concern. Indeed, the Federal Reserve’s (Fed) current 2021 estimate of inflation is now 3.4%, up a full percentage point from its estimate just three months ago². While the Fed believes this recent spike is transitory and its projections for 2022 and 2023 remain close to its target of 2%, estimates can change fast, presenting a risk to financial markets, as well as to consumers’ purchasing power.

The State of the Financial Markets

For fixed income investors, short-term yields remain close to historic lows. The two-year Treasury Note now stands at just 0.25%. Short-term rates are influenced by and anchored to the Federal Reserve policy and the current rate reflects the Fed’s 2021 target range of 0%-0.25%. Looking forward, the Fed expects to begin to shift its rate policy in 2022 in response to improved labor conditions and inflation levels. We will closely monitor the Fed’s actions to keep on top of any movements upward at these shorter maturities and to assess the impact of these changes on investors and the economy.

Long-term yields are up after sinking to record lows last year at the onset of the pandemic. The current ten-year Treasury yield is 1.45%, up significantly from its nadir of 0.52% in March 2020. We expect longer-term yields to continue to move higher in 2021 and possibly into 2022 driven by both inflation and a Fed withdrawal of its bond purchasing programs commonly referred to as quantitative easing.

Currently, the Consumer Price Index (CPI), the key measure of inflation, is around 3.8%⁴. This makes the ten-year “real” yield of Treasuries well in the negative. We would not expect such negative real yields to persist for an extended period, especially with the current upward pressure on inflation.

Our view of the stock market is one of cautious optimism. On the back of a strong economy, we expect 2021 S&P 500 earnings per share to be a healthy 15% to 20% higher than 2019 pre-COVID-19 levels and we envision that this positive momentum will continue through 2022. Low interest rates and a lack of attractive investment alternatives are also expected to provide some near-term support for stock prices.

However, we have some concerns regarding the near-term ability of stocks to continue to produce the robust gains recently posted. Potential changes in corporate tax policy may negatively impact 2022 earnings and stock market valuations may be negatively affected by rising inflation.

We recommend maintaining current exposures to U.S. equities to take advantage of the continuing strong economic recovery and material earnings advances through the end of the year. We, however, need to remain sensitive to the potential devaluation in stocks that may result from rising inflation. Inflation also remains the dominant concern in the fixed income market and we prefer a lower duration, defensive bond portfolio to suit our expectations of rising rates.