August has something of a reputation in the market. The month is typically a slower market month in terms of trading volume and expectations, and since 1950, August has also posted the second worst market performance of the year, falling an average of 0.16%. To provide some perspective, market performance for the “next worst” month, September, has historically been down an average of 0.54%.
But these past few weeks—and frankly, the past few months—have felt neither slow nor average. That’s not surprising: The recent recession, which is the shortest in history, and the recovery, which is historical in magnitude and scope, have no parallel to any other time.
Although the markets have recovered and the economy is still going through fits and starts, conversations today still reference our ongoing COVID risks and concerns. Today’s complex events, including the most recent—the withdrawal of a U.S. presence in Afghanistan and its possible disruption to the emerging markets—provide provocative headlines that have captured investors’ attention and been reflected in higher levels of market volatility.
Of particular concern these past weeks is the increasing caseloads of Delta variant virus infections, amounting to roughly 3.8 million cases globally last week. The markets’ nervousness has escalated in tandem with mask mandate debates and increasing hospitalizations. Fortunately, from a market perspective, there seems to be little risk of replicating a global shutdown reminiscent of the early months of the pandemic last year. Companies continue to open up, clearing up
channel bottlenecks, and they report strengthening earnings. Consumers are still going about their lives, back to school, back to the workplace, shopping and flying. As evidence, the most recent TSA travel data posted steadily increasing passenger levels, hitting roughly 80% of 2019 volumes. Still, risks exist over the next several months, including concerns (and opportunities) related to inflationary expectations, market correction risks, infrastructure spending, and of course, tracking the Delta virus variant.
Consumers and the Job Markets
This year’s consumer recovery has changed lanes a few times with the job markets accelerating and the Delta variant’s re-emergence signaling a more cautionary path ahead. As we observed in the recent University of Michigan Sentiment Survey, consumers have become more nervous in their outlook with the index reading falling by 13.5% to its lowest reading in a decade. For some investors, this change in sentiment signaled that perhaps consumers were again sitting on the sidelines, especially given the 1.1% dip in July’s retail sales data. Market concerns were fueled by the 3.1% drop-off in online sales and the 3.9% fall in autos.
Lost in translation, however, was the reality that consumers were actually spending more time out of the house as evidenced by the 1.7% uptick in restaurant and bar sales and a 2.4% increase in gasoline receipts. The slowdown in auto sales was also easily explained by an ongoing shortage in microchips which contributed to the car inventory shutdown.
When assessing the health of the retail markets, we must keep in mind that growth metrics that compare last year to this year or to any future time will continue to get more difficult. Future reports necessarily will compete with the extreme rebound in sales from the pandemic lows during the spring months of 2020. Since the retail sales lows 18 months ago, shoppers have already bridged the sales slowdown gap while adding another 19% to the pre-COVID retail peak.
Jobs have also made headlines lately as companies continue to hire (or at least try to hire) new employees. This past update was a reminder that unemployment levels are steadily falling to today’s 5.4% level while new jobs are being posted.
In June, job openings jumped to 6.2%, representing its sixth consecutive growth record of 10.1 million job openings. Hoping to attract new employees, companies have increased wages, with that metric increasing by 4%.
As job seekers move back into the labor markets, the overall financial picture has improved for the “average” household. According to the recent NY Fed survey, despite increases in new homeownership (and mortgage debt, up 6.8%), delinquencies are at historic lows. Likewise, even with an upturn in credit card debt during the second quarter of this year, overall balances have dropped by $140 billion since the end of 2019.
Over the past several weeks, the path for businesses has been much the same as that of consumers. On a positive note, this past quarter’s economic growth rate showed GDP up by 6.5%. The detractor, however, was expectations that were closer to a growth rate of 8.5%. As is often the case, the message was not only mixed, but more importantly, the data is now dated.
During the three-month look-back, however, consumer spending was on a roll (up 11.8%), including dining, socializing and traveling. Another big ticket item was business equipment spending, up an annualized 13% as manufacturers opened and updated their production facilities. Large detractors for the quarter, however, were residential investments (off 9.8%) and a significant drawdown in inventory levels resulting from the pandemic-induced factory shutdowns. The
benefit from the drop in inventories is that the restocking of distribution channels will likely be the underlying positive theme for this third quarter GDP release.
More recent business-related data has also carried mixed messages. As an example, the Small Business (NFIB) Optimism Index fell back to a late March level with respondents reporting a loss of confidence in the strength in the economy, difficulty in accessing supply chains and an expected slowdown in job creation. Although this sentiment was also reflected in the New York Empire Manufacturing Index (falling from a reading of 43 to 18.3), the opposite was true with the Richmond Fed Manufacturing Index. The index reported manufacturing (new orders, shipments and employment) expanding for the fourth consecutive month. Mixed signaling was also evident in a number of July industry reports, with the Institute for Supply Management (ISM) Services Index posting its highest reading (64.1) in the series’ history. By contrast to the service industry benchmark, the ISM Manufacturing report posted its second monthly decline (to 59.5), given a shortage of raw materials and a backlog of customer orders.
Of interest to businesses, consumers and investors is the prospect of escalating inflationary risks. Inflation has been a top-of-mind issue over the past several weeks as headline reports have highlighted or possibly magnified the prospects. Risks of a rate increase are certainly on the rise, at least according to a recent Atlanta Fed Business Expectations survey. Respondents expected a 3% inflationary increase in costs over the next 12 months.
Meanwhile, July’s CPI inflation rate rose by 5.4% (spiking prices in used vehicles, hotels, airfare, car rentals and hotel rates), while the Producer Price Index was up an annualized 7.8% for July, the largest increase since November 2010. Whether these cost levels are transitory or more permanent, only time will tell. Until then, all eyes are watching for some Fed intervention in the form of rate hikes and a paring back of asset purchases, most likely to occur this December or possibly January 2022.
Market Headwinds and Tailwinds
Investors are growing more and more concerned with obstacles ahead that are beginning to cloud market outlooks. Of course, the uptick in Delta-variant infections is once again accelerating health risks and the potential for economic disruptions. Commentary from the Federal Reserve has also put the market on notice that changes in rate policies and liquidity support are on the horizon, although the timing and magnitude are still open-ended questions. We should have
more clarity on monetary policy issues over the next month or two, but in the meantime, investors are now increasingly nervous about how the markets will react to potential changes.
Despite equity markets concerns, the markets have continued their post-pandemic rally, with July’s S&P 500 returns posting the sixth consecutive month of positive market performance. At least through July, global equities have been supported by improving margins and earnings growth. While earnings revisions have been accelerating overseas, companies here at home have reported banner growth in both revenue and earnings. At the close of the second quarter, we saw posted corporate revenues of more than 24%, which according to FactSet, was the highest year-over-year growth since the metric was tracked in 2008. With respect to earnings, the story was the same, as earnings growth for the full calendar year of 2021 is expected to post rates of 41.9%.
Through the balance of the year, however, expect earnings momentum to lose steam as year-over-year comparisons become more difficult and the growth rates become more “normal.” The downshift in earnings, coupled with the health and monetary impacts already discussed, will become more evident as we head into the third quarter, and I expect the markets to reflect the slowdown in growth rates and return expectations. Add to those factors the still developing regulatory uncertainty in Chinese markets, the ongoing discourse regarding the Afghanistan withdrawal and a bit of congressional wrangling over the infrastructure spending bill, and I expect more market nervousness.
Setting the Stage
Today, inventories are low and being replenished, distribution channels are reconnecting with bottlenecks unwinding, and job openings are still at historical highs, at least until filled. Households are in solid financial shape; corporate earnings growth is at a multiyear high (although peaking) while business investment is escalating. Retail sales are still growing, although rates have undoubtedly peaked from last spring. In that context, consumers’ spending will also likely migrate from pandemic trends (house hunting, groceries, and household goods) to more service-related spending (hotels, travel and restaurants). In fact, this trend is already evident in the most recent ISM surveys. Continuing worries about the new Delta variant infection levels are warranted, but businesses and consumers appear to be coping with the changing protocols for distancing and wearing masks once more. The likelihood of another global shutdown seems to be rather slim.
As I cautioned last month, heightened financial market risks will continue to exist as we close out 2021. This certainly isn’t a call for a return to the sell-off experienced last year because today’s fundamental economic outlook remains positive. There is risk from rising, sticky inflation but little risk that the impact will accelerate across all sectors of the economy or global markets.
None of this will change the ongoing debate about the timing of the first, post-pandemic interest rate hike for the foreseeable future. Inevitability isn’t the question. I expect the equity and fixed-income markets to continue bearing the brunt of Fed interest rate second-guessing, with investors either moving to the sidelines or continuing to look for sources of growth and income. Neither changes our longer-term outlook, but it does add to the near-term volatility.
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