Jon Manchester, CFA, CFP®, Senior Vice President, Chief Strategist - Wealth Management, and Portfolio Manager - Sustainable, Responsible and Impact Investing
June 30, 2021
Amidst record-breaking temperatures in the Pacific Northwest, the term “heat dome” has been used to describe how a high-pressure system traps warm air, like a lid on a pot. Seattle, with only three days over 100 degrees ever, hit triple digits three consecutive days in June. Portland established a new all-time high at 116 degrees, causing streets and sidewalks to buckle, and power cables supporting streetcars to melt. CBS News deemed the heat wave a once-in-a-millennium event for the region, while acknowledging this may happen more often due to our changing climate.(1)
Equities likewise continued on the boil over the first half of 2021, with the unrelenting sunny conditions pushing stock prices ever higher and parching the bear crowd. The benchmark Standard & Poor’s 500 Index closed at a new all-time high on 35 of the 124 trading days, including five straight to end June. With a total return above 15%, the S&P 500 Index posted its second-best return over the first half of the year this century, trailing only 2019. Smaller capitalization U.S. stocks fared even better, riding the recovery wave to a nearly 24% return in the S&P Small Cap 600 Index.
The heat dome hovering over equity markets can be attributed in part to the enormous fiscal support doled out, but perhaps most importantly to the Federal Reserve’s unyielding commitment to keep interest rates low. After an eye-opening first quarter in which the 10-year U.S. Treasury Note yield nearly doubled to 1.74%, it somewhat puzzlingly reversed course and finished the second quarter at 1.47%. This despite a rising chorus of inflationary data points and a normalizing U.S. economy. Gross Domestic Product (GDP) grew at a 6.4% annualized rate in the first quarter, inflation adjusted, and second quarter growth could be in the 8% to 9% range once the numbers roll in.
Bond market investors appear to be largely nonplussed by it all, perhaps coolly ignoring the inflation noise and looking past the artificially high economic growth data in the near-term. However, it hasn’t escaped attention that a major player in the bond market is our own central bank. The Fed’s monthly purchases of $80 billion worth of U.S. Treasuries and $40 billion of mortgage backed securities are designed to keep borrowing rates low, and this quantitative easing program has proven successful on that front. Raymond James calculated that the Fed has purchased nearly 60% of U.S. Treasury debt offerings since the pandemic started, and its importance is growing as issuance slows.(2) It also remains that the 10-year U.S. Treasury yield appears relatively attractive when you survey the global landscape: how do United Kingdom 10-year bonds at 0.7% sound, with a side of currency risk?
Stock market meteorologists expect the heat dome conditions to persist for some time yet, with the Fed potentially communicating its intent to taper bond purchases later this year. Fed Chairman Jerome Powell said of their June 2021 meeting: “You can view this meeting as the talking-about-talking-about tapering meeting.” The quote clearly burnishes Powell’s already stellar Fed-speak resume, but also underlines his heightened sensitivity to the markets’ reliance on easy money.
Expect less. Pay More.
According to Federal Reserve Bank of St. Louis data, M2 money supply jumped from $15.4 trillion in January 2020 to roughly $20.4 trillion as of May 2021.(3) This rapid expansion sent coffers overflowing, and subsequently those excess funds have poured into a dizzying array of asset classes. The nascent NFT (non-fungible token) market—where digital items are assigned ownership via blockchain—saw an investor spend $2.9 million earlier this year on Twitter CEO Jack Dorsey’s first tweet: “just setting up my twttr.” Fittingly, the transaction was done in cryptocurrency.
Money seems to be seeping into every possible area, seeking its level, perhaps nowhere more apparent than in the housing market. The S&P CoreLogic Case-Shiller 20-City Home Price Index shot up 14.9% year-over-year in April, registering its largest gain since 2005. Not surprisingly, the University of Michigan’s “Good Time To Buy A House” survey hit an over-30-year low in May. Inventory shortages and supply chain challenges have only turned up the heat on prices, underpinned by historically low mortgage rates and enabled by Fed policy. With homes routinely selling above the asking price, the FOMO (Fear Of Missing Out) gauge is stuck on high.
Despite the rabid and, in some cases, disconcerting enthusiasm for risky assets, there are notable positives for equities beyond helicopter money. Halfway through the year, analysts have sharply revised their corporate profits estimates higher for the S&P 500. Wall Street envisioned 2021 earnings of $164/share for the Index at the outset of the year, but now expect $187. Notably, the S&P 500 Energy sector has seen its 2021 earnings estimate more than double, with West Texas Intermediate (WTI) crude oil up to $73/barrel from $48 at the end of last year. As a result, the forward S&P 500 price/earnings multiple based on 2021 profits is essentially unchanged. At a shade under 23x, it’s a full valuation, but the forward-looking market is already considering 2022 and starting to gobble up the projected earnings upside. Other segments of the equity markets commanded less of a growth premium than the tech-heavy, U.S. large-cap benchmarks: mid/small-cap stocks, value, international.
In addition to robust earnings growth, equities have a strong buyer in the form of corporations themselves. Goldman Sachs tabulated $567 billion of share buyback announcements from U.S. companies through early June, a record-high for that point in a year.(4) Market behemoths Apple and Alphabet accounted for a combined $140 billion of that total. Goldman estimates $726 billion of repurchases for S&P 500 companies this year and believes corporations will represent the largest source of net U.S. equity demand for the remainder of 2021. When it comes to timing, corporations have not always been the most discerning of investors but they do serve as a key source of demand for equities, and this spike in intended buybacks is indicative of the confidence shown by management teams in future margins and cashflows.
The Jabs and the Jab Nots
In this new Coronaverse, the global economy remains beholden to public health outcomes. In May, the Organization for Economic Cooperation and Development (OECD) issued its semi-annual Economic Outlook and noted a stark disparity in how long it may take for countries to recover to their pre-pandemic GDP per capita levels. Among the G20 (Group of Twenty), some nations such as China, the U.S., and Japan have either already fully recovered or are expected to this year. In contrast, for G20 members including Argentina, South Africa, and Saudi Arabia, it may be 2024 or later. One key difference is the vaccination rate. In the case of South Africa, they had just one vaccination dose administered per 100 people in the total population as of late May.(5) As the report said, from an economic perspective, it is a case of “more jabs, more jobs.”
The U.S. jobs recovery has been uneven, perhaps distorted by the extended unemployment benefits and regional differences in vaccination rates. June’s employment report indicated an encouraging 850,000 jump in nonfarm payrolls, bolstered by a 343,000 increase in leisure and hospitality jobs. However, as a Bloomberg story pointed out, U.S. payrolls remain nearly 6.8 million below their pre-pandemic level, lessening the pressure on the Fed to react and withdraw some monetary support.(6) The nonpartisan Congressional Budget Office (CBO) projects that employment will grow quickly over the second half of 2021, surpassing its pre-pandemic level by mid-2022.(7) This potentially gives the Fed some cover to bide their time, at least with respect to raising the Fed Funds target interest rate.
Assuming the recovery remains on track, attention will likely swing to restoring some semblance of fiscal fitness. The CBO estimates the federal deficit will hit $3.0 trillion in fiscal year 2021, roughly triple the 2019 shortfall. This would take federal debt held by the public to around $23 trillion, or 103% of GDP, by the end of the year. Not surprisingly, D.C. budget hawks are circling and a host of investment-related tax proposals have been floated to boost revenues. Thus far, political gridlock has impeded progress, although 130 countries recently endorsed a global minimum tax rate of 15% for corporations. One notable holdout is Ireland (and its 12.5% corporate tax rate) but all major economies, including China, are on board. Nevertheless, this tax pact has miles to go as it will need approval from Congress and the European Union amongst other hurdles.
For now, the heat dome conditions remain largely favorable for corporate profits. Tax rates may move higher, but S&P 500 companies paid a roughly 18% tax rate in 2020, a steep discount to the more than 31% average rate since 1993.(8) In fact, this year’s first quarter S&P 500 operating margin of approximately 13% is a record high. It seems likely that rising labor, input, and eventually borrowing costs will dent margins going forward, but many companies enjoy strong pricing power and continue to achieve cost efficiencies via the ongoing digital transformation. Equities, of course, have a lot of this good news already baked into current prices. Any significant deviation from the consensus view—whether that’s greater-than-anticipated inflation, a hawkish turn from the Fed, or some other veer off script—will pressure elevated stock multiples. In other words, enjoy the warm front while it lasts. We will be watching for a barometer change.
1 “Pacific Northwest bakes under once-in-a-millennium heat dome,” cbsnews.com, 6/29/21
2 “Institutional Equity Strategy Update,” Raymond James, 6/18/21
3 “M2 Money Stock,” fred.stlouisfed.org, May 2021
4 “Households and corporations will drive $500 billion of incremental equity demand through year-end,” Goldman Sachs US Weekly Kickstart, 6/18/21
5 “No Ordinary Recovery,” www.oecd.org/economic-outlook, May 2021
6 “U.S. Jobs Jump by Most in 10 Months as Economy Gains Steam,” www.bloomberg.com, 7/2/2021
7 “An Update to the Budget and Economic Outlook: 2021 to 2031,” Congressional Budget Office, July 2021
8 “S&P 500 Earnings And Estimate Report,” www.spglobal.com, 6/30/2021