July 2021

Key takeaways

► Another Solid Quarter for Stocks

► Bonds Recover

► Inflation is Top Story

► Have Stocks Topped Out?

► Second Half Strategy

Stocks deliver

While the meme stocks phenomenon continues to some degree, the broader market continued to set record highs. The S & P 500 index of large US stocks is up double-digits so far this year – up 15.25%. We are in a “Goldilocks” environment where the economy is strong but not overheating – yet.

• Earnings continue to surprise
• Interest rates are very low
• President Biden is working on a big infrastructure package
• And the Federal Reserve insists on maintaining its easy money policies.

The Fed’s stance may change depending on how inflation transpires, but stocks tend to do well with modest inflation. Stocks also usually continue to go up for many months after the start of a Fed tightening cycle.

Value stocks were the winners at the start of the year but have cooled off recently. Over the past three months, the Russell 1000 Growth Index is up 11.5% to the Russell 1000 Value Index’s 4.7%. Oil is the exception. Oil is skyrocketing, and energy stocks are following. Marathon Oil and Occidental Petroleum are up 99.1% and 76.4% year-to-date, respectively. Oil is now over $73/barrel. The low for 2020 was $11.63. In the 2^nd quarter, we saw growth stocks make a comeback. Let us look at how our high growth darlings from past newsletters have performed so far this year:

• Facebook: +27.29%
• Etsy: +15.70%
• Amazon: +5.63%
• Tesla: -3.68%
• Zoom: +14.74

All are up from their 1^st quarter levels, except Etsy, down just slightly.

Yields fell

Bonds struggled in the first quarter due to fears of inflation, rising supply, and a booming economy. Bond yields began the year at very low levels but quickly rose. The yield on the 10-year US Treasury – a benchmark for bond yields – ended the first quarter at 1.75%. By June 30, the yield fell to around 1.47%, delivering solid performance for bond funds in the second quarter (remember, bond prices move in the opposite direction of yields). Lukewarm news on the economy and several disappointing numbers on retail sales and job creation helped bonds. And President Biden’s infrastructure package was running into turbulence. However, the economic recovery is not going to be a straight shot up. The Federal Reserve remained steadfast in maintaining loose conditions despite alarming inflation data. From now on, bonds may also be assisted by continued reports of spikes in COVID infections worldwide and the spread of new, more contagious strains of the virus.

Inflation is a top worry

Investors remain preoccupied with inflation. The monthly CPI number, along with the Labor Department’s employment report, was one of the most anticipated statistics every month. According to the US Bureau of Labor Statistics, the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.6 percent in May on a seasonally adjusted basis after rising 0.8 percent in April. Over the last 12 months, the all-items index increased 5.0 percent before seasonal adjustment; this was the largest 12-month increase since a 5.4-percent increase for the period ending August 2008. Will it last? More importantly, are expectations of higher inflation growing? Time will tell. The Federal Reserve insists that inflation is transitory – the result of a rapidly opening US economy after introducing effective vaccines. Overall, Americans surveyed expect the inflation rate will be up to 4% one year from now — a new high for one-year-ahead inflation expectations — and at 3.6% three years from now, the highest level since August 2013, according to the Federal Reserve Bank of New York’s Survey of Consumer Expectations for May. “Workers could start to ask for higher wages and speed up their big-ticket purchases, prompting companies to raise prices and creating the very phenomenon of inflation itself,” said Bankrate.com analyst Sarah Foster. 

Investors remain divided: one side says that the unprecedented amount of government stimulus in such a short amount of time to fight COVID-19 will overinflate the economy and lead to runaway inflation. The other side maintains that deflationary forces in the economy (think tech and Amazon, for example) before COVID are still in place. Fed Chair Powell is stoking inflationary fears with his talk of allowing inflation to run higher before raising rates, and President Biden promises more stimulus spending.

The case for inflation:

• Savings continue to pile up.Americans are saving! According to Euler Hermes North America, many are still cautious about things, and they are flush with cash – an extra $1.9 trillion. Savings grew during the pandemic when stimulus checks and lockdowns prevented eating out, travel, and even commuting. Although down slightly from early 2021, the personal saving rate in the United States amounted to 12.4 percent in May, according to the US Bureau of Statistics. The average in 1960 was 11%. As notorious as Americans are about their lack of savings, you know this is significant when we go back to 1960. All this money may eventually find its way into the economy – forcing a surge in prices.
• Dovish Fed. The Federal Reserve is maintaining its easy money ways. Fed Chairman Powell has stated that he is going to let inflation run higher for longer. The average inflation target is 2%, meaning inflation will have to ride higher for longer to counter the many years when inflation was below 2%. The average inflation rate since 2010 has been 1.72%. Minding its dual mandate to maintain stable prices and full employment, the Fed also hopes to decrease unemployment and achieve a measure of social equity by letting the economy run hot so that lower-income job seekers find jobs. However, several Federal Reserve board members have indicated that it is time to discuss tapering of its bond purchases.
• Scarce goods. A classic catalyst for inflation is too much money chasing too few goods. Factories continue to struggle to keep up with demand, especially for components needed in tech (semiconductors) and housing (lumber). The prices of several commodities, oil, in particular, continued to move higher in the second quarter. According to Andrew Hecht at Seeking Alpha, a composite of around thirty commodities that trade on US and UK exchanges moved 10.76% higher for the three-month period that ended on June 30.

The case against inflation:

• Nervous consumers. Despite flush savings, pent-up demand, and cabin fever, consumers may remain cautious about spending, worried about new virus strains and their jobs. Over four million Americans remain unemployed, and a poll from Monmouth University found that 1 in 5 Americans remain unwilling to get the COVID-19 vaccine. As a result, many Americans may wait a bit longer before venturing out.
• Unemployment. Too many Americans are still jobless. According to the US Bureau of Labor Statistics, in June, the number of long-term unemployed (those jobless for 27 weeks or more) increased by 233,000 to 4.0 million, following a decline of 431,000 in May. This measure is 2.9 million higher than in February 2020. These long-term unemployed accounted for 42.1 percent of the total unemployed in June. Also, what remains the most discouraging news on the pandemic economy, total employment in the US remained 5.7 million below February 2020 levels. 
• New COVID strains. While the economy continues to improve, the coronavirus continues to mute. Presently the new strains are called Delta and Lambda, and a new one seems to appear almost weekly. In addition, several parts of the world are experiencing severe outbreaks. Hesitancy to get vaccinated and a lack of vaccines in many third-world countries are not helping. All of this leads to a more hesitant consumer and makes for a shaky economic recovery.

We will probably continue to see prices go up through this year and next as the economy works to meet demand and wages go up to lure workers back. What investors, the Fed, and the White House are hoping for is an eventual leveling off or at least a very gradual increase in inflation in the next few years.

Stocks to move up

Many old and new tailwinds continue to support the stock market. Here are a few:

• The Fed’s easy money
• Hopes for infrastructure stimulus
• Rising vaccination rates
• Pent-up demand
• Strong housing
• Manufacturing coming home
• Tech disruption
• Biotech boom

Stocks owe their remarkable trajectory up to the Federal Reserve’s extraordinary efforts. Unfortunately, real rates (what is left after subtracting inflation) are still negative. And though yields have crept up from last year’s low, they are still relatively low by historical standards. The Fed’s pledge to keep rates lower for longer and foreign buying should keep rates low since our bonds sport higher rates than what you can find in many foreign countries.

Earnings continue to surprise. Analysts are falling all over themselves daily to increase their predictions for earnings and GDP. The stock market, being a forward discounting mechanism, may already reflect a lot of this good news. As a result, the market may flatten out over the next few months as we enter the summer and fall months, usually not a great season for stocks. However, earnings and growth may continue to surprise. And a lot will depend on the scope of President Biden’s infrastructure plan.

Tilt toward stocks

Stocks will likely continue their march forward in the second half of the year, propelled by strong earnings, strong growth, and low interest rates. However, we may have already seen the bulk of the gains for the year. Inflation and what the Fed may do about it remain key risks in the future. Continued success in beating back COVID will be crucial. Remain diversified with a tilt toward stocks, particularly value sectors in small-cap and international. We will monitor President Biden’s ability to navigate his infrastructure plan through Congress. Despite low rates and fears of inflation, I think it is essential to keep an appropriate amount in bonds. Bonds are like ballast in a portfolio. They provide income and protection in a stock market collapse.

Would you please let me know if you have any questions or concerns?

Enjoy the summer!

Sincerely, 
Henry 

Henry Gorecki, CFP® 
HG Wealth Management LLC 
10 S. Riverside Plaza, Suite 875
Chicago, IL  60606 
312-474-6496 
henry@hgwealthmanagement.com