Weekly Perspective: Red Hot American Summer

Everyone seems to agree. This summer is going to be jumping.

Local economies are fully reopening. Consumers are ready, willing, and able to spend. The labor market is healing. And if this past 80-degree weekend in Brooklyn is any gauge, there is a palpable eagerness to get out and return to “normal”.

All signs point to a continued surge in demand for goods, and a long-awaited recovery in demand for services. As the Oracle of Omaha, Warren Buffet, shared this weekend, the U.S. economy is “red hot”.

This surge in demand is occurring at a time when supply is constrained in numerous areas. Inventories are extremely lean whether it is for semi-conductors, cars, houses, or commodities. But manufacturers are struggling to replenish inventories given supply chain bottlenecks in both production and transportation. Further, businesses are reporting difficulty in hiring. Job openings are now higher than the pre-pandemic peak, despite unemployment still at 6.5% and 9 million fewer people employed compared to before to the pandemic.

This rush of demand and tight supply is leading to observed price increases throughout the economy. Here are a few, with charts included at the end of the piece (where we can, we will include the comparison to 2019 levels to remove the “easy comp”/base effect):

• Used car prices are up +50% YoY and +40% vs. 2019
• Lumber prices are up +367% YoY and +336% vs. 2019, adding an average $36k to the cost of a new home
  • If you want to learn more about what is going on with lumber, this is a great podcast
• Copper prices are up +92% YoY and +53% vs. 2019
• Home prices are running +11% YoY, the fastest since 2006 during the housing boom, and +16% vs. 2019
  • Housing is estimated to be undersupplied by 1.5-2 million units
• Food prices are soaring:
  • Corn prices are +134% YoY and +100% vs. 2019
  • Milk prices in Europe are up +50% YTD
• The cost of packaging is +40% YoY according to Mintec
• Transportation costs are soaring, with the composite ocean freight benchmark rate +240% YoY and +260% vs. 2019; many ships are sold out through the summer
• The Employment Cost Index hit its highest level since 2007

Companies are planning to pass through this input cost inflation to consumers by raising prices (see FT article here). For companies selling goods that have few substitutes and are in tight supply, these price increases are likely to “stick”, as customers will have few options but to pay more. Other companies may be less fortunate, being unable to fully pass cost increases on to customers, resulting in margin pressures (a dynamic we discussed two weeks ago).

Of course, many of these bottlenecks will eventually clear, but supply chain issues of this magnitude take time to resolve. Further, labor shortages, despite elevated unemployment, may not start to clear until full reopening is accomplished. Less than half of the school districts in the U.S. are back to full-time in-person learning, likely keeping some parents from reentering the labor force.

Despite all of these observed price increases, policy makers, most notably Fed Chair Powell and Treasury Secretary Yellen, are sticking to their guns that these price increases are purely transitory. They expect price increases to be one-time, and to fade once the near-term impacts from base effects (easy comparisons from 2020) are lapped and bottlenecks clear. They also do not expect the nearly $4 trillion of stimulus from 2020 and 2021, and additional $4 trillion of stimulus planned for the next decade, to be inflationary.

This world view led Fed Chair Powell to promise the continuation of ultra-accommodative monetary policy at last week’s Fed meeting. There is no discussion in sight for “talking about” tapering the $120 billion of asset purchases, while rate increases from near-zero are promised to be many years out in the future.

This is leading some market commentators to express concern that risks of a policy mistake are rising given this new combination of highly stimulative fiscal and monetary policy. Larry Summers has called the fiscal measures “substantially excessive”, while Mohamed El-Erian has urged that the Fed needs to taper, but notes that it won’t given its new framework.

This framework discussion is important. Last year, the Fed switched from a “forecast-based” to an “outcome-based” approach to policy. Under “outcome-based” policy, the Fed can justify observing the data running hot for “some-time” before even considering removing accommodation. Before the Fed would be inclined to remove accommodation as the data began to approach targets (hence the intra-cycle slowdowns in 2015 and 2018).

One way to think of this is “forecast-based” instructs the Fed to slowly lift its foot off of the gas as it anticipates an upcoming need to stop. “Outcome-based” allows the Fed to keep the gas pedal slammed to the floor until it is given more than ample reason to stop, possibly risking a future slamming on the brakes.

Cameron Crise, an astute macro strategist from Bloomberg made a sharp observation about the hypocrisy of this framework and the Fed’s messaging last week:

“It’s as funny thing, this new “outcome-based” policy framework from the Fed. Despite re-iterating that the Fed will focus on actual data rather than forecasts, at the same time Powell has insisted that the Fed will ignore the data on rising prices, falling back on their forecasts that it’s just a transitory phase. It’s hypocrisies like this that earn them criticism from some quarters, with perhaps some justification. For today, however, anyone running an equity book with a long bias– particularly one with a large dollop of mega-tech– probably won’t care.”

As this Red Hot American Summer kicks into high gear, we expect the Fed’s messaging of “nothing to see here” in regards to inflation to become more awkward and difficult to justify. A robust summer of activity characterized by upside surprises to growth, a more rapid recovery in the labor market, powerful demand, continued supply shortages, and rising prices, could pull forward discussions about tapering. Add on top of this admissions by Powell about froth in markets and concerns by Fed members about excesses in markets, the Fed’s commitment to its new framework could get tested.

This raises the potential that the U.S. equity market could be a victim of its own success. As we wrote last week, any removal of monetary accommodation is likely to put downward pressure on earnings multiples and upward pressure on volatility. The divergence of a weak economy and strong market that we saw in 2020 could possibly reverse this summer, with a strong economy and choppier market.

One thing is for certain: this summer won’t be boring.

Last Week in Markets and Data

Equities Flat to Down Last Week

Major U.S. indices were flat to down for the second week in a row (S&P 500 +0.02%, NASDAQ -0.39%, Dow Jones -0.50%). Growth (-0.56%) underperformed Value (+0.40%), while smaller cap sizes were also negative on the week (Russell 2000 Small Cap -0.24%). Communication Services, Energy, and Financials were the best performing sectors, while Technology and Healthcare lagged.

Earnings Update

As of last week, 60% of S&P 500 names have reported 1Q21 earnings. 86% have beaten Street expectations (compared to a 74% 5-year average). The degree of earnings surprise is notable, with an aggregate 22.8% beat (compared to a 6.8% 5-year average). Aggregate 1Q21 earnings are now running up +45.8% YoY, which is significantly higher than the +23.8% growth expected when the quarter ended in March.

Yields Resume Their Ascent

After moving lower for much of April, the U.S. 10 Year Treasury yield resumed its march higher (+7 bps to 1.63%; notably after finding near-term support at its own 50-day moving average). We had noted that yields likely moved “too far too fast” in the first three months of the year, with long dated Treasury prices the most oversold on record. We continue to see a near-term uptrend for the 10-year yield, with room to move as high as 2.5% and remain in its 40-year downtrend.

Strong GDP for 1Q21

U.S. GDP grew at a seasonally adjusted annual rate of 6.4% in 1Q21. At $19.1 trillion, GDP adjust for inflation is now within 1% of the 2019 peak. Nominal GDP is now 1% above its 2019 peak (see chart below) Personal consumption, the biggest component of the U.S. economy surged +10.7% in the quarter, fueled by direct stimulus checks. The GDP report also included that PCE (Personal Consumption Expenditures, the Fed’s preferred measure for inflation) increased +2.3% in 1Q21 vs. +1.3% in 4Q20, showing that inflation pressures are building. The Personal Savings rate jumped to 27.9%, also fueled by the stimulus checks and pointing to strong spending potential by U.S. households as the economy reopens.

Continued Healing for the Labor Market

Initial jobless claims were below 600,000 for the third week in a row, coming in a 553,000, the lowest in the pandemic-era. This Friday we get a slew of jobs data.

Copper Touches $10,000 on Thursday

Copper futures prices, often used as a gauge of cyclical economic activity and health, briefly touched $10,000 last week. The last time copper reached these levels was in 2010/2011 the peak of the last commodity super cycle fueled by the massive infrastructure build out in China. Today’s rally is partially fueled by Chinese demand, but is also getting a boost from strong consumer demand for goods and housing (copper is a cost-effective conductive metal used in many consumer and industrial goods, with even more intensive use in “green” goods like electric vehicles). Further, supply is constrained due to pandemic disruptions (such as in Chile where mine production has dropped due to COVID infections). This is causing a drawdown in inventories and upward pressure on prices. Some capacity will come back as COVID restrictions are eased, but adding new incremental capacity is a long process (10 years for a new mine, 2-3 years to expand an existing mine).

DOMESTIC EQUITIES

Index Name	1 Week	YTD	Price
S&P 500	0.02%	11.32%	$1481
NASDAQ	-0.39%	8.34%	$13,963
Russell 2000 Small Cap	-0.24%	14.77%	$2266
S&P 400 Mid Cap	-0.75%	18.14%	$2725
Russell 1000 Growth	-0.56%	7.55%	$2611
Russell 1000 Value	0.41%	14.95%	$1551
Dow Jones Industrial	-0.50%	10.68%	$33,875
Dow Jones Transportation	1.41%	22.71%	$15,347

^{Source: Bloomberg, as of 4/30/21}

S&P 500 SECTORS

Index Name	1 Week	YTD	Price
Consumer Discretionary	0.94%	10.24%	1436
Consumer Staples	-0.06%	2.49%	714
Communication Services	2.88%	16.06%	258
Energy	3.59%	29.87%	372
Financials	2.38%	22.74%	602
Health Care	-1.90%	6.71%	1413
Industrials	0.33%	14.94%	862
Materials	0.03%	14.34%	521
Tech	-2.12%	7.04%	2453
Utilities	0.20%	6.25%	339
Real Estate	1.14%	17.18%	267
S&P 500	0.02%	11.32%	4181

^{Source: Bloomberg, as of 4/30/21}

 

 

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