Inflation, Disinflation & Rotation
by Clare Market Investments on Jul 2, 2021
Client Letter | 2Q 2021 Recap & 3Q 2021 Outlook
Economy Reopening & Market Rebounding
The reopening pace accelerated during the second quarter. Rising vaccination rates allowed more states to ease restrictions. Indoor dining capacity restrictions were lifted, and stadiums filled up as fans returned to the stands. Subway ridership rose, and the skies grew more crowded as people booked vacations. Economic data confirmed the economy’s recovery as the labor force grew and unemployment claims fell. The outlook continues to improve as life gradually returns to normal. This quarterly letter looks beyond the reopening -- at inflation headlines, interest rates, and market performance as we enter the second half of 2021.
Federal Reserve Surprises At June Meeting
The Federal Reserve’s June meeting created waves across the stock market. In line with investors’ expectations, the Fed said it would keep interest rates near zero and continue to buy $120 billion of U.S. Treasury bonds each month. However, the Fed’s press conference after the meeting hinted at changes to its economic projections and this surprised the market. More specifically, the Fed increased its 2021 inflation expectations and pulled forward its expected timeline for hiking interest rates. More members of the Fed’s policy-making committee now see the potential for at least one interest rate hike by the end of 2023, with some members predicting multiple interest rate hikes.
The Fed’s tone marked a significant change from prior meetings and represented the first step toward tightening monetary policy. Moving forward, the Fed has the difficult job of phasing out support for the recovery without alarming the market and stalling the economic recovery. The job will be made more difficult by an economic recovery that is both uneven and progressing at a faster pace than historical standard. Investors will be intently watching and listening to the Fed over the coming months for clues about its next steps.
Inflationary Pressures Are Concerning
Rising inflationary pressures also grabbed the market’s attention during the second quarter. Manufacturing costs rose due to supply chain bottlenecks, high raw material costs, and global shipping challenges. Labor costs also rose as companies struggled to fill open jobs. Figure 1 shows the record number of job openings, which is causing companies to increase wages as they compete for workers. The labor supply crunch is expected to ease later this year as enhanced unemployment benefits end, virus fears recede, and schooling returns to in-person.
These inflationary pressures are starting to show up in consumer prices. The headline consumer price index rose +4.9% year-over-year in May 2021, which was the fastest pace since September 2008. The key question is whether current inflation pressures are transitory (i.e., temporary) or longer lasting. The Fed views inflationary pressures as transitory and points to big price drops early in the pandemic artificially making today’s inflation figures look higher. As further evidence, data indicates most of the price pressures are occurring in categories where demand is soaring as the economy reopens, such as used cars, air travel, and hotel rooms.
The Fed previously said it would let inflation run slightly above its target to make up for years of weak inflation. The Fed’s new inflation policy suggests it will wait longer to raise interest rates, which is why the market was caught off guard by the Fed’s change in tone at the June meeting. But, the risk is inflation runs too hot, forcing the Fed to raise interest rates sooner rather than later.
Reflation Trade Loses Steam During 2nd Quarter
The market environment and investor sentiment both shifted during the second quarter. While the first quarter focused on the reopening trade and strengthening economy, the Fed’s changing outlook and rising inflationary pressures during the second quarter caused investors to question if the market was too optimistic. Investors’ appetite for riskier asset classes, such as small cap stocks and cyclical sectors, cooled at the thought of higher interest rates and rising consumer prices.
Figure 2 shows how second quarter stock market performance differed significantly from the first quarter. The S&P 500 Index of large cap stocks returned 8.4% during the second quarter compared to the Russell 2000 Index’s 4% return. Large cap stocks underperformed small cap stocks by over 6.5% during the first quarter. Likewise, the Russell 1000 Growth Index returned 11.8% during the second quarter compared to the Russell 1000 Value’s 5.1% return, a significant shift after growth stocks underperformed value stocks by over 10% during the first quarter.
Sector returns were also noticeably different. Real Estate was the top performing sector during the second quarter. Technology was the second-best performing sector during the second quarter after investors rotated out of growth stocks during the first quarter. In contrast, Materials and Industrials both underperformed the broad market index during the second quarter after being top performers in 1Q 2021.
The change in equity market performance points to a recent unwinding of the reflation trade, which focused on the rebounding economy and rising prices. The timing coincided with the Fed’s June meeting. While the Fed did not actually change its policy, the change in tone was enough to cool the reflation trade.
Credit Market Repositions Due to Fed & Inflation
The credit market also felt the effects of the Fed’s changing outlook and rising inflationary pressures. After long-term interest rates rose during the first quarter in anticipation of a stronger economy, investors reversed course and rates moved lower during the second quarter. The move lower was especially pronounced in long-term rates. Figure 3 shows the 10-year Treasury yield fell from 1.74% at the end of March to 1.45% at the end of June. Falling interest rates support higher bond prices, which caused longer maturity bonds to outperform during the second quarter.
While long-term rates fell during the second quarter, Figure 3 shows short-term rates rose. The 3-year Treasury yield rose from 0.34% at the end of March to 0.45% at the end of June. The timing of the move higher in short-term rates coincided with the Fed’s June meeting, suggesting investors are already positioning for the Fed to start hiking short-term rates. The move higher in short-term rates, paired with the move lower in long-term rates, suggests investors are more concerned about the risk of the economic recovery slowing.
Second Half 2021 Outlook – A Confused Market
Market volatility is picking up as the second quarter comes to an end. And Wall Street opinion has never been more divided. The big question is whether investors will return to the reflation trade later this year, and asset class returns are producing mixed signals. Interest rates rise one week and fall the next as the market attempts to find a new normal. Cyclical sectors outperform one week only to underperform the next week. There is a push and pull occurring beneath the market surface as the market struggles for direction.
The unresolved questions will likely continue to weigh on the stock market in the coming months. However, this does not mean the market will necessarily trade lower. It simply means the ride could be bumpier in the months ahead. The pandemic’s unique nature and corresponding quick economic reopening are unlike recent recessions. Figure 4 shows the S&P 500 Index has returned 92% from its pandemic low point and 32% since the start of 2020. The market has already priced in a strong recovery, and the second quarter performance reversal suggests the “value” trade might have gotten ahead of itself. The next quarter should provide actionable new information about the ongoing recovery. As Fed Chairman Jay Powell has repeatedly stated, there is not a template or model for the current recovery.
Important Disclosures: Clare Market Investments, LLC is a Registered Investment Advisor. This material is for informational purposes only. It is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a recommendation to buy a security. This summary is based exclusively on an analysis of general market conditions and does not speak to the suitability of any specific proposed securities transaction or investment strategy. Judgement or recommendations found in this report may differ materially from what may be presented in a long-term investment plan and are subject to change at any time. This report’s authors will not advise you as to any changes in figures or views found in this report. Investors should consult with their investment advisor to determine the appropriate investment strategy and investment vehicle. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. Except for the historical information contained in this report, certain matters are forward-looking statements or projections that are dependent upon risks and uncertainties, including but not limited to such factors and considerations such as general market volatility, global economic risk, geopolitical risk, currency risk and other country-specific factors, fiscal and monetary policy, the level of interest rates, security-specific risks, and historical market segment or sector performance relationships as they relate to the business and economic cycle. See claremarket.com for additional information and disclosures. © 2021 Clare Market Investments, LLC
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