The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
"I think life is there for you to grab it and be positive. Just look for the good everywhere.” – Dusty Hill
The Fed tries to recalibrate its communication
The “dot plots” from June’s Federal Reserve meeting showed a growing number of members willing to raise interest rates earlier and faster in response to hotter inflation, which the Fed has insisted is “transitory.” At the time, markets interpreted the Fed’s tone and upgraded forecasts as hawkish.
Since then, the Treasury yield curve has flattened. The yield on the 2-year note (which is sensitive to Fed policy) has risen, while the 10-year rate (which gauges the market’s view on future growth and inflation) has fallen.
We think higher inflation has flattened the curve because the bond market is more worried about the Fed’s reaction to inflation than about inflation itself. In fact, inflation expectations — which normally rise in the face of accelerating economic growth — have actually declined on fears the Fed will tighten policy too soon, causing a recession.
At last week’s press conference following the Fed’s July meeting, Chair Jerome Powell sought to assuage those fears, reasserting his pledge that the Fed would remain patient. The question is whether he and his colleagues can ultimately convince markets that they will stick to their guns, acting only when full employment has been reached and inflation durably exceeds its 2% target. All told, the Fed will need to sound a more consistently dovish tone — and be proven right about inflation being transitory — to fully regain its credibility.
Helping the Fed’s effort to tamp down inflation anxiety: this past Friday’s release of the core personal consumption expenditure (PCE) index — the Fed’s preferred inflation barometer — for June. It showed a deceleration to 0.4% from 0.5% in May, meaning the likelihood that the Fed will move prematurely has probably declined.3
As for the timing of tapering the Fed’s $120 billion per month quantitative easing (QE) asset purchases, we expect an announcement in either November or December, with the actual tapering to begin in the first quarter of 2022. In our view, the monthly bond-buying program is about to outlive its usefulness, if it hasn’t already. The $40 billion component of mortgage-backed securities purchases, in particular, is being criticized by economists and market observers for overstimulating an already hot U.S. housing market.
How might fixed income investors navigate this uncertain backdrop?
The drop in interest rates on most bonds since March has certainly complicated matters. Long-term rates have fallen as credit spreads have compressed, raising valuations across markets. (Credit spreads measure the difference in yield between a U.S. Treasury bond and another debt security of the same maturity but different credit quality.) The prospect for cash looks no better — especially if we’re right that the Fed will wait at least another two years to hike rates.
Our Global Investment Committee’s Nuveens 2021 Midyear Outlook favors “B” rated corporate bonds and loans, as they appear attractively valued, have relatively high yields and are less exposed to rising rates than other areas of the market. We’re also leaning towards preferred securities, where issuers have healthy balance sheets and their bonds offer compelling yields. In addition, solid opportunities exist in areas of the municipal bond market tied to further economic reopening. These include bonds related to convention centers, hotels, gaming, malls, airlines and airports, as well as mass transit projects. We also favor lower-rated general obligation bonds, an area of the market that has been helped by the American Rescue Plan Act, which would further benefit from a new infrastructure package.
Second-quarter headline GDP growth disappoints — but the angel’s in the details
U.S. economic growth accelerated at an annualized 6.5% rate in the second quarter of 2021, according to the government’s “advance” estimate released last Thursday. This marked a slight improvement over the prior quarter’s downwardly revised 6.3% but was well below forecasts of around 8.5%.4 In our view, the details in the GDP report are far better than the headline result suggests, especially considering the headwinds to production and construction due to rising material costs and supply-chain bottlenecks. On the positive side of the ledger:
- Personal consumption increased at a white-hot 11.8% rate, ahead of the first quarter’s 11.4% surge, and contributed 7.8% to overall GDP.5
- Nonresidential fixed investment (i.e., expenditures by firms on items such as structures, equipment and intellectual property) climbed 8%, adding 1.1% to total growth.6
- Crucially, final sales to private domestic purchasers (the key measure used to estimate the strength of demand in the economy) rose 9.9% — down from the first quarter’s 11.8% but a remarkable outcome nonetheless.7 This ratio strips out the impact of trade, inventory changes and government spending, essentially tracking the growth in sales to the private sector regardless of where the good or service was produced.
Among the negative inputs to GDP, we believe the only concerning line items were the negative growth in construction of both residential and commercial properties. In total, this subtracted nearly 0.7% from GDP.8 That’s likely the result of both high material costs and businesses not wanting to invest in new buildings until the post-pandemic work-from-home dynamic becomes better defined.
Other, less worrisome GDP detractors included:
- Trade (-0.4%), as the U.S. purchased more imports while selling somewhat fewer exports.9 (Exports, however, still grew nicely.) This shouldn’t be a surprise, considering the relative financial health of U.S. consumers and their preference for imported goods.
- Federal government spending (-0.4%), following the larger positive contribution in the first quarter from multiple stimulus bills.10
Net-net, what does this GDP report bode for the third quarter and beyond? With consumption increasingly turning to services over goods, inventories should grow in the second half of the year. This comes on the heels of robust demand growth in the first six months of 2021, along with key supply shortages in semiconductors and other components, which prevented the restocking of manufactured goods like cars.
On the consumer side, the upswing in spending on goods and services (11.6% and 12.0%, respectively) was far more balanced than it was in the prior quarter (27.4% and 3.9%).11 This is what we’d expect as the economy opens and individuals’ consumption patterns approach normalcy, as they were before the pandemic hit.
Households are still spending more on goods and less on services than they have in the past, so this particular normalization remains incomplete. Savings rates also remain high (+10.9%) despite the torrid pace of spending in the first half of 2021.12 We can thank the series of federal stimulus payments and the forced savings that occurred during the pandemic for that.
But we highly doubt that consumer spending will continue to increase at a double-digit annualized rate in the second half of the year. So the peak growth rate for aggregate U.S. demand is likely behind us. However, the third quarter’s headline GDP figure still may exceed 6.5%, as supply constraints gradually loosen up, while inventories and construction bounce back. The bottom line: although the U.S. economy didn’t meet its outsized forecasts in the second quarter as we’d hoped, lingering a bit longer at a slightly lower, yet still impressive level of GDP expansion has its benefits, too.