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:
"Summer should get a speeding ticket.” – Anonymous
Strong U.S. jobs report raises more questions than answers for the Fed
After generating an upwardly revised 938,000 jobs in June, what would the U.S. labor market do for an encore? More of the same — and then some. Employers added 943,000 payrolls in July, handily beating expectations of about 870,000.3
And the good news didn’t stop there:
- The unemployment rate dropped by a whopping 0.5%, to 5.4%.4
- The number of workers in part-time jobs who would prefer full-time roles has dropped back to pre-pandemic levels, as has the percentage of workers on temporary layoff.5
- Total unemployment dropped to 8.7 million in July, down from 9.5 million in June. That’s still 3 million above February 2020’s total, just before the COVID-19 lockdowns started, but well below the April 2020 peak of 23 million.6
Overall, average hourly earnings (AHE) growth came in a bit higher than forecast (+4% year over year), with nonsupervisory workers seeing a 4.7% gain.7 Although AHE is closely watched by investors, this metric is actually not the best way to capture wage growth during times when the labor market’s composition has undergone dramatic changes, as it has during the pandemic. Over the past 18 months or so, many low-wage earners have left the labor market, artificially boosting AHE.
In our view, investors were likely correct in interpreting this latest jobs report as one that will compel the Federal Reserve to begin behaving more hawkishly, yet “responsibly.” Indeed, back-to-back months of 900,000+ job gains could represent the “further progress” the Fed has been looking for as an impetus for ending its quantitative easing program. We still expect a fourth-quarter announcement from the Fed that it will begin trimming its monthly bond purchases in early 2022, but another month of job creation as good as June’s and July’s could pull that communication forward to September.
We’re on the threshold of a period in which the effect of vanishing unemployment subsidies and the full reopening of schools should release more able-bodied adults into the U.S. labor market. But a swift return to full employment is not guaranteed, with the Delta variant raging in many states and a large minority of Americans unvaccinated (and therefore less eligible for gainful employment at a rapidly growing number of companies).
Against that backdrop, here are our three most plausible scenarios for the remainder of 2021, in order of decreasing likelihood.
- Base case: Millions more people enter or re-enter the workforce and quickly find jobs, temporarily easing the upward pressure on wages and broadening the base of economic growth. Most financial markets would give this scenario a “thumbs-up,” including investors currently worried that the Fed may have to quickly tighten policy to forestall spiraling inflation fueled by a spike in wages.
- “Too hot” case: Weaker-than-expected job growth occurs because of a lack of new labor supply. Higher productivity growth, spurred by innovation and efficiency in the “new normal” labor market, cannot fully absorb cost pressures, which are passed on to customers as inflation. This leads to higher interest rates from the Fed, the bond market, or both.
- “Too cold” case: The economy slows down. Employment plateaus well below its pre-pandemic level due to the lack of both demand and supply for labor, and wage growth doesn’t pick up. As a result, the Fed has no need to tighten. This is the scenario that, as recently as last week, seemed to be gaining traction in money market futures and in longer-dated (10+ year) Treasuries, which gauge the market’s view on future growth and inflation.
July’s jobs data gives us more confidence in the base case. When will we know if we’re correct? Probably not until November, when the October employment report will provide our first “clean” month without enhanced unemployment insurance and after kids have returned to school.
While the “too cold” case is the least likely, it’s one that seems to be gaining purchase among some investors. But there’s little to no evidence that stagnation is setting in. On the contrary, incoming economic data remains healthy. The Institute for Supply Management’s non-manufacturing U.S. Purchasing Managers’ Index (PMI), for example, a closely watched gauge of activity in the service sector of the economy, reached an all-time high last month.
Equity markets ignore Delta and other risks amid earnings blowout
The plummeting 10-year U.S. Treasury yield has gotten a lot of attention lately — and for good reason. Despite several hotter-than-forecast inflation readings and robust GDP growth in the first and second quarters, this bellwether yield has fallen 31 basis points over the past two months, closing at 1.31% on Friday, August 6.8 While a focus on the 10-year yield is certainly warranted, we think the most important news for markets in recent weeks has been another stellar quarter of corporate earnings reports for companies worldwide.
On average, S&P 500 companies have exceeded already-high second-quarter earnings forecasts by 17%.9 And according to Bloomberg, earnings more than doubled compared to the lockdown-impaired second quarter of 2020.10 Remarkably, companies achieved these results during a quarter in which employment costs rose more than 4% (annualized) and producer prices jumped 10% — increases that would normally crimp profit margins.11 For 2021 as a whole, S&P 500 earnings are now expected to surge by more than 42% over last year, smashing January’s estimates.12
This earnings explosion has fueled the S&P 500’s 18% gain for the year to date.13 Could earnings propel the index even higher in 2021? It’s possible, but there are caveats. An increase in the 10-year U.S. Treasury yield, were it to occur, would not only signal higher borrowing costs for U.S. businesses, but also make “risk free” assets like U.S. government debt somewhat more attractive. And higher corporate taxes as proposed in the budget bill about to wind its way through Congress would likewise take a bite out of corporate profits.