The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2021 Q2 Outlook
- U.S. economy: Poised for its best year of GDP growth in decades.
- Global economy: Should also surge as large developed countries sprint into the post-pandemic world.
- Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
- Fixed income: Take more risk in credit-sensitive parts of the market.
- Equities: Bullish on cyclicals but looking for opportunities again in growth.
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
“When April steps aside for May, like diamonds all the raindrops glisten; fresh violets open every day; to some new bird each hour we listen.”— Lucy Larcom
In the first quarter, the boom arrived in the U.S. (not Europe)
The overriding U.S. economic theme during the first half of 2021 — which has spilled over into financial markets via higher stock prices and longer-dated U.S. Treasury yields — has been forecasters’ struggling to catch up to the economy’s ever-improving backdrop.That’s why last week’s “advance” estimate of first-quarter GDP growth (+6.4% annualized), just a shade below Bloomberg’s final consensus, was somewhat of a formality.5 But what’s especially important about this already impressive release is that some of the underlying details hint that the economy could accelerate even faster in coming quarters.
Among the report’s highlights:
- Final private sales to domestic purchasers increased at a 10.6% annualized rate, an unusually large difference from the headline figure but an encouraging indication of just how fast demand is returning.6 This measure strips out the impact of trade, inventory changes and government spending (more on those below) and essentially tracks the growth in sales to the private sector — regardless of where the good or service was produced.
- In terms of GDP “line items,” consumers, as expected, contributed the most to GDP growth.7 That was due in large part to (1) fewer COVID-19 restrictions (both self-imposed and mandated) and (2) real incomes rising at an astonishing 61.3% annualized rate on the back of two rounds of fiscal aid that hit individuals’ bank accounts in January and March.8At the same time, spending growth data on goods vs. services shows how the pandemic continues to warp consumer behavior. For example, greater expenditures on durable goods (aircraft, machinery, computer equipment and other big-ticket items) dominated in the first quarter, while spending on services has been slower to recover.9 Moving forward, we expect a substantial catch-up in services as people dine out, fly and stay in hotels.
- Residential and nonresidential private investment combined to add about 1.8% to GDP growth.10 However, an inventory drawdown wiped away those gains and then some.11 This is consistent with recent monthly data: a sharp rise in demand has depleted shelves in stores and factories, forcing companies to ramp up production and speed up their supply chains. But given the pace of demand growth that’s likely to continue, inventory restocking may not add much to GDP for several more quarters.
- As in the prior two quarters, trade “subtracted” from GDP because Americans purchased a lot more stuff from the rest of the world while selling a bit less to those outside the U.S.12 This shouldn’t be a surprise considering the relative strength of “well stimulated” U.S. consumers and their preference for imported goods.
- The Federal government’s spending added about 1% after detracting moderately in the second half of 2020.13 This bump up was due to the timing of the last two rounds of fiscal stimulus measures.
The first quarter’s economic boom leaves the size of the U.S. economy less than 1% below its prior peak in 2019, which we believe it will comfortably exceed once second-quarter GDP data arrives in late October.14 As robust as consumer spending was this time around, the personal savings rate actually averaged 21% in the first quarter, fueled by surging incomes.15 That leaves plenty of room for growth to accelerate further, especially as demand picks up in the rest of the world, and the inventory drag fades while firms crank up their production capacities. We expect the consensus outlook for the remainder of 2021, which has already improved tremendously since the start of the year, to become even more bullish.
In contrast to the good news here at home, the eurozone has officially entered a double-dip recession. (This occurs when a recession is followed by a short-lived recovery and then, another recession.) Preliminary first-quarter GDP data in the region (-0.6%, following -0.7% in the fourth quarter) came in close to expectations as mitigation strategies (i.e., economic restrictions) to combat COVID-19 remained in place amid persistently higher caseloads and slower vaccinations.
We think the outlook is still bright for the eurozone, but it’s working its way through a longer and darker tunnel than much of the rest of the world. The region can still tap into a sizable relief fund, which we know from experience can have immediate economic effects, particularly if it’s deployed as COVID-19 cases are falling and the economy is reopening. But the eurozone’s poor first quarter underscores a shift in our outlook from a synchronous global bounce to more of a multi-stage recovery, with countries’ ability to exit recession depending on their pace of vaccination and size of fiscal relief.
The Fed doesn’t budge despite the economic boom
Evidence continues to mount that a combination of vaccinations and stimulus are generating some of the strongest economic growth data in decades. Even so, last week’s Federal Reserve meeting demonstrated a firm commitment to easy monetary policy until unemployment falls further and inflation heats up.
In its policy statement, the Fed reiterated its long-standing pledge to maintain the target federal funds rate at 0%-0.25% because “the ongoing public health crisis continues to weigh on the economy, and risks to the economic outlook remain.” At the same time, the statement acknowledged that “indicators of economic activity and employment have strengthened” — a likely nod to March’s robust jobs report and retail sales figures.
In his post-meeting press conference, Chair Jerome Powell emphasized that the Fed would not reduce its monthly asset purchases until “substantial further progress” has been made toward achieving the Fed’s dual mandate of full employment and 2% inflation. He added that those two objectives were unlikely to be reached anytime soon.
During the previous recovery cycle, the Fed started to remove accommodative policy (quantitative easing in 2013 and zero interest rates in 2015) as the economy slowly improved and forecasts signaled higher inflation just ahead. This time, the Fed is adamant that it will not tighten based on outlooks, but on actual data.
So the question for investors is quite simple: When will higher inflation appear?
Well, it already has, just as we’d anticipated. Base effects are showing up in the year-over-year data, as March 2020’s weak inflation results rolled out of the 12-month calculation. Due in part to that numerical quirk, the Consumer Price Index (CPI) hit a 2½-year peak of 2.6% for the 12 months ending last March.16 Also contributing to higher year-over-year inflation: the cumulative rise in energy prices, gasoline in particular.
In its policy statement, the Fed argued that this inflation “bump” will be temporary. We agree. That said, if base effects were prevalent in March, they’re likely to be even more powerful when April 2021 year-over-year CPI is released later this month. Prices slumped badly last April, especially for energy. And when that decline is reflected in the 12-month calculation, headline and core inflation will almost certainly top 3% and 2%, respectively, in our view. But those anticipated spikes needn’t be a source of undue concern, as we doubt they’ll presage an inflationary spiral.
Looking a little further ahead, when demand returns — swiftly and suddenly — to dormant segments of the U.S. economy, companies may find their supply chains stretched and good labor hard to find. This makes a material rise in prices over the summer a distinct possibility. But such inflation — a response to a one-time demand shock — should be less worrisome to the Fed than a genuine wage-price spiral that forces it to slow credit creation through reduced liquidity (i.e., smaller amounts of monthly quantitative bond purchases) and higher interest rates.
Against that backdrop, investors concerned about inflation might consider increasing their allocations to economically sensitive asset classes like U.S. small cap stocks and real estate. While neither provides the explicit inflation compensation like U.S. Treasury Inflation Protected Securities (TIPS), they may well outperform in an environment in which both growth and inflation are rising. The upswing in long-term U.S. Treasury yields may have paused for now, but we expect the Treasury yield curve to steepen between now and the end of the year, favoring cyclical areas of the market.