June Investment Outlook

July 1, 2021

After 15 months of lockdowns, social distancing measures, and the unfortunate widespread human suffering, the world looks to finally be emerging from the pandemic. Economic activity is accelerating, consumer confidence is high, and stock markets are at record levels. Our long-awaited reopening has arrived.

This past quarter, the story of the strong reopening focused on inflation fears. Commentary ranged from the extremes of “it’s a return of 1970’s-era gas lines” to “inflation is, has been, and will continue to be, dead”. The reality is different – price increases are in fact happening, in some areas substantially, but generally due to temporary supply constraints related to the global economy coming back online almost all at once. Businesses across supply chains scaled back operations and did not build capacity back up ahead of anticipated demand. Now, they are racing to meet consumers desires for goods, and the resulting bottlenecks have caused price increases and significant lag times in order fulfillment. If you’ve tried to buy items like a washing machine, a couch, or a new car in the past few months, you’ve likely experienced this firsthand. The drivers of the April and May inflation upticks were largely travel-related – airfares, used cars, rental services, hospitality – not coincidentally some of the hardest hit sectors last year where new business strength is reliant on vaccination levels. But as demand stabilizes, and production returns, these short-term price pressures should dissipate for most industries, moving headline inflation substantially downward. We see no troubling signs of accelerating prices in core categories such as ongoing housing costs, medical care, and general services. The bond market agrees, with 5 and 10-year U.S. treasury bond “break-evens” now trading only slightly above the Federal Reserve’s 2% long-term inflation target, suggesting fixed income traders expect inflation to retreat to target levels.

The semi-conductor industry stands out as a unique exception in which supply constraints appear longer lasting. This is not an example of scaled back COVID operations, but an outcome from years of under-investment by the industry. While some report that the rise in cryptocurrencies has drained chip supplies, the reality is that semiconductor chips have become increasingly ubiquitous, key components today in everything from autos to appliances. It is not clear how the industry so poorly projected demand and it will be playing catch up for some time. The CEO of Intel recently shared that he does not expect output to increase sufficiently until 2023 at the earliest. These unique circumstances will keep chip prices historically high for the foreseeable future, but the industry alone will not drive wide-spread inflation.

With the overall inflation outlook temporary, the Federal Reserve just increased its forecast for 2021 U.S. real GDP growth to an estimated 7% and 2022 GDP growth to over 3%, an annual rate we failed to achieve even once coming out of the Great Recession. Internal estimates from Federal Reserve Governors now suggest that interest rates may start to increase in late 2022 or more likely 2023. Markets initially pulled back at this news, beginning to reprice stock valuations for higher interest rates. Investors quickly reversed, though, concluding, as we have, that projected higher rates reflect a healthy, growing economy- a welcome change from one that was essentially on ice at this time last year.

Markets have shared in the economic optimism, with the S&P 500 up almost 8% in the second quarter and nearly 14% so far this year. We have participated in this strength with our rotation into economically sensitive sectors like consumer discretionary, industrials, and materials, areas that benefit as consumers gain confidence that we are on the path to a return-to-normal. It may not be the “old” normal – Zoom meetings, buying online, and hybrid work arrangements look here to stay – but with any disruption comes opportunity. Just as we monitor portfolio risks, we also continually consider and research the latest trends and innovations for investment to benefit portfolios. We expect new opportunities to continue to emerge and define the next leg of growth for our economy.

Of course, with any economic recovery comes the fears of the eventual slow down. When and how will the party end? We have many reasons to remain optimistic about the strength of the economy and financial markets throughout the rest of year, but we will continue to monitor the ongoing risks from COVID-19 flare ups, inflationary spikes and anticipated interest rate changes for their potential drags on the economy or markets.

For now, we wish you an enjoyable summer in which you can appreciate the little things again- eating at your favorite restaurant, visiting family, or attending a concert or sporting event, experiences we took for granted 16 months ago. Enjoy celebrating and socializing with friends and family!