Halftime — Week of July 6, 2021

As of market close July 2, 2021. Returns in percent.

Halftime

We hope you enjoyed your Independence Day celebrations. For us, the holiday is a chance for a quick look back at the first half of the year and a look forward. To date, 2021 has been a remarkable year for the markets. Stocks just put a bow on the fifth straight quarter of 5% or better gains. Performance has been sterling across every asset class. The keys: stronger than expected reopening demand, accommodative monetary policies and vaccines. 

Second half keys: herding the virus variants, solving supply chains and clarity from the Fed on tapering. Notice that GDP growth is not on that list. We believe the GDP growth rate peaked last quarter, likely in June. GDP growth will downshift in the second half, from crazy strong to merely really strong. 
 

Recap

In the U.S., only the NASDAQ started on a positive note. Most U.S. indices sank into the red at the end of January. That first month, international stocks were led by China’s 5% rally. The following five months were all positive to varying degrees for U.S. stocks. The S&P 500 and Dow Industrials roughly kept pace with each other, posting returns of 14.5% and 12.7% and setting multiple new highs in the first half. Our underweight to international stocks were supported by developed countries’ lagging performance ranging from 6.5% for China to the Europe, Australasia, Far East Index’s 9.8%. It is worth pointing out that 9% is a fine return in most years.

Most of the first half performance can be blamed on improving earnings. Much of the earnings jump in the first half of 2021 was due to easy comparisons with falling earnings during 2020’s early shutdowns. The Fed did its part by repeatedly assuring markets that it was in no hurry to change policy or its bond buying program. When the Fed’s projections did acknowledge the rapid price increases at its June meeting, markets shrugged off the news. 

Longer term interest rates continued their ascent in the first quarter, with the ten-year Treasury briefly touching 1.77% at the end of March. Much of the rise was due to increased supply from the Treasury to fund temporary stimulus spending. Once the supply settled down and traders comforted their inflation fears with Fed-speak, rates drifted lower by a third of a percent, finishing June at 1.46%. Intense competition by lenders combined with falling housing inventory pushed mortgage rates to record lows. 

Commodities rode supply chain problems and resurging demand to new heights. Lumber, copper, steel and other raw materials hit lifetime highs. Lumber futures were the clear winner, quadrupling over 2019 levels. Most had rolled over from their early May peak but remain well above 2019 “normal” levels. The exception: crude oil keeps rising. OPEC discipline in limiting production has made refiners rush to the U.S., drawing down West Texas supplies and forcing prices higher. Supply and demand still work. 

Another rally that will stick with us the rest of the year is price inflation. Year-over-year prices rising between 3.5% to 5% depending on the item. Shortages and delivery delays will continue into next year. Like GDP, we believe the rate of change of prices has peaked or will peak very soon. Droughts will likely impact food prices in the coming months. The continuing stream of wage increases coming from corporate America means that wage inflation is on the horizon. 
 

Ok, Next?

We begin with June’s nonfarm payrolls report, released last Friday. The BLS estimates that payrolls expanded by 850,000 in June, well above estimates of around 670,000. Unemployment rose one-tenth to 5.9% as more folks entered the workforce — a good sign. Private sector payrolls rose 662,000 pushing the second quarter monthly average to 468,000. At that rate, payrolls should return to their pre-pandemic levels by this time next year. Initial jobless claims can give an indication of subsequent payroll gains or declines. For the three weeks before the payroll survey, jobless claims averaged 411,000. Since mid-June they have averaged 383,000. This suggests that July’s reading released on August 6th will show similar gains. We would also expect a jump to near one million for September, reflecting the end of the Federal stimulus weekly supplement and full reopening of schools. 

Inflation should stay at or above 3% for the balance of this year. Supply chains messed up from here to Yantian will take until next year to unravel. Demand, meanwhile, has returned with a vengeance, and is rotating from goods and appliances to services and leisure. Thanks to pandemic childcare issues and virus concerns, workers will still be hard to come by. Corporate America got the memo and the pace of announcements of increased starting wages appears to be picking up. The $15 per hour minimum wage does not have to be a government order: scarcity in the labor market is taking care of that issue. The BLS reports that average hourly earnings are rising at a 3.6% annual rate. Note, that is keeping with inflation. Our sense is that after goods inflation moderates in the coming months, wage inflation will be here to stay. Companies will want to keep good or even average employees after the pandemic experience. 

As loyal readers know, we are in the History Does Rhyme camp. Year 2 of Bull markets is higher by the end of the year, but experiences bigger corrections along the way than Year 1. We have not had a correction of 5% in a number of months. We are not calling for a correction but are mindful that late summer stocks can get sold to buy school supplies. Our indicators and outlook would lead us to use a correction as a buying opportunity. Scoring high on the positive indicator list is second quarter earnings. The season gets underway on Tuesday the 13th led by Goldman Sachs, JP Morgan, and First Republic Bank. According to FactSet, companies have been much more optimistic than Wall Street analysts about their EPS guidance. To date, 66 S&P 500 members have issued positive guidance for the second quarter. This compares with FactSet’s average of the last five years of 37 companies. Analysts have been marking their earnings per share estimates higher literally week over week as the economy improves. Current forecasts are for a 60% rise in Q2 earnings over 2020, 22% in Q3 and 16% for Q4. For the full year 2021, they expect earnings to increase 37% over 2020 and rise 12% in 2022. Earnings will do their part to support the Bull. 

Interest rates are also very important to our Bull thesis. We maintain our view that rates will rise in the second half of this year. Someday, somehow, Congress will pass an infrastructure bill of some size. It will require more borrowing, which will goose the supply of Treasury bonds. Continued economic growth will also pressure rates higher as confident companies turn to banks for capex and working capital. Rising to 2% by the end of the year, the 10-year Treasury yield may crimp some mortgage loans but not stocks. Remember, growth and tech stocks did just fine the last five years with Treasuries moving from 1.4% to 3.2% and back. We believe the Fed will discuss slowing (“tapering”) their bond buying in their September meeting and implement a reduction in the first quarter of next year.

Nor will higher rates slow economic growth. GDP in the second quarter should be north of 7%, and the third and fourth quarters should ratchet down like earnings, likely at the 5% and 4%, areas respectively. This strong growth should average 6.5% for the full year. 
 

Wrap-Up

The shutdown recession was brief and violent. The recovery, thanks to quick action by the Fed and, remarkably, by Congress, has been one of the fastest on record. The economy will solidify its expansion trend in the second half of this year. The consumer is in great shape, and as more Americans return to work, consumption should grow above trend. Our indicators continue to favor investing more at home than abroad. Several countries with lower vaccination rates are grappling with mutations of the virus, slowing their recoveries. This is reflected in their companies’ forward earnings estimates which are not rising nearly as quickly as those in the U.S. Over the intermediate term, corrections would be a buying opportunity as the economic backdrop is bright green on our scorecard. 

Steve Orr is the Executive Vice President and Chief Investment Officer for Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts in Economics from The University of Texas at Austin, a Master of Business Administration in Finance from Texas State University, and a Juris Doctor in Securities from St. Mary's University School of Law. Follow him on Twitter here. Greg Kalb is an Investment Advisor at Texas Capital Bank Private Wealth Advisors. He holds a Bachelor of Arts from The University of Texas at Austin.

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