Perfect summer storm brewing?
Inflation, debt ceiling, Covid-19 and politics are among the reasons.
The S&P 500 hit a new high on Wednesday at just under 4,394, and we’ve already seen a remarkable 39 record closes over the course of 2021. Stocks have rallied more than 16% this year and have more than doubled from the market’s pandemic bottom in March 2020 at 2,192. The euphoric S&P is now only 3% away from our long-standing, full-year target of 4,500, and it’s only mid-July.
But benchmark 10-year Treasury yields are pointing in an entirely different direction. They hit a dramatically overbought, 5-month low of 1.25% last week—down from 1.75% at the end of March—and we’re only marginally higher at 1.30% today. Moreover, the volatility index (VIX) spiked last week from a staid 14 to an overbought 21, though it’s settled back down to 17 in recent days.
These low bond yields make little sense to us, with surging inflation and strong economic and corporate profit growth thanks to last year’s aggressive fiscal and monetary policy stimulus out of Washington. In fact, we continue to believe yields should rise to 2% by year end and to 2.50% or higher over the course of 2022.
What’s up with that? Bond vigilantes, in our view, believe there are some threatening storm clouds on the horizon, which equity investors have not yet begun to fully recognize or process. This includes Covid-related concerns, the recent spike in inflation, the impending debt ceiling, the growing risk of a fiscal or monetary policy error, and the possibility of peak profit and economic growth in the second quarter.
To be sure, we could certainly experience a seasonal 5-8% air pocket in stocks during the historically volatile August-through-October period, if these menacing storm clouds materialize. But we believe that a late summer/early fall consolidation would be healthy, removing some of the recent froth from stocks and positioning investors to enjoy a powerful year-end rally.
Fourth wave on deck? The highly contagious delta variant now accounts for more than half of all new Covid infections in the U.S. At the same time, the pace of vaccinations has slowed considerably, down 90% from an average daily peak of 3.5 million jabs in April to about 350,000 today. Consequently, with rising infections, hospitalizations and deaths, investors are concerned we are building to a dreaded fourth wave later this year, which could prompt President Biden to reimpose mandatory mask mandates nationally or lock down the economy again. But the two-shot Pfizer and Moderna vaccinations have proven highly effective against the delta variant thus far, so the Biden administration’s focus should be on reinvigorating vaccination growth.
Peak growth worries Second-quarter corporate profits in 2021, compared with the pandemic-impaired second quarter a year ago, likely will represent the strongest earnings growth since the fourth quarter of 2009. The consensus expects a 60-65% year-over-year (y/y) increase, but we’re a little more aggressive here at Federated Hermes, looking for a 75% gain. The splits tell the real story. Domestic large-cap growth companies (like technology) could grow by 30% y/y. But we think economically sensitive, domestic large-cap value companies (like financials, consumer discretionary, industrials, energy and materials) will experience a powerful y/y rebound of more than 100%, as these companies were left for dead when we shuttered the economy a year ago.
Comparisons in the second half of this year will be decidedly more difficult, as the economy experienced a powerful V-bottom recovery in the middle of 2020. To that point, we are forecasting a strong 9.2% increase in second-quarter GDP, compared with a negative 31.4% in the year-ago second quarter, which was the single-worst print in history. Economic growth in the back half of this year will still be strong, but quarterly GDP growth should tail off due to much tougher comparisons.
Debt ceiling dilemma Congress’ two-year suspension of the federal debt ceiling expires on July 31. Treasury Secretary Janet Yellen warns that if the debt ceiling is not raised or suspended by the end of this month, then she will exhaust her emergency measures to continue paying the government’s bills while Congress is out of session on its six-week summer recess that runs from August into mid-September.
There is zero chance, in our mind, that the U.S. government will default on its debt obligations or that Congress will fail to raise or adjust the debt ceiling in a timely fashion. But that doesn’t mean that one party or the other won’t use the debt ceiling as a political sabre, as it postures in an elaborate Kabuki dance to extract its pound of flesh ahead of the midterm elections next year. That could temporarily rattle markets now.
Inflation is soaring Retail inflation as measured by the core CPI is up 4.5% y/y in June, a 30-year high, and wholesale inflation (core PPI) is up 5.5% y/y in June, a record high. We expect the core personal consumption expenditure (PCE) index, which is the Federal Reserve’s preferred measure of inflation, to rise 4% y/y for June, which would also be a 30-year high, at a level twice the Fed’s long-term 2% target. Unlike the Fed’s transitory/temporary view, however, we think inflation is much stickier and more sustainable, largely due to the sharp rise in energy prices and wages.
Fed policy error brewing? Which brings us to Chair Powell’s semi-annual Humphrey Hawkins testimony this past Wednesday (House) and Thursday (Senate). In his prepared remarks, Powell admitted that “inflation has increased notably and will likely remain elevated in coming months before moderating.” This is a refreshing acknowledgement for the Fed, and Powell pointed to three causes. But the so-called “base effects” (the rolling off of negative inflation readings from a year ago) have already happened, while supply-chain bottlenecks and strong business and consumer demand are very much still in place, fueled by elevated savings rates and generous government transfer payments.
Powell attempted to hold the line in his Congressional testimony on adjusting the Fed’s approach to monetary policy, and we believe his Jackson Hole speech at the end of August will be critical. If rising inflation persists, we continue to believe Powell will need to accelerate the Fed’s torpid schedule for tapering and raising interest rates.
But Powell’s term as Fed chair expires at the end of January, and we believe that he would like Biden to nominate him for a second term, a political process that would typically happen between this August and October. We can’t discount the risk of a change in Fed leadership potentially roiling markets later this summer.
Congressional showdown looming Congress needs to pass the bipartisan $1.2 trillion infrastructure bill it crafted with President Biden in June. But this past Wednesday, 11 Democrats on the Senate Budget Committee drafted a $3.5 trillion social-spending proposal, paid for with higher tax rates and more debt. House Speaker Pelosi has said that she wants both critical votes concluded by the end of July, before Congress leaves for vacation. She also warned that if the social-spending package is not passed first—and it’s unclear if she’s garnered the necessary votes to achieve that goal—then she won’t bring the infrastructure bill to a vote.
So, there’s considerable risk in the uncertainty of legislation in coming weeks. In a worse-case scenario, we could end up with no infrastructure package, which Wall Street generally likes. But the social-spending package could pass on a strictly party-line reconciliation vote, sharply increasing entitlement spending, taxes, federal debt and inflation, while reducing economic and corporate profit growth, which could unsettle markets.