Falling interest rates had been lifting the technology sector versus financials and energy, but data showing inflation moderating helped drive rates back up. Investors began discussing when the Federal Reserve might announce its plans to taper. In China, an attack on the for-profit education industry and technology companies weighed on emerging markets. Crude oil and other commodity prices pulled back, but some agricultural commodities and natural gas hit new highs.
Economic data showed the economy on a strong footing in the second quarter. The U.S. economy grew 6.5 percent, below economist forecasts but in between the two best Federal Reserve models. Both models remain below economist forecasts in the current quarter. The Atlanta Fed (the more volatile model that weights incoming data more highly) projects 6.0 percent growth based on early July data. The Federal Reserve’s Nowcast model sees 3.74 percent growth. The blue-chip economist consensus is at 7.2 percent. Given the end of stimulus spending (for now) and the fact that the economy has almost completely reopened, growth in the range of 4 to 5 percent would be very good. Eventually, the economy could slow toward its post-2008 pace of closer to 1.8 percent.
The markets have been focused on inflation for months. The “transitory” inflation crowd was looking for a peak in inflation as early as April or May, but the July data tells us June was likely the high. Subcategories that drove the consumer price index higher, used cars being the most prominent, cooled in July. Other categories did not pick up the pace, indicating inflation isn’t spreading over the entire economy. While prices remain elevated and the increases over the past year should hold going forward, the rate of acceleration should moderate.
Core CPI, which strips out food and energy, increased only 0.3 percent in July, below the 0.4 percent consensus forecast. This is far below the 0.9 percent seen in June. Moreover, a rate of 0.3 percent is consistent with inflation in the 2 to 3 percent range preferred by the Federal Reserve, assuming prices continue settling in the months ahead.
The bond market has been saying for months that inflation has peaked. The 10-year Treasury yield was 1.75 percent at the end of March, and it bottomed below 1.15 percent in late July and early August. It has since rebounded to approximately 1.35 percent. Eyes are now turning to the federal government. The Senate approved a $1 trillion stimulus bill that paves the way for a vote in the House. Speaker Pelosi wants that bill and a $3.5 trillion budget voted on at the same time to minimize the risk of dissenting votes.
Approval of both bills could easily reignite inflation in late 2021 and early 2022, which is why some Wall Street analysts think the Federal Reserve could start discussing a taper of quantitative easing over the next month. Additionally, producer prices remain stickier. The producer price index climbed to 7.8 percent year-over-year. We have seen some companies, notably Clorox (CLX) in the consumer staples sector, suffer significant post-earnings drops after management discussed inflation cutting into margins and profitability. While the market is focused on consumer inflation, the elevated producer price index will also push the Fed toward reducing quantitative easing.
In addition to its belief that inflation will prove transitory, the Fed has pointed to current unemployment rates to justify its low interest rate policy. July saw 943,000 new jobs added, far more than expected, with unemployment sliding from 5.9 percent to 5.4 percent. The window is opening for the Fed to announce a taper either in late 2021 or sometime in 2022, but the timing remains uncertain.
Earnings season has been strong with an 88.8 percent blended increase. About 10 percent of the index has yet to report. This is the highest growth rate since the fourth quarter of 2009. It is also likely the peak of the post-pandemic spike in earnings growth, since lockdowns began easing in the third quarter of last year. Analysts currently project 28 percent growth in the current quarter, led by energy, materials and industrials all pulling the index higher. Consumer discretionary, utilities and consumer staples are the only sectors with projected growth below 10 percent in the current quarter, whose earnings season will kick off in October.
Rising rates are good news for value stocks. They arrested a multi-month slide versus growth stocks. Financials were particularly strong because low inflation and rising interest rates is the most bullish scenario for banks, as their profits increase without their assets being devalued. Vanguard Financials (VFH) rose 4.47 percent in the past month and is now up 30.74 percent this year. Vanguard Equity Income (VEIPX) and Vanguard Dividend Appreciation (VIG) both returned 2.08 percent. Parnassus Core Equity (PRBLX) was also strong with a gain of 2.37 percent.
China derailed emerging market funds last month. Vanguard FTSE Emerging Markets (VWO) fell 2.53 percent as the Chinese Communist Party launched major crackdowns on for-profit education companies and big technology firms. The party is reasserting its political control over the economy, effectively closing the door on what was a 40-year period of increasingly laissez-faire policies. Leadership has signaled this regulatory shift will go on for 5 years, indicating the pain might not be over for investors. Foreign investors in particular will have to reassess their allocation to emerging markets and should consider ex-China funds.
Bond funds were mixed last month. Thompson Bond (THOPX) added 0.27 percent, taking its 2021 return to 5.64 percent. Virtus Seix Floating Rate High Income (SAMBX) slipped 0.36 percent on rising credit risk, as did Vanguard Short Term Corporate Bond (VCSH).
Moving into the late summer, the key factors for stocks will be interest rates and Federal Reserve policy. If the Fed announces anything taper related, it could prove a headwind for stocks in the short term, although financials should outperform. If inflation remains elevated, we expect growth stocks, in particular technology, to be hardest hit, while if inflation cools, energy and commodity producers could prove weaker. A taper would also be interpreted as bullish for the U.S. dollar, adding a headwind to foreign shares.
Finally, while the pandemic is mostly behind us at this stage, there is much media hype around the Delta variant. The pattern seen in India and the U.K. suggests it will peak in the U.S. soon. This should alleviate some pressure seen in airline, travel and related stocks. The biggest risk since the start of the pandemic has been the response by governments around the world. Europe has seen riots in response to vaccine passports; Australia has locked down again despite a low death rate. China is back to strict quarantine policies as it tries to eradicate cases. These policies have dented growth forecasts for the global economy and again made the U.S. a far more attractive investment destination.