Second Quarter 2021 Update

July 12, 2021

Key Points

• The US economy grew robustly in the quarter as unprecedented fiscal stimulus and aggressive monetary policy have combined to create conditions ripe for growth.
• Analysts point to three primary drivers of the ongoing rally: First is the ongoing reopening of the economy as virus cases have declined precipitously; second, the FOMC continues to maintain an aggressive monetary policy stance, even in the face of a spike in inflation; and third, a historic level of fiscal stimulus is now coursing through the system.
• Despite the FOMC’s declaration that the rise in prices is “transitory,” inflation remains elevated and Fed governors are concerned enough that more of them now believe they will need to raise interest rates earlier than had previously been anticipated.

2cd QUARTER 2021 MARKET COMMENTARY

Below, we’ve highlighted 2021 broad market returns for the second quarter and year-to-date time periods:

Source: Refinitiv

THE GLOBAL ECONOMY

The US economy grew robustly in the quarter as unprecedented fiscal stimulus and aggressive monetary policy have combined to create conditions ripe for growth. In addition, the economy continues to open up with virus cases remaining on the decline. Within this context, the Bureau of Economic Analysis released the third estimate of the first quarter 2021 real GDP, a seasonally adjusted annualized increase of 6.4%, the same as the prior estimate, and higher than the 4.3% increase in the prior quarter. The employment situation also improved, but in spotty fashion as high unemployment payments continue to be a disincentive for many to return to work. The May report showed that employers added 559,000 jobs in the month, and that the unemployment rate fell to 5.8%. The Federal Open Market Committee (FOMC) maintained its supportive monetary policy response to the pandemic, leaving the funds rate target range of 0.00% to 0.25% unchanged. However, the central bank’s “dot plot,” a forecast of future rate changes, turned somewhat more hawkish, as additional Fed governors indicated that the current rise in inflation will necessitate increases in short-term interest rates earlier than previously anticipated. The FOMC now expects the first interest rate hike to occur sometime in 2023.

EQUITIES

Stocks continued to rally following the pandemic-related selloff of the first quarter of 2020. Broad-based indices posted their fifth consecutive quarter of robust gains, with many indices having soared more than 80% from the pandemic lows. Analysts point to three primary drivers of the ongoing rally: First is the ongoing reopening of the economy as virus cases have declined precipitously; second, the FOMC continues to maintain an aggressive monetary policy stance, even in the face of a spike in inflation; and third, a historic level of fiscal stimulus is now coursing through the system. Returns on broad equity market indices move steadily higher throughout the quarter. When the quarter ended, the S&P 500 Index had advanced +8.6%, and has gained +41% over the past 12 months.  International stocks also generated material gains during the quarter, and generally performed in line with US equities. The MSCI EAFE Index of developed markets stocks advanced by 5.3%, while Emerging markets performance was positive, as the MSCI Emerging Markets Index was higher by +5.1%.

FIXED INCOME

The FOMC made no change to the federal funds rate target range of 0% to 0.25%, but it is paying increasing attention to the acceleration in inflation. The committee left its outlook generally unchanged in the communication following its most recent meeting, but the recent acceleration in inflation resulted in a “dot plot” – the forecast of the fed funds rate – that was more hawkish than expected. The dot plot now shows that more governors than before believe that the first interest rate hike will be necessary in 2023. The FOMC termed the rise in inflation as “transitory,” but the equity and fixed income markets were nevertheless spooked. Analysts believe the Fed will announce that it will begin tapering its asset purchases beginning in September, with reductions occurring at monthly intervals.

Fixed income securities’ prices on balance were higher (and yields lower) in the quarter as the economic rebound continued but not at the pace of prior quarters. While inflation spiked as a result of the FOMC’s continued aggressive monetary policy and trillions in fiscal stimulus passed by Congress, interest rates moved only slightly higher on the negative news. Because there was not a more precipitous rise in rates, it is possible that the market agrees with the FOMC that the current inflation scare could be transitory.

SUMMARY

The global economy is forging ahead as it continues to recover from the very severe, but also very brief, recession triggered by the pandemic. The confluence of factors such as accelerating business re-openings resulting from a decline in virus cases, aggressive monetary policy implemented by world central banks, and historic levels of fiscal stimulus in the US have created favorable conditions for the economy. A byproduct of these conditions is that asset prices have risen to, in certain cases, extreme valuations. Another implication of the combination of simultaneous massive stimulus and an aggressive FOMC monetary stance is that inflation has spiked. Despite the FOMC’s declaration that the rise in prices is “transitory,” inflation remains elevated. Fed governors are concerned enough that more of them now believe they will need to raise interest rates earlier than had previously been anticipated.

The Fed is worried that a wage-price spiral may develop, where rising wages would increase disposable income, which in turn would cause increased demand for goods and an attendant rise in prices. While the rising wage component of the equation has not yet materialized due to the disincentives to work provided by the high unemployment benefits, it could eventually become an issue. Among the concerns cited by economists are that new variants of the virus that are causing issues in Europe and other parts of the world could make their way to the US; equity prices are at valuations that risk a correction; and rising gasoline prices could eat into consumers’ disposable income and erode confidence. In addition, trade wars and other geopolitical risks – including US-China and US-Russia relations – always pose a potential threat to growth.

Information provided is for informational purposes only and should not be construed as investment advice. The views expressed are current only as of the publication date, are based on information that St. Clair Advisors believes to be accurate, and subject to change without notice. All investment decisions must be evaluated as to whether they are consistent with your investment objectives, risk tolerance and financial situation. St. Clair disclaims any liability for any direct or incidental loss incurred by applying any of the information in this publication. Indexes are unmanaged and one cannot invest directly in an index. Past performance is no guarantee of future results.

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