As the U.S. economy continues to rebound, second-quarter earnings are coming in strong. From technology and financials to housing, steel, pharma and consumer staples, I’ve been impressed by how broad-based the recovery is. Along with earnings, companies are providing upbeat guidance for the next two quarters and into 2022. These developments factor into the question we’re all asking: Is growth at its peak?
Though GDP growth was below expectations for Q2 — 6.5% on an annualized basis versus a revised 6.3% gain in Q1 — it is still above trendline growth, with final retail sales up 7.7% and personal consumption for services up 12%. As COVID delta variant cases rise in the U.S., we will see some volatility, but given the widespread reopenings and high level of pandemic fatigue, I do not see delta having a material effect on growth.
That leaves investors with the other pressing question: Is the uptick in inflation real or transitory? The GDP report showed that core personal consumption expenditures (PCE) inflation was up a whopping 6.1%; this included a deflator not seen since 1983, according to Merion Capital. While some inflation is indeed transitory, such as commodities and used auto prices, some — namely, wages and shelter costs — are not.
For my portfolio, I’m seeking opportunities in financials, housing, steel, pharmaceuticals and consumer staples, and maintaining focus on technology, particularly in the cloud, e-commerce, digital video and other sectors that will benefit from trends in consumer behavior.
Economic Growth Continues
U.S. GDP rose in Q2 in large part due to increasing PCE, as well as nonresidential fixed investment, exports, and spending by state and local governments. Total personal savings came in at $1.97 trillion in the second quarter, a massive drop from a revised $4.07 trillion in the first quarter. The pent-up household savings we’ve been discussing for months is now starting to make its way into the economy. U.S. retail sales increased in June by 0.6% versus May, far exceeding expectations.
Consumer spending, which constitutes about 70% of GDP, continues to increase as people resume shopping, traveling, eating out and seeking entertainment. Low interest rates are bolstering consumers’ ability to make big purchases on credit. Consumer confidence continues to climb: The Conference Board reported in July that its index edged up to 129.1, above expectations, from a revised 128.9 in June, despite the rise of the delta variant and inflation concerns.
Direct stimulus payments for businesses and consumers may be largely over, but the liquidity is still in the system, contributing to what is likely to be 6.6% GDP growth this year, and 4% for 2022. Bond buying by the Federal Reserve continues, and in his latest statements, Chairman Jerome Powell did not provide a date for the Fed to taper its efforts. This stimulus, plus the imminent federal infrastructure package, will continue to fuel the economy.
The surge in consumer demand and expectations for further growth have affected manufacturing: The Institute for Supply management’s June manufacturing PMI registered 60.6%, with new orders at 66.0% (above 50 indicates an expanding economy). Both showed 13 straight months of growth, while customers’ inventories remain low.
The Philadelphia Fed Manufacturing Prices Paid Index decreased to 69.7 in July after reaching a 42-year high in June. Notably, over 72% of the firms surveyed reported higher input prices this month, while only 2% of the firms reported lower input prices.
While the Fed continues to express that inflation is transitory, I’m skeptical. What is likely transitory is higher commodities prices, as well as items affected by supply chain issues. Wages and shelter prices, however, are not. The Job Openings and Labor Turnover Survey (JOLTS), which tracks data on job openings, hires and separations, showed that job openings hit 9.2 million in May. Many companies are unable to find workers, which pushes up wages.
The consumer price index increased 0.9% in June on a seasonally adjusted basis after rising 0.6% in May. This was the largest one-month change since June 2008, when the index rose 1%. Over the last 12 months, the all-items index increased 5.4% before seasonal adjustment; this was the largest 12-month increase since a 5.4% increase for the period ending August 2008.
Shelter prices increased 0.5% for the month and 2.6% from June of last year. The federal moratorium on evictions is scheduled to expire at the end of July, which will push rents higher as landlords look to recoup income lost during the moratoriums.
From recent statements, it’s clear that the Fed is letting inflation run its course. As for bond yields, I believe they are skewed by global central bank interventions. For instance, we know the Bank of Japan is making bond purchases to fund its stimulus program. Concerns about the delta variant may also be suppressing yields.
How I’m Adjusting My Portfolio
We’ve seen a tremendous amount of rotation in the market. From January through mid-May, we saw value outperform. In mid-May, growth started outperforming value. All of this rotation is pointing toward economic growth being at its peak. However, given broad-based earnings strength, forward guidance and positive economic data, I believe growth will continue and the economy will start to normalize in 2022.
I continue to maintain a barbell approach with both cyclicals and technology, adding exposure to sectors that will benefit from recovery, such as financials, which are relatively cheap and are buying back stock. I also have my eye on industrials, at five-year inventory lows — keeping my focus on companies that are investing in process automation, supply chain efficiency or new technologies such as robotics. On the margin, I’ve been taking gains from energy and materials. I’m also positioning my portfolio to have exposure to the consumer by increasing discretionary, travel and leisure.
In the coming months, we expect to gain better insight into inflation, and what the Fed is willing to do to get non-transitory price increases under control. As the global economy continues to move toward recovery, we will likely see bond yields revert to their standard behavior.
The second-quarter U.S. GDP report told us three key things: Personal consumption is up, retail sales are up, and we continue to have more inflation. With an accommodative Fed that is showing no signs of tapering soon and a new infrastructure bill soon to be passed, the system is awash with liquidity — bullish conditions for equity assets.