Equity markets rallied to fresh new highs in the second quarter as the economic reopening accelerated. Although it is still difficult to meaningfully analyze year-over-year data because everything was effectively shut down at this time last year, many indicators have surpassed pre-COVID readings when the economy was chugging along and the unemployment rate was the lowest since December 1969. Activity has returned to “normal” so quickly that labor shortages are evident in almost every sector of the economy. Trucking companies can’t find enough drivers, airports are operating with too few air traffic controllers, and restaurants everywhere are scrambling to staff for full capacity.
This is all good news, of course, unless there is so little slack in the economy that the increase in demand, coupled with all the stimulus measures, leads to runaway inflation. Federal Reserve Chairman Powell is betting that it won’t. He has gone to great lengths to communicate the Fed’s belief that huge spikes in the price of lumber and rental car rates, for example, are “transitory,” not lasting. In other words, certain supply chains that were impaired by COVID disruptions are now utterly under-staffed and unprepared for the sharp snapback in demand. At the same time, millions of Americans who would normally fill these jobs are still receiving COVID relief benefits. Whether or not workers are being “dis-incentivized” from working is a political football, but when asked about the influence of these programs, Chair Powell testified to Congress when the payments stop, he thinks it will “help some” to reduce the nationwide number of unfilled jobs, now 9.3 million in total.
In all, the economy is on solid footing and poised to grow strongly in the second half of 2021. This bodes well for corporate profits, which provide support for stock prices near all-time high levels. When stocks stumbled in February as Treasury yields jumped, it became clear that investors are more concerned about higher interest rates and inflation than any other potential threats. Since then, rates have moderated and the areas of the markets that were most spooked by higher rates have regained their upward momentum. Historically, when the first half is strong for stocks, they do well in the second half also.
The Fed doesn’t seem to share markets’ concerns regarding inflation – having indicated that rate hikes are unlikely before late 2022 or early 2023. The Fed’s actions suggest that they’d rather risk moderate inflation if it reduces the odds of deflation – a far worse environment. Prior to the pandemic, there were so many secular disinflationary forces in effect (including technology disrupting many industries) that the Fed was struggling to stoke enough pressure to achieve its goal of 2% inflation. It seems reasonable that once things fully normalize these forces will remain in place and that the inflation that we’re seeing is truly transitory. This argument might also posit that powerful changes in consumer behavior might be temporarily driving up prices in certain segments of the economy (e.g. housing) but that the eventual supply responses will force prices back down.