Halftime Report: 2021 Mid-Year Outlook

With the 2021 economic year halfway done, we can say the U.S. economy is broadly on a path toward having a solid year of strong growth—but, as always, there will be bumps along the way.

The effects of the COVID-19 pandemic remain; supply-chain disruptions are weighing on output, while the Delta variant of the coronavirus is causing some reopening plans to change. At this time, we believe a return to the lockdowns of 2020 seems unlikely, but a full recovery from the pandemic will be choppy. Look for swings in the economic data going forward. We are entering the transition phase from massive government support for business and individuals to ultimate dependence on the private sector.  We could see a slowdown in retail sales and a rise in business bankruptcies.

Big Demand, Little Supply

The U.S. Bureau of Economic Analysis announced that the U.S. economy grew at an annualized rate of more than 6% in the second quarter. That growth is strong, but still fell far short of expectations.  Forecasters had expected inventories to be replenished, but they fell sharply for the second quarter in a row. In some situations, companies have intentionally kept their inventories lean; but with demand booming, many inventory shortages seem to stem from frictions in production and logistics.

We’ve seen evidence of this trend in economic indicators for months. Manufacturers report that delivery timing has stretched out to new lengths. A record number of small businesses report that inventories are much lower than they would prefer. Shipping costs are skyrocketing. For some products, such as automobiles, sales growth has been inhibited by lack of availability.

For services, supply shortages have resulted in higher prices for hotel rooms, restaurant meals, and air fare. We continue to think that the labor supply will rise to meet demand in the coming months as pandemic-related support, such as enhanced unemployment benefits and furlough plans, expire. Increased labor should curb the inflation we’ve seen in the service sector.

In the goods sector, however, bringing supply and demand into closer alignment may take longer. Output may remain suppressed for some time as the latest wave of coronavirus infections crests. Even if production were at its peak, the ability to distribute goods to their intended destinations remains limited. Modern manufacturing supply chains rely on precise timing and coordination and have limited redundancy.

The Crystal Ball is Murky

Going forward, the economy is not likely to stall. However, year-over-year comparisons are going to become much more difficult now that the recessionary 2020 data is replaced—when calculating growth rates—with data from the first few quarters of the ongoing 2021 recovery.

For example, in the third quarter of 2020, global GDP growth was close to 10%. Even if U.S. economic conditions continue to improve from here, maintaining the same pace will be increasingly difficult—especially when considering fiscal stimulus measures may also be peaking and, therefore, may become less of a catalyst to economic activity going forward. Federal Reserve Bank of Atlanta’s GDP forecast for the third quarter has declined from 5.5-6% in late August to 3.7% in September.

The third wave of infection that is developing could also hinder global supply chains.  Already strained by the pandemic, international production and shipping systems will be further challenged if component countries must sustain restrictions. International tourism is still a fraction of what it used to be, and the Delta variant will only extend the slump in global travel.

Inflationary pressures are still subject to ebbs and flows in the nearer term and will be largely conditional on how supply and demand dynamics for many goods and services—including labor—end up playing out over time. If supply does increase while demand stays flat or begins to wane as the economy struggles to keep up its current pace, investors may worry about disinflation—whereby prices continue to increase, but at a slower pace—or deflation in the case that prices begin to drop from current levels. Indeed, lumber prices have already begun to retrace some of their meteoric rise of earlier this year, and it’s precisely this scenario that the U.S. Federal Reserve is alluding to when it talks about the transitory nature of inflation these days.

Wage inflation differs, and here’s why: Once a worker is given a pay raise—and not just a one-time signing bonus—it tends to set a new standard rate of income for that job that is very difficult to reduce. That new standard rate can have a ripple effect on salaries for other related employment opportunities.

In other words, investors should keep in mind that wage inflation is stubborn: not only because wage inflation likely holds the key to whether inflationary pressures persist more broadly, but also because it could lead to a period of stagflation if incomes continue to climb in the context of a slower pace of growth for the global economy.

Going On a Spree?

The drop in yields largely reflects the growing possibility that consumer demand— which has surged in a “relief spree” in countries where lockdowns have mostly ended—will exhaust itself eventually and be replaced with a less exuberant attitude towards spending.

Moreover, consumer behavior may be subdued even further if concerns about COVID-19 variants and all they might entail—including new lockdowns and vaccine booster shots—become more pressing in the weeks ahead. In turn, that could lead to another spike in personal saving rates, at least until we have a better idea of when life may truly return to some semblance of normalcy.

Of course, this uncertainty may not be all bad for investors. While higher savings rates obviously mean less consumption, they could also lead to more capital investment and, therefore, more opportunities.

The second quarter is expected to represent the peak in the earnings growth rate (although not the level of earnings). While earnings have already surprised to the upside in the second quarter, the magnitude of strength has been expected. It’s the typical pattern we see after a recession, when analysts’ forecasts become overly pessimistic and easy for companies to surpass as the economy recovers. The primary driver of the upside is operating leverage, as revenues return to pre-recession levels before costs are layered back in.

Conclusion: Zig-Zag Paths Ahead

Looking ahead, we think earnings growth rates will likely continue to cool, as comparisons to the prior year inevitably become more difficult. As of now, the growth rate is expected to slow to the mid 20% in the third quarter, a noticeable decrease but still strong.

Future estimates show a consistent downward, stairstep pattern. Investors should focus not just on the earnings growth rate but also what companies are saying with respect to inflationary pressures, profit margins, and forward guidance. If supply constraints and some temporary spikes among commodity prices are severe enough to weigh on companies’ pricing power, profit margins risk a hit in the near term.

For now, forward margin estimates haven’t weakened, and companies have raised forward guidance at an impressive rate: a welcome improvement relative to last year, when a record number of S&P 500 companies were forced to eliminate guidance, given the unique uncertainty brought on by the pandemic. The upgrades in outlooks after second quarter earnings are signaling continued strength for profits.

Market behavior could become choppier as earnings growth slows, with continued large swings in sector leadership (on a day-to-day and week-to-week basis). Adding to choppier market behavior going forward is Washington’s discussion on raising the debt ceiling. Investors’ best protection against volatility continues to be diversification across and within asset classes, and discipline around periodic rebalancing.