Quarterly Economic Update
After a decline in output in the first quarter, economic activity in Europe picked up in the second quarter thanks to a widening vaccination distribution and a relaxation of economic restrictions. Despite its slow start to the year, the Euro area economy is projected to grow by 4.3% in 2021, powered by consumer spending, fiscal support, and exports. Unemployment levels are expected to fall to near pre-crisis levels.10
As vaccination rates have hit 70% in the U.K., the return to economic normalcy has been quicker than on the continent. This high rate of vaccinations, along with accommodative fiscal policy, is expected to lead to a 7.2% growth in GDP this year.11
China’s vaccination rollout has only recently gathered steam, with its slow start limiting full recovery from the pandemic shutdown. Nevertheless, China’s recovery has been strong, with economic growth this year projected to be 8.5%. Investment has led the recovery, with consumer consumption growth rebounding more slowly. Imports and exports have seen a solid improvement.12
After finding early relative success in recovering from the pandemic’s economic impact, Japan declared a state emergency in April due to rising infection rates in certain prefectures. The economic containment measures subsequently implemented were insufficient to stem the virus’s spread, resulting in muted economic growth in the second quarter. Despite this, Japan’s economy is anticipated to expand this year, albeit at a tepid 2.6% rate.13
The MSCI-EAFE Index, which tracks developed overseas markets, rose 4.37% in Q2, while emerging markets, as measured by the MSCI-EM (Emerging Markets) Index, gained 4.42%.14
Quarterly Tip
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Investors have enjoyed strong gains so far this year as stocks have responded well to rising vaccination rates, economic reopening, fiscal stimulus, and an accommodative monetary policy.
If the market is to build on these gains over the next quarter and through the year-end, it may depend on how several important questions are answered over the coming months.
Second-quarter GDP growth is expected to come in very strong, perhaps the strongest in decades, leaving investors to wonder if this represents peak growth. In other words, how much will the economy continue to expand absent further fiscal stimulus and with the prospect of Fed tapering? There is a case for above-trendline economic expansion as consumers spend their accumulated savings and people begin filling open jobs once schools reopen and their comfort level with the safety of returning to work rises. Nevertheless, economic expansion appears set to slow, and that’s a potential hurdle for the market.
Then there is the matter of inflation and how “transitory” is defined. The Fed believes that the recent acceleration in inflation is transitory, but transitory is not a technical economic term. It’s a rather ambiguous term. Is “transitory” three months? Six months? Or longer? The market may have a different definition of transitory than the Fed, which could lead to future market dislocation.
For the three-month period ending May 2021, the annualized rate of inflation accelerated to 5.2%, the fastest pace since 1991. The months ahead should provide a clearer picture of whether inflation proves transitory or becomes a more sustained feature of a post-Covid economy.15
There is an additional, more overlooked, concern regarding inflation, i.e., its impact on consumer spending. While inflation may be transitory, price increases generally are sticky. Thus, it remains uncertain if increases in overall consumer prices will dampen consumer discretionary spending, which investors may be expecting to drive future economic growth.
The Fed’s easy-money policies have been a contributing factor in the market’s sharp recovery from its pandemic lows. Consequently, investors are expected to continue to focus on Fed signals about the timing and degree of its plans to taper its monthly bond purchases. (Its June meeting was silent on this issue.) Tapering is a concern, but given the excess liquidity worries of many investors, any start of Fed tapering later in the year may turn out to be a welcomed development.
Another market headwind is stretched investor sentiment. Though markets are hovering around all-time highs, market breadth has not been exceptionally strong, which suggests investor enthusiasm has moderated. A weekly survey by the American Association of Individual Investors reflected a 10% decline in bullish sentiment and a concomitant rise in bearish sentiment in the month of June. With potentially fewer positive economic surprises ahead and muted buying sentiment, the market may mark time until a new catalyst emerges.16
The economy appears in good shape, and most economists expect it to remain strong into 2022. This portends a positive second half, but investors shouldn’t lose sight that the market is currently priced above historical average.
This material does not constitute a recommendation to engage in or refrain from a particular course of action. The information within has not been tailored for any individual. This commentary is brought to you courtesy of MML Investors Services, LLC (Member SIPC) and a subsidiary of Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111-0001. Past performance is not indicative of future performance.
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9. federalreserve.gov, June 16, 2021
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