Pandemic Restrictions Lifted…
- Historic efforts to stimulate the economy and the remarkably fast development of vaccines have borne fruit, resulting in the lifting of virtually all pandemic activity restrictions by mid-May. Armed with accumulated excess savings, consumers are increasingly back on the move.
- The economy has accelerated considerably, fueled by pent-up consumer demand and the removal of COVID-19 activity restrictions. 1Q21 GDP growth accelerated at a 6.4% q/q annualized pace.
- With virtually all measures of economic activity signaling a robust rebound for the remainder of the year, 2Q21 GDP is expected to be 10%-11% q/q annualized. Furthermore, full-year GDP growth projections are in the 6%-7% range.
…Return to Normal Underway but Constraints Remain
- Consumer confidence has generally been on an upward trend and retail sales have displayed a strong correlation to government stimulus. Sales rose rapidly in January and March (7.6% m/m and 11.3% m/m respectively) while increasing by a more subdued 0.9% in April and falling by 1.3% in May. Sales are now 18% higher than February 2020, indicating consumers continue to spend at an elevated rate.
- With the economic flood gates open, a commensurate rebound in employment has been expected; however, the labor market recovery has been somewhat underwhelming. The June payroll number was stronger than expected at 850k jobs added, but total employment is still ~7 million jobs lower than pre-pandemic levels.
- Businesses are expanding rapidly in an attempt to meet consumer demand. While supply chain bottlenecks and labor shortages remain, there are signs they may be easing somewhat. Both the ISM Manufacturing and Services Indices remain strongly in expansionary territory, settling in at 60.6 and 60.1 in June after both reached historic highs earlier in the spring.
Government and Fed Still in Stimulus Mode…
- As expected, the Fed kept its policy rate unchanged throughout the quarter; however, published forecasts and expected future rate hike messaging turned slightly hawkish in June. While many have stated that the dot plots should be taken with a considerable grain of salt, it is noteworthy that an increasing number of Fed members have moved up the timing of rate increases and the impact of rising inflation in their projections.
- The market now expects a formal announcement of QE tapering at the September Fed meeting with implementation in early 2022. However, after years of cheap financing there is some question as to the market’s ability to tolerate higher rates and “normalized” monetary policy. Some form of unconventional monetary policy may be here to stay.
- After alleviating considerable financial stress for millions of Americans during the pandemic, a number of financial relief programs have already expired or are schedule to expire in the coming months. However, considering the current political impetus to remain accommodative, it seems likely that portions of these programs will get extended, perhaps on a more targeted basis.
…As Inflation Heats Up but Expectations Remain in Check
- Elevated consumer demand and supply chain bottlenecks are accelerating near-term inflation. Core CPI rose by 0.9% m/m in April, the largest one-month increase since 1982, before rising an additional 0.7% m/m in May. As with many measures, y/y inflation readings are distorted due to base effects, but for illustrative purposes, headline and core CPI are running at 5% and 3.8% y/y respectively.
- Forecasts generally call for core inflation in the 2.5% range by the end of the year, falling back to closer to 2% in 2022. Importantly, these rates do not imply problematic inflation on the horizon, suggesting the market has thus far agreed with the Fed’s current assessment that inflationary pressures will likely pass.
- Further, by design, the Fed’s new FAIT framework provides breathing room to let inflation run hot; however, the more hawkish pivot at the June FOMC meeting suggests the Fed is more likely to capitulate to inflationary pressures and perhaps sooner than previously expected.
Fed Flattens the Yield Curve, Most Non-Treasury Sectors Continue to Outperform
- In a partial reversal of the first quarter’s steepening, the Treasury yield curve flattened considerably in 2Q21. The 10-year Treasury started grinding lower in May, falling from 1.74% to 1.47% to end the quarter. The 2-year Treasury yield rose by ~0.10%, settling in at 0.25% at the end of June. Altogether, 2s vs. 10s flattened 36 bps (0.36%), reflecting the Fed’s more hawkish tone.
- Most major fixed income spread sectors outperformed like-duration Treasuries modestly during the quarter, with the exception of Agency MBS. Once again, relative performance was led by Corporate bonds, with longer bonds outperforming short/intermediate maturities, and BBB and crossover/high yield issuers outperforming up-in-quality names. The picture is similar for the previous twelve months.
- Corporate new issue supply year-to-date has been robust. According to SIFMA, investment grade supply was ~$830 billion for the first half of the year. While this is down relative to 1H20, it is well above 1H19 levels. High yield issuance also remains strong with supply of ~$300 billion through June. This is meaningfully above issuance over the same timeframe in 2020 and 2019. Spreads generally tightened across the board during the quarter and remain at historically tight levels overall.
- The Agency MBS sector struggled during the quarter, the only major spread sector to generate negative excess return vs. Treasuries. The idea of earlier than anticipated asset purchase tapering caused spreads to move wider in May and June. However, post-June FOMC the curve flattened and relative value brought buyers back in. At $418 billion YTD, net supply of Agency MBS has already been considerable. Should trends in housing continue, net supply could reach $700+ billion, double to triple the normal amount over the last handful of years.
- ABS credit performance continues to be strong as a result of fiscal stimulus and excess consumer savings; however, with many government programs scheduled to wind down, we expect credit performance to deteriorate modestly over the near term. New issue remains robust, with $66 billion of supply in 2Q bringing the year-to-date total to $130 billion (Citi Research).
- The new issue CMBS market has picked up steam, providing $31 billion of supply in 2Q and $45 billion in 1H21 (BofA). Notably, single-asset/single-borrower supply has outstripped conduit supply by a margin of 2:1 so far this year. With the economy opening up, we expect CMBS credit performance to continue to improve; however, less favorable trends in sectors like retail, multifamily, and office will continue to weigh on performance.