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Economic news is interpreted by emotions and political views. But the business cycle works despite what we believe should or should not be happening. Analysts squabble over the type of recovery we might have. We are inventing letters and symbols to describe it: V, W, M, U, L, K, and square root. The slowdown started in mid-2018 and ended in March 2020 as supported by the trend in Markit PMI, ISM PMI, employment in manufacturing, heavy truck sales, and many other economic data.
The reason it ended and growth resumed with a vengeance is because inventories were completely depleted. Few things were on the shelves, parking lots, and construction sites. Business had to rebuild and restock aggressively those inventories. Following the scare of the pandemic, sales started to come in and business found itself forced to produce aggressively to match inventories to sales growth.
The increase in production required labor and raw materials. The sharp rise in copper prices, lumber, and manufacturing employment confirmed the new business cycle started with a vengeance. Meanwhile, most analysts were still thinking about the letter to assign to the recovery.
The many surveys available from the regional federal reserve banks, like the one of the Richmond Fed, confirm the sharp increase in production and employment. Of course, manufacturing employment receives above average wages. Income growth continues. Sales growth continues. And inventories must be replenished by increasing production to match sales.
Consumers now have new income to spend, increasing job opportunities. Young undergraduates with one more year to go before graduation are getting excellent job opportunities. People have resumed their aggressive home buying due to low interest rates.
The outcome has been a sharp increase in housing starts confirmed by a spike in lumber prices. There is no doubt all these charts have two main features. The first one is there has been a sharp increase in economic growth caused mostly by the need to rebuild depleted inventories. We are going through a V-shaped recovery obfuscated by the pandemic, but nevertheless a V-shaped recovery.
The second feature, and this is the most important point I would like to make: The V-shaped recovery is behind us. It’s done. Not all, but many surveys and economic indicators are at pre-pandemic levels as in the above graphs. If I am right, now the economy is on a pre-pandemic growth path of about 2%.
Do the markets agree? Lumber and housing are correcting sharply. Crude oil stopped rising, reflecting slower growth ahead. The stock market has increased its volatility uncertain of what is going to happen next. 10-year Treasury bond yields have stopped rising and refuse to go above 0.70%.
In the past 200 days the market has not given a vote of preference about which way to go: defensive stocks or growth stocks. They all performed about the same compared to the S&P 500 (see above chart) – except for technology, with its defensive features. The above chart shows a very uncertain behavior of the market. The weakness in financials and energy shows the lack of conviction about the future growth pace of the economy. The continued resilience of bond prices also suggests the growth path is much more subdued than the one from March to July. This evidence just seems to say that we’ve seen the V-shaped recovery and now we are back dealing with slower growth and lower stock price appreciation in a post-pandemic economic economy.
The point I am trying to make is investors should again consider an investment strategy consistent with slow economic growth. The implications: avoid deep cyclical investments in financials or commodities (XLF, XME, XLE, XLB). Some exposure to growth in the industrial and transportation (XLI, IYT) sectors seems right because growth will continue albeit at a more moderate pace.
Technology stocks (XLK) should be a part of the strategy given their huge global competitive advantage and profit growth. Bonds (TLT) in this environment continue to have an important role in reducing portfolio volatility and still supply some hedging advantages.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.