The Covid-19 pandemic has helped create a financial environment characterized by unusual (and possibly unsustainable) asset price spikes.
The rapid economic standstill in spring 2020 resulted in a brief but painful recession. But the resulting reopening has sparked a massive boom that has left some wondering if America is now in the middle of the new Roaring Twenties … just like it was 100 years ago.
Still, there are signs that the economy and market could hit highs soon – for pretty much anything.
“What will the return to normal be like? We may have peaked soon,” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management.
The earnings momentum should subside
Investors and consumers should prepare for the possibility that the economy could finally settle down in the second half of 2021 and through 2022, especially if the delta variant becomes an even bigger problem.
Stocks may have a harder time rising as valuations become more expensive and earnings growth inevitably cools.
According to FactSet estimates, the price / earnings ratio for stocks is well above their five- and ten-year averages.
Analysts believe the S&P 500’s earnings were up nearly 90% year over year in the second quarter. But that is likely to be the highest growth rate for the foreseeable future.
Earnings growth is expected to decrease to 28% in the third quarter and to 21% in the fourth quarter. In 2022, earnings are expected to grow by just 9.5%. Once it becomes clear to investors that this could be the peak of corporate earnings growth, company valuations (and stock market levels) could decline.
“I think the markets – all markets – priced in really good prospects. So there could be more downside risk as so much good news has been priced in, ”said Tim Schmidt, chief investment officer at Prudential.
Schmidt added that he doesn’t see any bubbles per se, but that the market could be a bit ahead of itself.
Real estate prices could finally give way
New home sales declined in July, a possible sign that buyers are unwilling to lose one bidder battle after another in a market where housing supply is still scarce.
Renters may choose to stay there until prices finally cool down a bit. Should sales continue to fall, it stands to reason that prices will inevitably also fall.
Economists don’t expect this to lead to another major real estate market collapse like the one seen in the late 2000s. However, any noticeable drop in property prices should have a negative impact on the economy as a whole. That’s because, according to the National Association of Home Builders, housing construction accounts for around 15 to 18% of the country’s total gross domestic product.
A potential spike for the broader economy isn’t all bad news, however. Inflation could be less of a problem in the next few months.
Eric Winograd, chief economist at investment firm AB, stated in a recent report that “with the pace of gasoline price hikes slowing, we are likely to be at or near the high of the CPI.”
The prices of other goods and services, which have risen gigantically due to temporary factors such as supply bottlenecks and a massive, rapid recovery in demand, could also cool off.
“Inflation is high, but probably at or near its peak,” said Scott Rüsterholz, portfolio manager at Insight Investment, in a report.
“We will look to see if volatile categories that have caused much of the recent price spike, such as rental cars, hotel prices and used cars, show signs of moderation,” he added.
Inflation may cool off, but it won’t go away forever
But what happens next in the labor market is the big wild card for inflation. Wages have risen. And when workers make more money, it has the greatest potential to drive up longer-term prices.
BMO’s Ma said wage pressures should continue to rise due to the permanent changes in labor market dynamics as a result of Covid-19.
Staff shortages in key service industries have forced retailers and restaurants to raise wages to attract more workers.
“We don’t want to stick to pre-pandemic norms. It’s a new environment and in many ways things will be very different. Inflation could continue for some time,” he said.