The heat is on

Today, in the middle of record-breaking North American heat waves, economists and investors are sweating as they struggle to determine whether the world economy will expand sustainably, stumble or overheat. Plenty rides on the outcome, not least the underpinnings of the bond market and the sustainability of an equity bull market entering its 16th consecutive month.

Signals remain conflicting

Economists and investors remain highly uncertain, mainly because the data has been conflicting. For instance, after racing ahead for most of the year, lumber prices have tumbled 40% from their recent peak.[1] Yet, energy prices continue to surge, and the widely watched Bloomberg commodity index hovers near one-year highs. House prices, too, are soaring. However, construction spending in June disappointed consensus expectations.?

Job growth has picked up, but so too have resignations. In April, nearly four million Americans quit their jobs, the highest number ever recorded by the Bureau of Labor Statistics.[2] Some may be testing a buoyant job market for higher pay, but others may be disgruntled or unable to find childcare. In the most recent employment report, a higher-than-expected 850,000 new jobs were created,[3] but most were in lower-paying hospitality, leisure and government sectors. Elsewhere, job growth is more pedestrian, which may reflect a scarcity of skilled candidates. And despite soaring job openings and faster wage growth, the US labor force participation rate remains mired at 61.6%,[4] well below its pre-pandemic level of 63.4%.[5] Total US employment is still nearly seven million workers short of where it was before COVID19 arrived.[6]

Are we accelerating towards a new normal?

Globally, indices of production appear to have peaked. What remains to be seen is whether manufacturing is being held back by temporary parts and supply shortages, or even transportation bottlenecks. US auto production, for example, remains gummed up by a shortfall of computer chips. Backlogs at ports and onward distribution nodes have slowed international shipping, in some cases by several weeks.

Don’t forget, the pandemic unleashed simultaneous demand and supply shocks. Moreover, disruptions to global production and distribution processes came directly on the heels of trade wars, Brexit and slowing globalization. Now, as demand rebounds amid economic reopening, the supply response is sluggish in many places, including energy, manufacturing, shipping and labor markets.

Are price or wage increases due to excess demand? Or are they the result of inadequate supply? And how long might it take for supply to catch up with demand??

If temporary supply bottlenecks are to blame, then monetary policy need not adjust. Higher investment in production and distribution, to alleviate shortfalls, would boost the fortunes of cyclical shares. Rising growth expectations would be reflected in rising long-term bond yields, resulting in a steeper yield curve. ”Risk on” would produce a weaker US dollar in global currency markets as investors flock to more cyclically sensitive regions, such as Europe, Japan or emerging markets.

If supply is impaired longer term, the result would be dramatically different. Prolonged rigidities in labor markets or costly onshoring of global supply chains would simultaneously slow potential gross domestic product growth rates and crimp corporate profit margins. Overall, equity markets multiples would have to fall, as would long-term interest rates, reflecting poorer trend growth and corporate cash flow generation. Yield curves would flatten, and the impact on the dollar would be ambiguous.

Lastly, in a pure overheating scenario, monetary policy tightening would be warranted. Shorter-term interest rates would rise relative to long rates, leading to a flattening of the yield curve. Profit expectations would be lowered, cyclicals would be hardest hit, and investors would rotate toward more defensive or durable growth strategies. To the extent the Federal Reserve were leading a global tightening cycle, the dollar would probably rally.

Who is reading the signals right?

Against such divergent possible outcomes, investors appear optimistic as broad equity markets indices are flirting with all-time highs and relatively low volatility. However, the US dollar has strengthened, bond yields have slumped, the yield curve has flattened, and the outperformance of cyclical sectors in the equity markets have waned. That’s not what one would expect if supply constraints were purely transitory, and all was well with the world.

In the northern hemisphere, summer has just begun. If the early indications are right, it will be a long, hot one. The debate around the prospects for the economy and the impact on asset prices will continue. This could either continue to light a fire under asset prices or catch some investors by surprise if they get too close to the flame.

For?additional?market and investment views for the second half of the year?read:

US: Franklin Templeton’s?Global Investment Outlook: Guarding?for Inflation and Searching for Quality ?and the Franklin Templeton Fixed Income Views: The Fed’s long, hot summer .

Non-US: Guarding?for Inflation and Searching for Quality ?and the Franklin Templeton Fixed Income Views: The Fed’s long, hot summer .

[1] Source: Nasdaq. Lumber (LBS). https://www.nasdaq.com/market-activity/commodities/lbs

[2] Source: US Bureau of Labor Statistics. Economic News Release. Table 4. Quits levels and rates by industry and region, seasonally adjusted. https://www.bls.gov/news.release/jolts.t04.htm

[3] Source: US Bureau of Labor Statistics. Economic News Release. Employment Situation Summary. https://www.bls.gov/news.release/empsit.nr0.htm

[4] Ibid.

[5] Source: Economic Research. FRED Economic Data. Labor Force participation Rate. https://fred.stlouisfed.org/series/CIVPART

[6] Source: Cox, Jeff. CNBC. US adds 850,000 jobs in June, better than expected. https://www.cnbc.com/2021/07/02/jobs-report-june-2021.html

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.?Interest rate movements may affect the share price and yield. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.

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