The economy shifts from a recovery to an expansion

by Badgley Phelps | Jul 27, 2021

Outlook: Third quarter 2021


The economy continues to grow at a fast pace fueled by the combination of government aid, high levels of stimulus from the Federal Reserve, healthy consumer balance sheets, and the reopening process. Growth is expected to peak in the second quarter and then decelerate resulting in an expansion of 6.5 percent this year and levels more consistent with the historical norm in the coming years. Given the current strength of the expansion, our economy is on track to fully recover the loss sustained during the pandemic and is projected to rise to a record level this summer.

The extreme level of stimulus from the Federal Reserve has been one of the drivers of the economic recovery. At their meeting in June, the members of the central bank’s Federal Open Market Committee maintained their easy policy stance. However, they noted that a change in policy may be necessary in the future with a potential reduction in the magnitude of their bond purchases. They also projected that two rate hikes would be necessary in 2023 which is a change from previous meetings where they forecast no rate increases between now and the end of that year. While their comments signal an eventual change in policy, it is driven by solid improvement in the economy and a reduced need for the central bank’s support.


Inflation has advanced in a sustained manner since bottoming last spring. In June, it reached the highest level since 2008 with the Consumer Price Index up 5.4 percent year over year. Some of this inflation is transitory as COVID induced supply bottlenecks will eventually be normalized. Base effects also play a role as inflation was below 1 percent in June of last year making comparisons against that level appear unusually large. Despite these temporary factors, the Federal Reserve has been aggressive in its attempt to boost inflation and there is a risk that the rise in prices will be enduring. This is a dynamic we are closely monitoring as it has the potential to negatively impact consumers and corporate earnings.

U.S. dollar

The shift in the Federal Reserve’s guidance at the end of the second quarter led to a strong rally in the U.S. dollar. Prior to that shift, our currency had been on a steady decline that began in May of 2020. Looking forward, we expect the U.S. dollar to remain elevated in the near term. However, on a longer-term basis our high level of government debt and improving conditions in foreign economies may weaken our currency.

Asset class

Cash/money market instruments

On June 16, the Federal Reserve updated their economic projections and, given the improving outlook, pulled forward their expected timing for the next increase in interest rates. Seven of the eighteen members of the committee indicated that at least one rate hike will be necessary in 2022 and a majority of the committee members indicated that at least two rate hikes will be necessary by the end of 2023. While the timing is far in the future, the shift is significant as it represents an eventual change in stance by our central bank.

For much of this year, short-term interest rates remained range bound, and close to zero, yet the recent shift in tone from the Federal Reserve has translated to an increase in short-term yields beyond the pre-established trend. At the end of the second quarter, the two-year U.S. Treasury yielded 0.27 percent, which was roughly twelve basis points higher than the average year-to-date. However, no rate hikes are expected soon and we anticipate that short-term interest rates will remain close to current levels in the coming quarters.

Intermediate government/credit bonds

The change in tone from the Federal Reserve resulted in an increase in short-term rates while driving yields on intermediate and longer-term bonds to lower levels. Currently, the yield on the 10-year U.S. Treasury is approximately 1.3 percent, a level that is roughly 45 basis points below the high for this year. The decline in longer-term yields reflect expectations that the central bank is unlikely to allow inflation to remain at a high level for a long period of time.

Looking forward, we expect yields on intermediate to longer-term bonds to have an upward bias, while remaining at historically low levels. In terms of corporate bonds, the dramatic economic rebound has served as a tailwind for businesses and has resulted in corporate spreads remaining near historical lows. For the foreseeable future, the strength in the economy should keep these spreads tight.

Tax-exempt municipal bonds

Despite a few weeks of robust new issue activity, the municipal market is still contending with negative net supply. Unique to the tax-exempt bond market, a large amount of coupon and principal payments come due during the summer months and generally needs to be reinvested. Normally this has not been much of an issue but over the last few years supply has not increased to absorb the additional demand. Peak cash-redemption season is forecast to propel negative net supply toward $40 billion in the coming months. Add in substantial fiscal support from the government, as well as the prospect of higher tax rates, and municipal bonds have some strong tailwinds that support high prices.

U.S. equity

The U.S. equity market remained strong last quarter fueled by the rollout of vaccines, continued implementation of government aid packages, aggressive monetary policy, and the reopening of the economy. However, market leadership shifted from small-cap and value-oriented stocks to those in the large-cap growth segment. This was driven by the recent decline in long-term interest rates and the widely held view that both growth and inflation will moderate later this year. Accordingly, stocks that are less dependent upon a robust economic environment, such as those in the technology sector, outperformed.

Looking forward, we expect the current drivers to remain in place: the economy is recovering, vaccines provide optimism for the long-term outlook and stimulus programs provide near-term financial support. These dynamics have generated a “V” shaped recovery in corporate earnings while also fostering a strong economic rebound. This is a favorable backdrop for equity investors, and we expect the market to trend upward following the growth in corporate earnings. However, the market is likely to be more volatile going forward given the strong rise in equity prices over the past year, the high level of valuations, the gradual shift in stance of the Federal Reserve and the possibility of higher tax rates for both individuals and corporations.

International equity

International equities rallied last quarter in conjunction with the U.S. markets. Foreign economies are being driven by similar dynamics to the U.S. High levels of monetary and fiscal stimulus have been deployed in countries around the world and in recent months vaccines have been distributed in greater quantities. The combination of these factors has helped to foster a reopening of many economies around the world and the trend is expected to continue as we progress through 2021.

The factors noted above set the stage for a strong recovery in earnings which is expected to drive foreign markets higher in the coming year. However, vaccine distribution is occurring at an uneven pace across countries worldwide, generating differentiated returns across countries and regions. As we progress through the remainder of the year, we expect an increasingly broad distribution of vaccines, but this will take time. In the near-term, the developed markets such as those in Europe are reopening and their markets have performed well. On a long-term basis we continue to have a more favorable outlook for Asian countries and the emerging markets as they have strong opportunities for growth.


Commodity prices continued to increase last quarter given expectations for a sustained economic expansion. The gains were highest in energy related commodities with significant increases in prices for oil and natural gas, but many agricultural products and metals also participated in the rally. Looking forward, we expect commodity prices to grind higher as the global economy expands.  


Potential opportunities & risks


New opportunities/new markets—The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand. Prevalent themes include the increased use of technology, home improvement, home ownership, products and services that facilitate working from home, and a significant increase in the use of online retail relative to shopping in stores.  

The emergence of new technologies—The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time.

The evolution of finance—Technological advancements are disrupting traditional methods of banking, finance and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Online payment systems facilitating money transfers, e-commerce and electronic bill paying services are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies.


Setbacks in the re-opening of the economy—The rate at which vaccines have been developed is unprecedented. However, variants of the virus and the uneven distribution of vaccines could be problematic and may slow the rate at which we can return to more normal lifestyles.

Debt-related issues—Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus, debt has increased significantly. In the U.S., government debt increased 24 percent last year and stimulus measures adopted recently will sustain that trend.

Inflation—Given the unprecedented amount of fiscal and monetary stimulus, as well as the Federal Reserve’s policy of allowing higher rates of inflation, there is a risk that the recent increase in price levels may persist and be harder to contain than policy makers anticipate.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We continue to monitor events across the Middle East, Russia, and the South China Sea. In particular, tensions between the U.S. and China remain elevated and we are closely watching relations between the two countries.

Cybersecurity—Cybersecurity remains a significant issue as evidenced by persistent attacks on governments, businesses, and individuals worldwide.


July 27, 2021


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