Happy Summer! I hope that this commentary finds you well and that you are enjoying some time with family and friends. It is much needed for all of us after a tough year and a half.
While virus concerns remain, primarily with the highly contagious variants and under-vaccinated areas around the country, we are less driven by COVID-related data. The new questions for the markets are now more focused on classic economic concerns: economic growth trends, corporate earnings and expectations, interest rate trends and subsequent actions by the Federal Reserve.
The markets continue to benefit from a return to normalcy. As of June 30, the S&P 500 Index is up 15% in the year-to-date period – the second-best first-half performance since 1998, behind only 2019’s 17% gain. The Nasdaq has advanced more than 14% this year and is trading near all-time highs.
The quarterly market streak, in particular, is impressive. The S&P 500 has gained more than 5% for five consecutive quarters – only the second time since 1945 that the index has been able to pull off that feat. The last time this happened was in 1954, also a time when the economy was emerging from a period of ultralow interest rates.
It is indeed interest rates that are currently the key focus of investors, with inflation being the lynchpin for Fed decisions over the next several quarters. There is some fear that hot inflation readings are not going to be as fleeting as central bankers expect, but that rising prices could become a bigger problem for the economy. Stocks can be an inflation hedge if inflation does not cause increases in interest rates. The concern is that recent inflation readings could accelerate the Fed’s timeframe on interest rate hikes – currently forecasted by Fed officials to start in 2023.
The Fed still perceives recent inflation as temporary, or “transitory,” due to short-lived, supply-related bottlenecks caused by a surge in demand after the broad, post-COVID economic reopening. Restaurants are filled, hotels and flights are packed, cruise ships are back out at sea and workers are returning to the office. All of these factors are causing a big swell in demand for goods and services, while suppliers are finding it difficult to hire workers fast enough to meet the flood of orders.
There is some evidence to support this transitory inflation argument. The precipitous deceleration or drop in headline COVID recovery inflation signals, such as used car and lumber prices, may be an indication that ‘core’ inflation has already peaked, confirming the adage that “the cure for higher prices is higher prices.” Other items, such as gas prices and many food items, remain stubbornly high. Nonetheless, for inflation to become a problem in the US, it most likely needs to become a problem for the rest of the world as well. Until we start to see inflation pick up in regions such as Europe and Japan, the threat of sustained inflation, the kind that would keep the Fed up at night, hopefully remains a low probability scenario.
Whether or not inflation remains in check longer term remains to be seen. What is important to view now is the “reflation trade” that has taken place during the first half of the year. Think of reflation as “normalization.” It is a quick bout of inflation to bring prices back up to their long-term trend. The rollout of vaccinations and artificial demand created by the trillions of government stimulus has aided this normalization. The reflation trade has a larger impact on economically sensitive value stocks – particularly commodities, industrials and financials.
These shifting macroeconomic conditions have fueled a dramatic reshuffling in market leadership. Small-cap outperformance earlier in the year was powered by expectations that the accelerating US vaccination rollout and easing lockdown measures would usher in a period of robust economic growth, as activity normalized. This outlook fueled a massive rotation into the beneficiaries of a reflating economy (which make up a bigger share of the small-cap index), at the expense of last year’s pandemic outperformers, predominantly large-cap tech stocks.
That calculus has changed more recently with the rally in 10-year Treasuries and unwinding of the reflation trade. Growth-heavy sectors, such as technology and consumer discretionary, have reversed their earlier underperformance since mid-May, while traditional value sectors (most notably, financials) have recently lost favor. The Russell 1000 Value Index fell by about 1.5% in June, trailing its growth counterpart by more than seven percentage points as tech stocks outperformed with bond yields stabilizing.
Overall, however, stocks appear to be the most attractive asset class for investors. The main reason behind the rally in equities is that stocks have little competition, given that bond yields remain lackluster and credit spreads have tightened to their lowest levels in over a decade.
This is coupled with a high degree of pent-up demand now that economies are reopening following last year’s lockdowns. US money-market fund assets have ballooned to a record $5.5 trillion during the pandemic, showing that there is a lot of cash on the sidelines. There is still overwhelming liquidity in the system that is looking for a home.
A recovery in earnings growth is key to continuing the equity rally. Globally, profit expectations have bounced back to pre-pandemic levels, and nearly 50% of S&P 500 companies have raised their full-year outlook over the past three months. Likewise, companies are hiring at an accelerating pace, with the June jobs report handily beating expectations and the unemployment rate trending down to 5.9% from a pandemic high of 14.8% last April. This kind of hiring is almost always a good sign for accelerating revenue and earnings growth.
Given these ever-changing macro factors, we have and will be trimming position sizes to reflect the elevated risk levels of certain positions and allocate capital to areas of opportunity. As investors, it is important not to over-emphasize individual positions but to focus on your investment portfolios as a whole.
If you have not reviewed your financial goals and investment priorities in the past 6-12 months, this is a great time to do so. Please feel free to contact us at your convenience to discuss your specific situation and how the various strategies that we offer can accommodate your needs. As always, we appreciate the trust and confidence you have placed in us, and we appreciate the opportunity to serve your investment needs.
Scott A. Goginsky, CFA®
Partner, Research Analyst
Sources: Index returns & statistics – Bloomberg, Barron’s, Forbes, Seeking Alpha; Inflation – Seeking Alpha; Money-market fund assets – Yahoo Finance; Unemployment rates – CNBC
The information set forth regarding investments was obtained from sources that we believe reliable but we do not guarantee its accuracy or completeness. Neither the information nor opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Past performance does not guarantee future results.