2021 Second Quarter Review of the Markets

Investment Commentary

The S&P 500 returned 8.6% for the quarter. Smaller stocks, as measured by the Russell 2000, returned 4.3%, although they remain ahead of the S&P 500 for the year.

International stocks lagged their U.S. counterparts, but were still up over 5% during the quarter. All in all, the first half of 2021 would have made for a great full year in the equity markets.

The bond market had positive performance for the quarter, though it is still down for the year after a poor first quarter. Falling interest rates, though not back to levels seen at the beginning of the year, contributed to positive performance. Yields on risky bonds fell more than U.S. Treasury bonds during the quarter as the interest rate premium investors demanded to hold riskier bonds declined (we refer to this as “spread tightening”). This also helped returns in the bond market.

A primary factor in the decline in interest rates during the quarter came from decreasing future inflation expectations. Market-based inflation expectations over the next 5 years increased from 2% at the beginning of the year to 2.7% at their peak, before ending the quarter at 2.47%. Short term inflation expectations remain elevated relative to longer term expectations with 10 year market-based inflation expectations ending the quarter at 2.32%. While future inflation expectations have somewhat moderated, oil hit its highest level since 2014 during the quarter.

Economic Outlook

Minutes from June’s Federal Reserve FOMC meeting suggest they are likely to taper asset purchases sooner than originally forecasted. “Tapering” is the process by which the Federal Reserve (“The Fed”) stops fully reinvesting the interest and principal from the bonds they hold on their balance sheet. This represents the first step in shrinking their $8 trillion balance sheet, which grew by over $3T in 2020 as they provided liquidity by purchasing bonds during the recession through the process now commonly known as “Quantitative Easing” or “QE”. While QE was considered an experimental emergency measure when first rolled out during the Global Financial Crisis, the Fed can now look back at the last economic cycle and use the playbook they developed in the subsequent recovery. The Fed will endeavor to be more transparent with expected changes to their balance sheet this time around as initial discussions about tapering in 2013 kicked off the “Taper Tantrum” that roiled bond markets and created substantial losses in safe assets over a relatively short period of time.

Tapering makes a lot of sense given the progress the economy has made from the depths of the recession. However, the Fed’s dual mandate of full employment and price stability poses significant questions about whether or not the Fed will tighten sooner rather than later. With regard to full employment, it is clear that the labor market has not fully healed from the wounds caused by the pandemic. It is possible that some of those are scars and not just wounds. To that end, it’s probably not reasonable to expect that the Fed will remain ultra-accommodative until we reach pre-pandemic unemployment of about 3.5%. However, with job openings at the highest level on record, it is safe to say the labor market is not at full employment. This suggests continued accommodative monetary policy is warranted.

Price stability (read “inflation”) is another matter. Inflation has been in the headlines in 2021 and we continue to receive questions on the topic. Prevailing sentiment early in the quarter was that inflation was back, and would overshoot pre-pandemic levels. First, as mentioned above, this expectation seems to have moderated in markets and in the Fed’s own comments. Second, even though inflation expectations above the Fed’s 2% inflation target might suggest tighter monetary policy is warranted, the Fed has indicated a new policy stance that suggests it is willing to allow an overshoot of inflation before undershooting on employment. This new policy will allow for average inflation targeting in which a period of higher than target inflation will be accepted following a period of lower than target inflation.

One of the key measures we will watch, as employment continues to recover, will be sustained wage inflation. Wage inflation might suggest that higher inflation in goods and services could be shifting to a more permanent and less transitory state. We are already beginning to see some indications that wage inflation pressures may be increasing as there have been increasing numbers of job changers and employers are offering more hiring incentives. It is worth keeping in mind that experts consistently struggle to correctly forecast inflation with any accuracy and market-based
expectations have also consistently been incorrect. We consider inflation to be a major risk which we will continue to closely monitor. However, it is important to separate the causes of temporary inflation that have little influence on long-term inflation (such as chip shortages and supply chain issues that have led to a spike in prices for used vehicles) versus structural inflation (a sustained increase in wages).

More accommodative monetary policy will likely be good for risk assets, although unexpected indications of policy tightening may lead to short term volatility. Tapering could potentially be a negative for the bonds markets as the Fed has been a major source of demand for treasury bonds and less demand could lead to lower prices (higher interest rates). This is why the Fed continues to try to telegraph any policy changes in advance. The taper will be the first step, but eventually the Fed will return to hiking short-term interest rates from the current levels of near zero. According to the Fed’s comments, rate hikes are likely several years away.

Other developments over the course of the quarter that we continue to monitor are the emergence of the delta variant of COVID-19 and the (lack of) progress on an infrastructure package in congress. In the short term, higher COVID-19 case counts globally and less fiscal stimulus are negative for the short-term growth outlook. These issues alone should not derail the recovery.

Investment Strategy

There were no material changes to client asset allocations for the quarter. As yields rose during the first quarter, the relative attractiveness of stocks versus bonds ebbed. The second quarter saw the pendulum swing the other way as the bond market erased half its losses for the year and stock valuations cheapened on the back of strong corporate earnings growth. We will continue to keep an eye on relative valuations to assess opportunities across markets.

Generally speaking, growth stocks outperformed value stocks for the quarter though they do still trail for the year. Much of this could be attributed to falling interest rates. While we do not necessarily anticipate keeping our deep value equity allocations for the full business cycle, we do think this change in relative performance is likely transitory and we will continue to hold the cyclically-oriented value positions for now.

Finally, we maintain a positive outlook for the economic recovery. However, we would like to reiterate to clients that financial assets remain broadly expensive. Continued strength in the economy as well as low interest rates should mean that high valuations can be sustained for a time, but ultimately as our economy grows out of the recovery phase and normalizes, valuations will likely also normalize. Our base case is that this happens over a period of time as opposed to abruptly, but both possibilities do exist. In either case, the takeaway is that valuations normalizing would be a drag on returns. While we have enjoyed strong performance from financial assets over the last 15 months, we do expect that the portion of return that is attributable to valuations increasing (higher multiples on equities, lower interest rates on bonds and tighter spreads on risky bonds) will likely reverse at some point and shift from a positive contributor to performance to a drag on performance everything else held constant. Our long term return assumptions remain low (albeit still positive) by historical standards.

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