Broker Check

Second Quarter Investment Notes and Outlook

July 06, 2021

“As sure as the spring will follow the winter, prosperity and economic growth will follow recession.” – Bo Bennett

The severe downturn of 2020 is now largely behind us. Here in New England the general mood is of relief, exuberance, and a return to a sense of normalcy. Summer barbecues, wedding celebrations, family reunions, and international travel are returning, and none too soon. Last sixteen months have been extraordinary and unlike anything that most everyone has experienced in their lifetime. It is safe to say that the global pandemic will have significant and far-reaching consequences for humanity, our personal lives as well as the way we conduct business, but we will not know its true impact for some time.

With 3 billion vaccine doses administered globally(1), major markets in China, Europe, and the US are reopening. We have learned that our modern society can be effective when we put our minds and muscle into solving a well-articulated problem. The Covid 19 vaccine is a superb example of the synergistic benefits of combining modern medical science, easing regulations, and substantial federal assistance in crafting an effective cure in record time. (Note: (1) Sources of all data used in the writing of this article are listed at the end).

In contrast, the vaccine for polio took more than twenty years and for measles more than a decade. The science of mRNA also shows strong promise for solutions to other dangerous diseases, such as cancer. Fortunately, the science behind the vaccine was developed a decade ago and was available when we needed it. The learned benefits should accrue for many years.

But before we get too optimistic about the future, look overseas to the favelas of Brazil and the bustees of Calcutta and witness the devastation still recurrent in crowded, unsanitary cities with limited access to the vaccines. Death rates in these two countries still exceed 1,000 per day on average (if counted correctly) and, while declining from March, peaks remain worryingly high. Many countries are still in lock-down or should be. Not every country has turned the corner on Covid. Eventually, vaccinations will even come to the poorest, but we need to stay vigilant until then.

By contrast, US investor and consumer confidence are buoyed by the mountains of cash supplied by central banks and governments and a general feeling that the worst is behind us. The Conference Board Consumer Confidence Index sentiment for the US was 127.3 in June, its highest level since the beginning of the pandemic.

It is still a little early to say what kind of recovery this will turn out to be. Certainly, we have seen rapid second-quarter GDP growth, coming off a low base from the second quarter of 2020, but who and how this growth will be distributed is still somewhat fuzzy. US GDP growth in the first quarter grew 6.4%, while second-quarter development likely ran more than 10%, although rising price pressures are already weighing on some sectors, namely the housing market. US GDP is expected to grow 6.5% on the year, more than 4% in 2022, a run-rate significantly above the 2-3% range since 2014. Some service and travel-related services will find it hard to reset -- staffing airplanes, hotels, and setting up for the return of the high-margin business traveler (if they return). Other sectors such as real estate, energy, technology appear to be returning to normalcy or never left normalcy.

The S&P 500 (4,297.50) hit a new record high on June 30, as investors focused on prospects of a robust economic recovery. For the quarter, the S&P 500 returned 8.5% for the quarter and 15.3% for the year. Since the end of 2018, the S&P 500 has returned 58.9%. Not bad for two and a half years. US Growth stocks returned 11.9% and 13.0% (Russell 1000 Growth), and US Value stocks (Russell 1000 Value) returned 5.2% and 17.0% for the quarter and year, respectively. Small-cap US stocks (Russell 2000) slowed their torrid pace from the first quarter but still returned 4.3% for the quarter and 17.5% for the year, the best returning primary US asset class.

Overseas markets also grew rapidly with many of the same dynamics as we observe in the US; the MSCI All Country World ex-US index returned 5.5% for the second quarter and is up 9.2% for the year. Developed Markets (MSCI EAFE) returned 5.2% for the quarter and 8.8% for the year, while Emerging Markets (MSCI EM) returned 5.0% and 7.4%, respectively. Asian markets underperformed in the second quarter and year relative to the rest of the world.

The recent impressive returns of the major indexes do not come without future risk, although the earnings multiple for the S&P is now about 22.9 on 2021 estimated earnings and 20.4 on 2022 estimated earnings. If forecast earnings come in as expected, these valuations are elevated but not unreasonable given investor confidence in continued stimulus and economic growth. The spiky volatility in the market has receded -- the VIX ended the quarter at 16, its lowest level since the beginning of the pandemic in February 2020. However, it was as high as 33 in January 2021.

Some of the warning signs in equity markets beyond the somewhat elevated earnings multiple include high inflation expectations and how markets respond to an unwinding monetary policy if the Fed is forced to control inflation. Covid, shipping, and weather-related supply chain bottlenecks have created shortages in semiconductors, steel, plastic, and many household goods. These shortages and shipping delays are causing many companies to hike prices and delay production and add to worries about future earnings.
While no one expects inflation to return to the rates of the early 1980s, even a rise to 3% or more will require Fed action to slow the money supply by raising rates and quantitative tightening. It is interesting to see whether the Fed will maintain its political independence if fiscal policy is expansive while the monetary policy of necessity becomes contractionary. The annual US inflation rate accelerated to 5% in May of 2021 from 4.2% in April and above market forecasts of 4.7%, the highest reading since August 2008. Core personal consumption expenditure rose at their highest rate since 1992. Still, Fed officials reiterated that such price pressures are transitory because of fiscal stimulus, supply constraints, and rising commodity prices. We will see if they are correct.

Despite these hopefully temporary inflation fears, the Fed left its target range for the federal funds rate unchanged at a maximum of 0.25% in June 2021; even as policymakers signaled that they expect two increases by the end of 2023. The yield on the US 10-year Treasury note dropped to 1.45% at the end of June from a high of 1.74% at the end of April, as US Fed officials tried to reassure financial markets that the recent spike in prices is temporary and there will be no immediate tightening of monetary policy.

Nearly every developed economy has lower interest rates than the US with European rates averaging about around 0.1% with rates in Switzerland, Germany, and the Netherlands in negative territory. Japan’s 10 year bonds currently yield 0.4%.

As a result, US Fixed Income returns, as measured by the Bloomberg Barclays US Aggregate Bond Index, are negative for the year at (-1.6%) but up for the quarter at 1.8%. Shorter duration bonds (1-5 Year Gov/Credit) returned (-0.3%) and 0.4%, this year and quarter respectively, while low credit rated bonds (High Yield Corporate Composite) gained 2.8% and 2.4% for the year and quarter. Credit spreads are 0.86% (ICE BofA Corporate Option Spread) the lowest level in more than 13 years.

The average prices of US single-family houses with mortgages guaranteed by Fannie Mae and Freddie Mac advanced 1.4 percent from a month earlier in March 2021, the most since last October and following 1.1 percent growth in February. Year on year, house prices increased 13.9 percent in March, the most significant gain on record. Considering the first quarter, US house prices were up by 3.5 percent compared to the fourth quarter of 2020 and 12.6 percent from the first quarter of 2020.

The US unemployment rate dropped to 5.8 percent in May 2021, the lowest since March 2020 and below market expectations of 5.9 percent. It added to signs that the job market consolidated its recovery as the economy further reopened. Still, the rate remained well above the 3.5 percent recorded in February 2020, just before the virus tore through the economy. A steady decline in the number of daily coronavirus cases due to vaccinations has allowed authorities to lift restrictions on businesses. However, employers have been complaining that they cannot find enough workers to respond to growing demand.

According to estimates from the Office of Management and Budget, gross federal debt in the United States increased to 108% percent of GDP in 2020 from 107% percent in 2019 and is expected to reach 115% by the end of 2021. In the long-term, the debt to GDP ratio is projected to trend around 122% in 2022, the highest level in US history and up from 31% in 1980. With Federal outlays at 31% of GDP, the highest level since World War 2, the high debt and spending levels represent one of the most considerable risks to long-term US economic growth.

Looking forward, we remain optimistic for global equity markets but expect some pull-back from current levels later in the year. Without an exogenous shock, which we cannot anticipate, earnings growth should continue, leading to higher long-term valuations. Fiscal stimulus will also help short-term earnings and consumer finances, particularly spending on infrastructure projects, at the expense of long-term growth due to elevated debt levels. Supply and labor shortages should drop as we go into the fall, which will also help earnings.
Fiscal policy uncertainty remains a significant driver of sentiment, but we expect expansive fiscal and monetary policies to continue for at least the following year. As for fixed income, we are not looking for high returns from these low-interest levels and tight credit spreads. Inflation-protected bonds look relatively attractive compared to other fixed income assets.
We celebrate the founding of the United States and the Declaration of Independence this weekend. The self-evident truths expressed in its Preamble are America’s greatest gift to the modern world. This weekend, we celebrate both our American freedoms and the joyful release from our long pandemic-induced winter. Let freedom shine as our economic growth spreads across the land and to all its citizens.

Data Sources: Bloomberg, History of Vaccines, JHU CSSE Covid-19 Data, Conference Board, Trading Economics, S&P Global, iShares, MSCI, YCharts, FRED.