Life is good for investors as returns from equity markets continue the expansion path of the past two and a half years. Yet, there continue to be concerns around markets being very high versus historical averages. The saving grace comes from extremely low bond and savings yields, so investors continue to invest where the returns have been strong.
As markets hit higher highs, some investors choose to pull money off the table to protect themselves. Yes, sooner or later there will be a 10-15% setback – but these same investors leave 20-30% on the table trying to protect themselves. As we have learned over the past several cycles, although these setbacks are scary, they are temporary and the market moves higher again.
Equities around the globe continued to surge in the second quarter. The U.S. and developed international markets led the way, with the S&P 500 Index gaining 8.5% and developed international stocks rising 5.7%. Emerging-market stocks trailed in terms of progress on the COVID-19 front and in turn rose by a more modest 4.9%.
Within the U.S. stock market, the rotation we experienced in the first quarter from growth to value stocks took a pause, with the Russell 1000 Growth Index gaining 11.9% versus a 5.1% rise for the Value index. Smaller-cap value stocks slightly outperformed their growth counterparts and have been the top-performing segment of the U.S. market this year.
In fixed-income markets, the 10-year Treasury rose as yields dipped below 1.50% in June, ending the quarter at 1.45%, down from 1.75% at the end of March, despite higher inflation readings during the quarter. This contributed to a solid 2.0% return for the core bond index, as the value of bonds moves inverse to the yield. In fact, inflation fears were felt more strongly last quarter, and core bonds remain down 1.6% for the year because of the first quarter selloff. Private Real Estate continues to show impressive results, especially since we are concentrated in Multi-Family and Industrial which has been strong.
As COVID-19 vaccinations and immunity spread across the globe, we continue to expect a strong global economic recovery contributing to healthy corporate earnings growth. This should bode well for riskier but higher-returning asset classes over the near term (next 12 months) at least. Credit markets should benefit as well. While the Federal Reserve is now signaling it is moving closer to beginning to taper its quantitative easing asset purchases, monetary policy and interest rates should remain accommodative for a while.
On the major question that is still unanswered is whether recent data will signal a period of meaningfully higher inflation. We believe it is too early to tell. But our current thinking is that inflation does not get out of control. The core question is whether the recent higher inflation will moderate and eventually settle in at once again low historical levels of 2-3%.
The U.S. economy still appears to have significant slack before aggregate demand would start overwhelming the economy’s productive capacity (the supply side), leading to the economic “overheating” that could cause significant, sustained, and broad-based inflation.
The labor market is a key supply-side indicator. There were nearly 8 million fewer jobs at the end of May compared to February 2020. Meanwhile, more than 9 million people are currently unemployed and potentially available to work immediately. This seems a bit confusing as we see many businesses that are unable to hire employees to run their business. Perhaps when enhanced unemployment benefits stop, people will decide they need to work. But the answer to the labor shortage is multi-dimensional. It may be due to temporary factors related to COVID-19, and a mismatch between the jobs that are available. (and what worker are trained or willing to do.)
Meanwhile, consumer price index (CPI) inflation numbers have been surprisingly high, and longer-term CPI inflation expectations have increased from their pandemic lows. That said, inflation remains well within its 20-year historical range and consistent with the Fed’s long-term 2% core inflation objective. Digging deeper into the numbers reveals that some of the bigger drivers (like spiking used car prices and a sharp rebound in prices for travel and leisure services) are clearly driven by pandemic disruptions. In all, we think it is more likely that most of the recent sharp price increases will prove transitory, as current supply shortages catch up to demand as the pandemic recedes.
The path of fiscal policy in the United States is less certain, given the political dynamics and polarization. The expiration of the pandemic support programs will turn from a fiscal boost to a fiscal drag later this year and in 2022. But this should also lead to increased labor supply, mitigating wage inflation pressures.
With the likelihood of a U.S. recession very low—absent a severe external shock—we see low risk of a near-term bear market. Of course, 10%-plus stock market corrections can always occur and are normal in the investment process. As we move further into the U.S. earnings cycle, the odds of a typical mid-cycle market correction increase. But despite elevated S&P 500 valuations and a likely deceleration in S&P 500 earnings growth, we believe global equities have additional return potential in this cycle.
As always, equity investors should be prepared for a bumpy ride.
While our outlook is positive, the range of possible outcomes is always wide, and these are far from ordinary times. As a result, we do not make aggressive bets on a single outcome even if our analysis suggests it is more likely. We still play defense in case the economy turns negative.
While a sustained period of high inflation could be bad initially for most equities, over time many areas would likely do well, including emerging-market stocks, real estate and value stocks. And in the event of a macro shock and deflationary pressure, we maintain meaningful positions in defensive assets of bonds and real estate, which would help offset declines elsewhere. Put simply, we are diversified, as always.
We thank you for your continued trust in us and invite you to reach out to us with any questions about the markets or your portfolio.
Ron Dickinson, CPA, CFP®, MPA-Tax
P.S. Once again, we appreciate the large number of referrals we have been receiving from our clients. We are honored that you consider us worthy of being introduced to your family, friends, and neighbors.