Q2 2021 Market Perspective
The summer months are historically associated with reduced levels of market volatility. While the summer ‘slowdown’ appeared earlier this year, the reality is that equity market volatility has been trending down since April of last year as stock prices have moved higher. The VIX index, a popular measure for S&P 500 index volatility, has continued to steadily decline this year and is now back near its 2020 pre-pandemic lows. All eyes remain on the Federal Reserve and the ongoing stimulus that has provided stability to the fixed income markets and has fueled the rally in the equity markets.
The Fed has its next scheduled meeting at the end of July. It is unlikely that they will signal any material change in monetary policy until at least after their annual Jackson Hole Economic Policy Symposium, which takes place the last week in August. As economic data continues to roll in over the next couple of months, investors will maintain a close eye on inflation, unemployment, and GDP growth. While the Fed remains in a wait and see mode, we expect this reduced level of volatility to continue during the final summer months.
These expectations should not result in complacency as it relates to each individual’s investment strategy. In our last communication we discussed the various phases of investor behavior, specifically extreme optimism, where common investment risks are often ignored. When feeling overconfident, the desire to assume greater levels of portfolio risk is understandable, however, emotional decisions can significantly impact long-term results. A few examples of excess risk taking include, making large concentrated bets on individual stocks, investing based on momentum information, and taking on additional credit risk in order to achieve greater yields.
We reiterate the importance of maintaining your long-term investment strategy, which has been created for you to span multiple market cycles in most cases. Even in today’s low-volatility market environment, investors should avoid any temptation to deviate from the blueprint established within a well thought out IPS (investment policy statement).
2021 Second Quarter Market Highlights
· Index returns:
Major Asset Class Returns in Q2 2021
*Source: 2021 Total Return as of 6/30/21, Bloomberg; See Chart A in Appendix
· U.S. equity markets continue to record broad gains in 2021. Driven mostly by optimism over the reopening of the economy and support from accommodative monetary and fiscal policies. Small and Mid-Cap U.S. stocks have led with performance year-to-date, up 23.5% and 17.6% respectively. Large-Cap stocks are up more than 15% for the year.
· International and emerging market stocks also recorded positive gains in the quarter and are up nearly 9% and 7.5% for the year, respectively. International stocks have continued to lag the performance of U.S. stocks, a trend many investors expected to reverse this year. We continue to recommend weightings to international stocks in portfolio construction.
· During the second quarter, the 10-year Treasury Bond yield settled to 1.47% as of June 30th (down from nearly 1.75% at the end of Q1). While most segments of the bond market have bounced back during the 2nd Quarter, many are still in negative territory for the year.
· Other notable headlines during the quarter that we are paying close attention to: Variants of Covid-19 have gained prevalence in the U.S and China has pursued aggressive regulatory actions intended to dampen the impact of higher commodities on growth.
The Inflation Debate
The debate continues as to whether or not rising prices are a temporary phenomenon as a result of the pandemic. Consumers are feeling the impact from the rising costs for goods and services, such as housing, food, and gas, for example. However, investors appear to be most concerned with how the Fed will act to maintain order and combat rising inflation. As it stands today, the Fed has not signaled any change to its accommodative policy, with the consensus now expecting the Fed to slow the rate of asset purchases in the Fall of this year and not raise short-term interest rates until late 2022 or early 2023.
In mid-June, stock prices fell in response to May’s annual inflation rate, which came in at 5% (up from 4.2% in April) and was the highest reading since 2008. The immediate concern was that the greater than expected increase would force the Fed to raise interest rates sooner than expected. Yet, the Fed finished up its two-day policy meeting shortly after this data was released and reiterated that it would not be changing its policy. Furthermore, the Fed released comments that they attribute the rising costs to “transitory factors”, that are expected to abate. Equity prices have continued to push higher following those comments nearly a month ago.
The definition of “transitory” simply means not permanent. Since this is fairly vague, what does the Fed really mean in using this description? Essentially, the idea is that as the economy reopens and pent up demand hits the market, prices soar due to the lack of supply caused by last year’s economic shutdown. A magnified example of this is reflected in the recent volatile price of lumber. Earlier this Spring, prices for lumber hit exorbitantly high levels (up nearly 350% versus pre-pandemic prices) as factory outages resulted in wood shortages. Demand was already high and the lack of product resulted in aggressive buying by homebuilders who feared not having material to complete projects. As producers ramped up wood production and consumer demand weakened (due to the high prices), prices have fallen almost 60% over a short period of time. Circling back to the Fed, the argument would be that lumber prices should continue to retreat to more normalized levels as supply and demand factors return to balance.
We expect this inflation debate to be a material driver of market performance during the second half of the year. Will inflation be “transitory”, and return to more normal levels as individuals return to work and schools reopen, or will higher prices (such as gas and housing rents) be here to stay and be a catalyst for swifter action by the Fed. Potentially more important, will the Fed continue to provide transparency for its plans to hold back inflation. We believe that it will and ultimately this remains a positive for the equity markets.
Takeaways From The Fixed Income Market
The bond markets in general were quiet and have traded within a tight range during the last weeks of the 2nd Quarter, but that relative calm in no way represents what had happened with rates, inflation, and monetary policy during the first half of the year. We began 2021 with investors concerned that the unprecedented fiscal stimulus to revive the economy (from the effects of a Covid induced slowdown) could result in inflationary pressures and rising interest rates. The yield on 10-year Treasury bonds rose from .90% at year end to 1.74% on March 31. The size of this move was historic and resulted in losses across most bond categories during Q1. During the second quarter, the bond markets seemed to ignore higher inflation readings and uncertainty about the Federal Reserve’s timing of changes to monetary policies. 10-year Treasury bond settled back down to 1.47% as of June 30th. While most segments of the bond market have bounced back during the 2nd Quarter, many are still in negative territory for the year.
As we develop our outlook for the rest of 2021, we question why 10-year Treasuries are at these levels and range bound for the last month. The yield on Treasuries as of 6/30/21 seems inconsistent with the consensus of market expectations. The unprecedented fiscal stimulus in response to Covid has enabled the economy to recover the output that was lost during the pandemic. While employment levels still lag (unemployment is currently at 5.9% as of June) and some sectors of the economy have recovered better than others, economist’s estimates call for GDP to expand at 6.5% this year and 4% in 2022.6 One risk to this type of growth is that strong consumer demand relative to supply will lead to higher prices. While some of these price increases could be transitory, there is the risk some of these inflationary pressures do not recede as quickly. In addition, “real” yields which adjust nominal Treasury yields for inflation expectations remain negative. Please note: in a normal, growing economy, yields adjusted for inflation should not be negative. All of these conditions, in addition to the Federal Reserve hinting that they are considering when to taper their bond purchases, would lead a rational investor to think there is room for yields to rise.
The risk to these views is that the re-opening of the economy will be slower than expected and that is exactly what has played out in the first two weeks of July. The recent global surge of a new variant of the Covid virus, along with an opinion that inflation will be tame, has altered market sentiment and sent bond yields lower at a fast pace catching many investors off balance.
As we write this letter in early July, the markets are telling us that inflation fears are muted and fears of slowing growth are here again. Our takeaway is that sentiment can change quickly, and the length of these cycles can be very short during times of extraordinary Federal Reserve policies. As we position our fixed income holdings for the second half of the year, it is more important than ever to understand the risks involved with a fixed income portfolio. The key to our success will be building a diversified portfolio of fixed income securities with different drivers of returns, in line with your stated objectives. For example, in the past year, we have added securities that will perform well during a period of higher inflation and rising rates like Treasury Inflation Protected Securities and floating rate securities. At the same time, we will continue to manage the duration of your portfolio and hold high quality investment grade corporate, municipal, agency and mortgage backed bonds to provide downside protection if the economy should slow down.
The Federal Reserve has committed massive amounts of stimulus to the financial system, while the Federal government has extended its own stimulus programs directly to consumers and businesses aimed at pulling the economy out of the pandemic induced recession. While the economy is growing, we still have a long way to go regarding unemployment and we are now dealing with fears over rising inflation. Yet, the broad equity market indexes in the U.S. are near all-time high levels and volatility has nearly dissipated. It may seem, based on the stock market conditions, that there is no uncertainty in the market, but we all know that uncertainty is a constant risk that exists when investing. We should be prepared, as always, for the return of market volatility.
As the market awaits further direction from the Fed regarding its asset purchases and the direction of short-term interest rates, we reiterate the importance of staying true to your investment strategy. We want to avoid unnecessary risks and manage the portfolio within the parameters established in your IPS. Now is not the time to deviate from the plan, as overconfidence may breed emotional behavior that may be harmful to your long-term strategy.
We can all use a summer slowdown and we hope that you and your families are able to enjoy the next couple of months.
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A: 2021 Total Return of Major Asset Class Indexes
*Source: Bloomberg; 2021 Total Return, MSCI EAFE, MSCI Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes
1 – Source: Bloomberg: Chicago Board Options Exchange Volatility Index (VIX).
2 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
3 - https://tradingeconomics.com/united-states/USinflation
4 – Bloomberg: Lumber Spot Price; Historical prices
5 – Bloomberg: 10-yr US Treasury Historical Prices
6 - https://tradingeconomics.com/united-states/GDP; https://tradingeconomics.com/united-states/USunemployment
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