Last fall, Chairman Powell of the Federal Reserve (Fed) indicated that the pace of the economic recovery was highly dependent upon the pace of the virus and the acceptance of a vaccine. Since then, several vaccines have been approved and accepted and the virus has waned. Coupled with the massive stimulus provided by Congress, the economy has experienced dramatic growth during the first half of the year. As measured by GDP, the economy expanded by 6.4% in the first quarter and when the growth rate for the second quarter is reported later in July, it will likely be in the double digits. Americans are more confident than they have been since the pandemic began and are increasing their spending – 70% of GDP – as they venture out of their homes demanding more goods and services. As stated by an economist from Oxford Economics, “The great consumer rotation to services has begun.” For the year, the Fed estimates that economic growth will be 7%, the fastest expansion since 1984.
Different from most recoveries, this one has mainly been fueled by government stimulus rather than a robust labor market. Congress has already approved over $5 trillion for Covid-19 relief, and President Biden’s budget has another $2.3 trillion for infrastructure and $1.8 trillion for his American Families Plan. Stimulus funds have created a disconnect between the strength of the labor market and the growth of the economy. Weekly claims for unemployment are currently around 365,000, better than the 900,000 in January, but above the pre-pandemic level of 220,000. Jobs are plentiful but the unemployment rate is 5.8%, well above the 3.5% prior to the pandemic. There is no shortage of jobs to be found. The latest data from the Jolt’s survey shows there are currently 9.3 million job openings, 26% more than prior to the pandemic. Rather, it appears that the employment stimulus money is providing enough support without having to work. As a result, potential employees are not taking jobs, or are waiting for better positions to become available.
The rebounding economy is creating a dilemma for the Fed. On one hand, they are faced with price levels increasing and on the other hand with a slower recovery in the labor market. The goal of the Fed is to manage the economy in a manner that will keep inflation at 2% with full employment – around a 3.5% unemployment rate. Currently, the annual rate of core inflation is 5.8% and the unemployment rate is 5.8%, both outside their acceptable ranges. Thus, the dilemma: to increase interest rates and roll back other stimulus polices to slow the economy and inflation vs. maintaining current monetary policy until full employment is achieved.
The Fed currently views inflation as “transitory,” a consequence of a pandemic produced supply shortage. They believe that prices will fall as businesses reopen and supply expands. Even though they view current inflation as temporary, the Fed did express their concern about inflation at their recent meeting. Laying the groundwork for an earlier change in policy, they shortened their plan to raise the benchmark interest to twice in late 2023 rather than starting in 2024. In his remarks following the June meeting Chairman Powell painted a positive picture about the economy reiterating that he felt the recent inflation spike will be temporary and hiring should accelerate as the virus recedes allowing schools and daycares to reopen and parents to re-enter the labor force. He said, “There is every reason to think that we will be in a labor market with very attractive numbers with low unemployment, high participation and rising wages across the spectrum.” To confirm this, they would like to see a “string” of hiring reports showing about 1 million added jobs each month. In May there were only 586,000 jobs added.
In summary, we are encouraged by the growth of the economy and expect it to continue as the virus wanes and if Congress, as expected, provides more stimulus. Hopefully, the Fed is right about current inflation being temporary. Historically, you need wage pressure to have sustained inflation and as more workers reenter the labor force seeking employment it should keep wages from rising too rapidly adding to inflation pressures. Stay positive.
We asked the question last quarter – Can the market momentum continue? The answer, at least in the second quarter of 2021, is an emphatic yes. As I begin to write this commentary on June 30, I am watching the S&P 500 close in on a fifth straight record close and approach 4,300. You could argue that prices are simply following earnings expectations higher. Analysts started the year expecting earnings in 2021 to grow a solid 23%. After the first quarter reporting season, that number is now 37% and moving higher. With equity markets up nicely in the first half of the year, heading into the second quarter reporting season starting in a few weeks, expectations are now higher and we will ask again can the price and earnings momentum continue in the back half of the year. Time will tell. For now, let’s examine what happened in the past three months.
After going straight up in April, the market saw some bumps along the way in May, with a 3% to 4% pullback mid-month, before resuming higher into the Fed meeting in mid-June and another hiccup. Ultimately, the S&P 500 Index closed the quarter on a positive note, reaching new record highs the last five trading days of June. For the three-month period, the S&P 500 ended up 8.5%, including dividends and now sits 15.2% higher for the YTD period. After charging out of the gates to start the year, small-cap stocks (as measured by the S&P 600) underperformed their larger peers but still rose 4.5% for the quarter and are up 23.6% on the year. International stocks were positive for the period but relatively underperformed with Developed International Markets gaining 5.4% for the quarter (as measured by the EAFE Index). Emerging Markets (EM) fared slightly worse, rising 5.1% for the quarter (using the MSCI Emerging Market Index). For the first six months of the year, Developed and Emerging markets are up 9.2% and 7.4%, respectively. Putting the US and International markets together, the MSCI All-Country World Index (ACWI) rose 7.5% for the quarter and 12.5% for the first six months of 2021.
The sector performance was decidedly cyclical for the first two months of the quarter as Financials and Materials led the way. However, Real Estate and Technology had a strong June to move up the leader board. In the end, ten of eleven S&P 500 sectors were again positive for the three-month period, but just four beat the overall market return for the S&P 500. Real Estate was the leader, up over 13%. Energy, Technology and Communication Services followed up, each rising over 10%. The bottom four sectors were a mix of cyclical and defensive sectors, including Utilities, Consumer Staples, Industrials and Materials. Utilities fell by less than 1% while the other three were higher by 4% to 5% for the quarter. In the middle, Consumer Discretionary, Healthcare and Financials increased between 7% and 8%. For the first half of the year, all eleven sectors were positive, with five outperforming the broader market. Energy was way out in front, up over 45%, but Financials, Real Estate and Communications Services were up nicely between 19% and 26%. Utilities and Consumer Staples occupied the bottom two spots YTD, rising less than 2% and 5%, respectively.
As we look forward to the second half of the year, it would be very easy to conclude that the good times cannot last. And while there is certainly a risk of a 5 to 10% correction at any time, history would suggest that a good first half tends to be followed by a solid second six months. Going back to 1950, there have been sixteen prior years of the S&P 500 first six-month returns greater than 12.5%. The next six months in those years have been positive 75% of the time with an average return of 7.1% and median return of 9.7%. Not bad odds. For those market historians out there, I will highlight one notable exception in 1987, when the market was down 18.7% in the second half. Right now, the fundamental data seems a bit like Goldilocks’ porridge, not too hot and not too cold. However, it could easily move one way or other, causing a disruption in financial markets based on the Federal Reserve’s reaction. Stay tuned.
Yields remain quite a bit higher than the beginning of the year, but changes this quarter depended on the maturity as some moved higher and a few were lower. Most of this rate movement lower occurred near the end of the quarter after the most recent Federal Reserve meeting. Their quarterly release of the Statement of Economic Projections plotted the potential for federal funds rate hikes to occur before the market’s current assumptions. Additionally, a television interview by one Fed member was considered to be particularly “hawkish”. Short-term rates responded by moving higher, but longer rates moved lower as market participants posit that any action by the Fed will hinder the economic progress. The 2-Year Treasury Note ended the quarter at 0.25%, 9 basis points higher on the quarter and 13 more than the beginning of the year resulting in returns of negative 0.08% and -0.11%, respectively, for these periods. The 10-Year Treasury Note fell by 27 basis points to 1.47%, but is higher by 56 on the year equating to returns of 3.23% and -4.10%, respectively.
This flattening of the yield curve (narrowing of the spread difference between the 10-Year and 2-Year yields) from 158 to 122 basis points is still wide relative to the last five years. This has led us to add duration this year to take advantage of higher rates and the yield curve shape. We will continue to focus on incoming economic data and anecdotal reports for insight into the employment backdrop as well as whether the higher inflation we are experiencing is more permanent. These will influence the path of rates going forward.
Corporate bonds kept the outperformance going in the second quarter and produced nice returns with the help of narrow credit spreads and lower underlying yields. The total return of ICE BofA 1-10 Year Corporate Index was 1.76% and -0.34% for the quarter and year, respectively. Similar to Treasuries, longer-dated bonds outperformed shorter ones and those of lower credit quality performed the best as investors continue to reach for yield. High-yield bonds outperformed investment grade bonds by 50 basis points for the quarter and reached the narrowest spread levels since 2007. It is important to note that was when Treasury yields were above 5%, so the combination of current rates and spreads are at extreme lows. We suspect spreads can stay at these low levels for some time given the extraordinary support from the government. We think it is prudent to gravitate towards companies with higher quality balance sheets, but remain overweight to the sector.
Municipal bond performance moderated during the quarter, but remains the best performing fixed income sector for the year aside from corporate bonds rated below investment grade (junk bonds). The Barclays 5-Year Municipal Index had a total return of 0.48% and 0.17% for the quarterly and yearly periods. The ratio of Municipal yields to Treasury yields is 68%. This measure of relative value is nearer historical averages, as Municipal rates have not responded as quickly to the lower move as Treasury rates. Given the near certainty that tax rates will move higher to fund the aforementioned programs, tax-exempt bonds should continue to see strong demand. Additionally, continued improvement of state and local government financials reduces the need for increases in debt issuance. We continue to favor this sector for those in the higher tax brackets.
|QTD 2021 Total Return1||YTD 2021 Total Return2||52 Week Total Return3|
|MSCI Emerging Markets||5.08%||7.43%||41.29%|
|Barclays Int. Gov’t/Credit||0.98%||-0.90%||0.19%|
|Barclays Aggregate Bond||1.83%||-1.60%||-0.33%|
|Barclays 5-Year Municipal||0.48%||0.17%||2.24%|