- Historic GDP growth, employment gains and corporate earnings all highlight a strong first half for the U.S. economy.
- Tailwinds such as massive inflows into global equity funds and the “Fed Put” remained supportive for equities and risky assets in general.
- Cyclical stock leadership took a turn in June as Info Technology and Large Cap Growth stocks overall outperformed in tandem with a drop in Treasury interest rates.
- Our base case for the second half of 2021 assumes the economic recovery continues and that recent inflationary pressures prove to be more transitory in nature.
What Piqued Our Interest
It’s hard to believe that just six months ago the U.S. was averaging 240,000 new cases of COVID-19 daily and that much of the world was still in lockdown. As of June 30, the seven-day average of new cases leveled off at around 12,000, as roughly two-thirds of the adult population in the U.S. has now had at least one vaccination shot. While the possibility of a resurgence still exists, the probability of a severe outbreak and grand-scale lockdowns diminishes by the day, all of which bodes well not just for our physical and mental well-being, but also for the economic recovery, which has instilled hardships on so many.
Looking back at the first half of 2021, we observed historical improvements and record-breaking performance across the economic spectrum. In tandem with the massive drop in COVID-19-related hospitalizations and fatalities, the U.S. is realizing its fastest pace of economic growth in decades. First quarter GDP in the U.S. climbed at a 6.4% annualized rate, while consensus estimates for second quarter growth are currently at 9.8%, according to FactSet. IHS Markit projected that global GDP will rise by 5.3% in 2021, as total output surpassed its pre-pandemic high this past quarter. The OECD has an even more optimistic 5.8% year-end target, which was a sharp revision from their original projection of 4.2% last December. Consumer spending and fixed investment rebounded in spectacular fashion, while global trade and tourism are likely to be the drivers of growth in the second half this year.
According to the Bureau of Labor Statistics, the U.S. added another 850,000 jobs in June, which significantly surpassed expectations of 706,000, as well as the 583,000 jobs in May, which were also revised higher. The unemployment rate did, however, tick higher—from 5.8% to 5.9%—but did so based on more entrants to the workplace, which can be viewed in a positive light. In total, 15.6 million nonfarm jobs have been recovered of the 25.3 million laid off in March and April of last year. Alongside the impressive gains in total payrolls, average hourly earnings also increased 3.6% year-over-year, which was in line with expectations. Another notable observation, the labor-market differential, defined as the spread between those seeing jobs as plentiful versus hard to get, expanded to +43.5%, which is the widest spread since June 2000.
As Americans are reentering the workplace and customers are returning to stores, S&P 500 corporations have thrived in 2021. After smashing expectations for corporate earnings in the first quarter, analysts increased their EPS estimates for the second quarter by 7.3% during the past three months, which was the largest intra-quarter increase going back to 2002. More often than not, analysts decrease their earnings estimates going into quarter-end by an average of -5%, but as Figure 1 below demonstrates, during the past four quarters, the outlook for the economy has improved and is reflected in higher earnings data. Currently, the estimated EPS growth rate for companies in the S&P 500 is +63.6% year-over-year, which would be the highest increase in corporate earnings since the fourth quarter of 2009.
Figure 1. S&P 500 Change in Quarterly Bottom-Up EPS (3 Months)
Another observation which surprised to the upside was investment fund inflows, particularly for global equities. As the equity market has continued its upward trajectory, more investors are leaving the sidelines and getting in on the action. According to the financial data provider Emerging Portfolio Fund Research (EPFR), about $580 billion flowed into global equity funds during the first half of 2021, the largest on record by a long shot. In fact, if the current pace were to continue for the rest of the year, the total inflows would surpass the total past 20 years combined! The good news is that according to J.P. Morgan, there is still almost $4.3 trillion resting in money market funds (yielding close to 0%) which could continue to flow into equities, providing yet another tailwind for global stocks.
Shifting to the housing market, the S&P Case Shiller national home price index rose 14.6% year-over-year in April, which was the largest reading in over 30 years, following a 13.3% gain in March. The 20-city composite rose 1.6% in April and is up 14.9% over the past year. Tight supply, low interest rates, and a pandemic-driven shift toward suburban homes have all been factors. Higher home prices have a known wealth effect, which tends to spur more discretionary spending. This is further reflected in the June Consumer Confidence survey, which came in at 127.3, well above consensus and at its best level since last February.
While these factors bode positively for the economic recovery, rising inflation expectations remains to be one of the key risks as we head into the second half of the year. A pickup in inflation was expected by many due to low base effects and pent-up demand, but the surge in some material prices, used cars, rents, and energy has some investors concerned. We continue to believe that most of these inflationary concerns will be transitory in nature, but we’re cognizant of these issues and will closely monitor messaging from the Fed and other Central Banks for any change in monetary policy that could affect capital markets.
Equity markets finished out the second quarter on a high note, but the rally wasn’t driven by cyclical sectors like earlier in the year. Large Cap Growth stocks led the surge in June, reversing a trend which had seen Value stocks significantly outperform Growth in 2021. The Russell 1000 Value Index is still higher year-to-date at +17.05% compared to +12.99% for the Growth Index, but that margin shrunk considerably as Technology stocks regained their strength. The Info Tech sector climbed 6.95% in June and is now up 13.76% YTD, slightly ahead of the S&P 500 at 12.3%. Energy was the second-best performer, gaining 4.6% and 45.6% YTD—the top-performing sector so far in 2021 after lagging last year. Consumer Discretionary (+3.8%) and Real Estate (+3.2%) also pumped out good gains, while Materials (-5.3%) and Financials (-2.96%) both took a dive. Small Caps, as represented by the Russell 2000 Index, gained 1.94% in June and continue to lead Large Caps by a subtle margin. International stocks cooled off in June, as the MSCI EAFE Index, which tracks developed countries, fell -1.13%. The Emerging Market Index was close to flat, gaining just 0.17%.
The big story for fixed income has been the rally in Treasuries, which has seen the 10-year yield fall to 1.45% from as high as 1.75% this March. The Bloomberg/Barclays U.S. Aggregate Bond Index gained 0.70% in June, slowly clawing its way back from losses earlier this year and still down -1.6% YTD. While the recent drop in rates has been a boon for the broad index in price terms, the fall has been accompanied by some peak-growth concerns. Our belief, however, is that the reflation trade is not dead, and that the economic recovery should drive growth and inflation and send yields higher. This is supported by a June Reuters poll of fixed income strategists which expect the 10-year yield to rise to 2% by June 2022. Elsewhere in fixed income, credit strategies generally outperformed last month, as they have done most of the year, with the high-yield index gaining 1.34% in June. Municipal bonds were just above flat, as the broad muni index is up a paltry 1.06% in 2021.
Lastly, we saw modest gains for the broad commodity index, which were entirely driven by the Energy sector. WTI crude oil surpassed $74 per barrel, its highest level in three years, and a whopping 374% over its lows reached in March 2020. The crude oil index was up 10.8% in June and is up 51.4% YTD. Natural gas was also higher by 22.2% last month and 43.8% for the year. Other commodity sectors including precious metals and agricultural were both negative last month, -6.96% and -3.8% respectively. Industrial metals also fell by 3.46% but is still up over 20.5% YTD.
Our base case for the second half of 2021 assumes the economic recovery remains strong through the year but begins to taper off by the end of the fourth quarter. Those sectors most negatively affected by the pandemic will likely continue to surge, including Travel and Hospitality, Services, Retail, and Live Entertainment. Inflation may run above average in the short run, but the rate of increase will decrease as supply bottlenecks are resolved and pent-up demand dissipates. Manufacturing businesses are likely to outperform, while many of the current headwinds, including high material prices and labor shortages, should subside as inflationary pressures normalize and extended unemployment benefits expire. In terms of asset allocation, the combination of renewed growth and rising-but-moderate inflation tends to favor equities over fixed income, and credit over duration. Of course, there are scenarios based on outlier events including a resurgence in COVID-19 cases or the surge in inflation becoming more structural and permanent in nature, however, we view these as lower probability outcomes at this time. Should either of these come to fruition, our outlook for risky assets will adjust accordingly to the new realities.
Upon reviewing the minutes of the most recent FOMC meeting in June, we noted few surprises and didn’t alter our outlook for Fed policy. Nothing dramatically changed our views on the potential timing and tapering of the Fed’s Quantitative Easing program, and the next meaningful communication likely won’t come until the Jackson Hole meeting at the end of the summer. While we acknowledge that equity valuations are extended and expect there to be pockets of volatility, the “Fed Put” remains securely in place.
As we enter the second half of the year, it is a good time to review your asset allocation to ensure that the level of risk in your portfolio is in line with your long-term objectives. While we have an optimistic outlook on the economy, we acknowledge that markets do not go up in a straight line, and hidden risks lurk around every corner. Most recently, China’s crackdown on Chinese ADR listings in the U.S. poses the latest risk to a $2 trillion market dominated by popular Technology stocks. While this new oversight is still unfolding, tensions between our two countries increase the likelihood of escalation and increased volatility. Preparation and awareness of these risks is the first step to achieving investment success.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
MBA, CFP®, CFA® Gary began his career in investment strategy and management in 2003. He is highly-skilled in the areas of macroeconomic research, portfolio management and investment analysis. Gary also enjoys delivering market commentary and guidance to clients. He lives in Morris Township, NJ with his wife Andrea and their daughter Avery. In his free time, you will find Gary spending time in the outdoors, running and playing sports. MBA, Seton Hall...Read More