3^rd QUARTER 2021 MARKET OUTLOOK

Anxiety over COVID-19 diminished dramatically during the 2nd quarter due to widespread vaccination efforts that led to dramatically falling infection rates and deaths. This provided a powerful backdrop for the U.S. economy to continue its strong recovery, fueled by exceptionally low interest rates, government fiscal support programs, increasing employment, and healthy consumer spending.

Not unexpectedly, the equity market responded to this very positive environment by surging during the 2nd quarter, with the S&P 500® up over 8%.  However, value and small cap sectors of the market, which are considered the prime beneficiaries of the economic reopening, began to again lag in performance relative to the large cap growth sector with its heavy orientation to technology.  (The S&P 500 is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)

However, in a very unexpected twist, interest rates reversed the upward trajectory they had been on due to inflation fears, and actually declined by roughly 0.2% for longer term treasury bonds.  This is surprising given the dramatically higher levels of reported inflation statistics and evidence that Federal Reserve (Fed) policy makers may be preparing to move away from extremely low interest rate policy they have followed for some time.

As the second half of 2021 approaches, it is a good time to assess key elements of the economy and to consider whether any changing dynamics warrant changes to investment strategy or tactics.

What has changed, and what has not?

Let’s start with some of the key elements that continue to support the economy and markets:

• The consumer remains flush with cash.  Consumer wealth is also at an all-time high, although unfortunately disproportionally distributed. This healthy consumer spending will continue to drive economic growth; however, some spending may be shifting from big ticket items and non-discretionary items to discretionary and service items. The consumer still drives over two-thirds of the U.S. economy.

• The labor market continues its rapid improvement. Initial claims for unemployment insurance and the overall unemployment rate have fallen dramatically (though still not close to pre-pandemic lows). Meanwhile wages are steadily rising.

• Government spending programs remain a considerable tail wind for the economy.  Recently enacted pandemic response programs are in full swing, and more spending is expected from a possible infrastructure bill.

• Commodity prices, especially oil, lumber, and copper, continued to rise, although this trend started to show some signs of reversing as the quarter came to a close.

• Domestic manufacturing seems to be strengthening, as U.S. companies try to reduce dependence on foreign supply and manufacturing sources. This has contributed to a spurt in capital spending as well.

• Corporate earnings were very robust in the 2nd quarter, continuing a stretch of impressive results. Revenue growth continues to be surprisingly robust, even in the face of the pandemic.
  

Now for some key elements that are changing:

• The Fed finally seems to be acknowledging the need to consider dialing back its unprecedented policy of providing huge amounts of liquidity to the financial system. At the Fed’s most recent policy meeting, the consensus outlook of participants was for short-term interest rates to be adjusted higher no later than the end of 2023. This is the first indication that the Fed may be planning to modestly raise rates. Our expectation is that the Fed will announce plans this year to taper its purchases of securities, starting to reduce the $120 billion in monthly buying early next year. We expect rate hikes to start in 2023.

• The bond market responded to the possibility of the Fed hiking rates earlier by driving bond prices higher (yields lower). Our expectation remains that, over time, rates will rise further, driven by inflation and economic growth.

• In response to this perceived change in the collective thinking of Fed policy makers, the U.S. dollar immediately strengthened relative to other major global currencies. Meanwhile the stunning rally in Bitcoin and other alternative cryptocurrencies came to a screeching halt with Bitcoin falling nearly 40% from its frothy top.

• Although the S&P 500 and other broad stock market indices were strong during the quarter, there was a noteworthy rotation of investor sentiment back to large-cap growth names and away from small-cap and especially value sectors of the market. We expect continued choppiness in value versus growth and large versus small against a backdrop of moderate equity returns.
  

Our view

With interest rates remaining stubbornly at levels that are well below reported or expected inflation, fixed-income returns will continue to be lackluster at best. But exceptionally low interest rates continue to be a bulwark against any significant correction in the equity markets.

We remain moderately overweigh equities. But in such a high valuation market, with inflation signals flashing warning signs, and growth likely peaking, we continue to believe this is not a time to be aggressively positioned in the portfolios.

Some speculative dynamics of the market, such as “meme” stocks and cryptocurrency trading, are abating. Security selection, focusing on quality, durability and solid fundamentals regardless of sector is expected to prevail as the second half of the year unfolds.

Outside the U.S. equity market, the developed markets, particularly Asia and Europe, appear to be in a better position than the emerging markets. Emerging markets may be challenged by rising interest rates, a stronger dollar and declining commodity markets.

See 2nd Quarter Market Review: Stocks climb, inflation heats up as pandemic diminishes

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