For the Quarter Ending June 30, 2021
For the past eighteen months the world has contended day-to-day with the reality that we are living through a major event in history. It will be years, maybe decades, before the full story is clear, but in the midst of it the narrative depends on the perspective. All three of the major stock market indices in the United States marched on to fresh record highs during the quarter producing, on the surface, a kind of fairy tale recovery scenario. And there, working away with the tools at its disposal, has been the Federal Reserve doing its best to play Goldilocks to fulfill its mandate of promoting maximum employment, stable prices, and moderate long-term interest rates. Not easy tasks when faced with the triple bear threats of rising inflation, an economic recovery still reliant on government stimulus, and a global virus intent on unleashing variants.
The S&P 500 closed on June 30th at 4,298, representing a very robust return of 8.55% for the second quarter and 15.25% for the first six months of 2021. The Dow Jones Industrial Average (DJIA) ended June at 34,503 for a comparatively more subdued return of 5.07% in the past three months but a still very healthy 13.78% for the year-to-date. The S&P 500 hit a milestone on the very first day of the quarter, closing above 4,000 for the first time. The index ended the quarter on a high note too, with a record closing high of 4,298 on June 30th. The DJIA also notched an all-time closing high, reaching 34,778 on May 7th, but then lagged the broader, and more tech-heavy, S&P 500 as growth stocks regained back some relative momentum.
Going into the final week of the quarter, sector rotation exerted added pressure on the relative performance of value stocks compared to growth. This still leaves opportunities for acquisitions in the value universe at reasonable and, in some cases, likely oversold levels. We remain skewed towards value retaining its recent strength in the coming months due to what we view as signs of strong fundamentals and relative valuations that are cheap by historical measures. Based on year-to-date returns as of June 24th provided by Raymond James, U.S. Large Cap Value Equities are still the best performing investment style domestically so far, also beating all fixed income categories and almost all international equities, with the exception of Small Cap Emerging Markets.
While the S&P’s 500’s rise over the past eight months has looked relatively steady (the index hasn’t experienced a 5 percent correction
since last October), it’s not a homogenous picture underneath with investors switching between styles and sectors causing notable performance gaps over relatively short periods. Utilities and Consumer Staples have proved laggards so far this year with low single digit gains, while the Energy Sector, both in terms of equities and commodities, and has by far led the pack, with Energy stocks and WTI Crude up around 50 percent the first six months. Financials and Real Estate are the next two best performing, but with gains only around half that level although, on a year-on-year basis, Financials lead, up over 60 percent, with Energy and Industrials the next closest. Once again, however, it’s about the measurement window. Energy is still negative on a 3-year basis, and over 3-, 5- and 10-year periods Information Technology remains the top performer.
Investors seem optimistic about the current domestic economic outlook, and consensus estimates now forecast the U.S. economy to grow 6.6% in 2021, up from 4.0% at the start of the year. This would represent the nation’s fastest growth rate in decades. Consensus S&P 500 EPS estimated for this year and next continue to move higher, with estimates for 2021 up close to 20 percent from a year ago. A cloud tempering this optimism is the concern that emerging coronavirus variants could prolong the pandemic. These variants are currently more prevalent in other areas of the world and the U.S. is vigilantly monitoring.
As America works to regain a firm economic growth footing, The Federal Reserve has come under the spotlight. Extraordinary times warrant extraordinary measures, but it doesn’t mean these measures don’t come with a steep price. The Fed now finds itself backed into a corner faced with the prospect of two unpalatable outcomes. It could continue to expand its balance sheet, exerting sustained downward pressure on interest rates, and risk inflation (or inflation expectations) rising unabated. Or, it could reverse course on its unprecedented loose monetary policy, reigning in very cheap borrowing costs, and face the consequence of riskier assets, such as equities, retreating from record high valuations. In neither scenario does Jerome Powell, nor his team, emerge popular. We also cannot write off an outcome in which inflation continues to run above the Fed’s average 2 percent target but is not accompanied by a level of growth to support rising costs. In other words, stagflation.
By any normal measure the fuel feeding inflation presently is substantial even if responsive rather than entrenched. Since January 2020, the Fed has added $3.9 trillion to its balance sheet, almost doubling it. It now holds almost 25 percent of Treasuries outstanding, close to double the percentage held at the end of 2019. The Federal Open Market Committee (FOMC) must also feel pressure to keep interests rates close to zero so the government can continue efforts to stimulate the economy through unprecedented levels of spending. So far, roughly $3 trillion in fiscal stimulus has been passed by Congress. The current administration has run with the baton passed on, amassing a record amount of public debt, now standing around 130% of GDP (Gross Domestic Product), having stabilized close to 100% for much of the decade before 2020.
Real gross domestic product (GDP) increased at an annual rate of 6.4 percent in the first quarter of 2021. This compares to an increase of 2.4 percent in the fourth quarter of 2019, before Covid-19 started to spread around the world. In dollar terms, it should be noted, GDP growth since the start of 2020 has been dwarfed by the increase in government debt.
Part of this disparity is that an enormous amount of monetary firepower is standing on the sidelines with the velocity of money (the rate at which money is flowing into and around the broader economy) still vastly suppressed from pre-pandemic levels and financial institutions less willing to take on the risk of lending with base rates low now, but expected to rise. Industrial and commercial loans have dipped over 15% from a year ago. Data also indicates that American have accumulated $2 trillion plus in savings during the pandemic, although such accumulation has been far from evenly felt. Supply chain disruptions due to pandemic effects on global production and transportation, exacerbated by worsening U.S.-China relations, are causing supply price rises in certain sectors also, but some of this should resolve. Many businesses in America are also having to raise wages to incentivize workers to fill positions or stay on given some government safety nets still in place to support those out of a job, as well as widespread shifts that have taken place in work and life priorities over the past year.
According to the ADP National Employment Report for the end of June, which reports on nonfarm private employment: “While payrolls are still nearly 7 million short of pre-COVID19 levels, job gains have totaled about 3 million since the beginning of 2021.” Biggest changes are seen in the service sector as businesses reopen or move to full capacity. Job openings are at record levels, and unemployment may well fall below 4 percent in the next 12 months.
So, are we seeing inflation? It depends where you look and who you ask. Policy makers have been apt to sidestep some fairly glaring evidence such as a soaring stock market, real estate and commodity prices and instead point to official measures, which themselves paint a limited picture, or they have taken to emphasizing the term ‘transitory.’ In the three month period to May core consumer prices (which leave out food and energy) rose at a rate of 8.3 percent, annualized. This is the highest rate since Paul Volker, Fed Chair in the 1980’s, was ramping up rates to combat inflation. In fairness, overshooting inflation targets was not of primary concern when leaders worldwide were focused on spending their way out of the threat of economic disaster only months ago. And, while the Fed talk of tapering is now voiced out loud, no interest rate hikes are up for consideration until 2023 at present, although even this is sooner than previously slated, causing a brief spike in long term bond yields and a short-lived dip in the equity markets.
Meanwhile the Federal Reserve announced the opposite of a taper in mid-June saying that it will: “continue to increase its holdings of Treasury securities by at least $80 billion per month and of agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” At the same time it “will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent.” As noted, they appear to be hoping to hit that Goldilocks solution – enabling the federal government to spend as much as needed to maintain economic recovery while keeping a lid on inflation. Maybe the dollar’s privileged status as the world reserve currency, which supports demand for it, will allow them to achieve just that. Time will tell.
On the government spending front, President Biden’s infrastructure bill is moving along but facing challenges based on added commitments sought by more progressive members of his own party. A bipartisan agreement is on the table, which would inject $1.2 trillion into roads, bridges, tunnels and broadband, but vocal Democratic progressives fear that, if they agree to pass it quickly, support will backtrack for a second, larger bill with a wider scope to include health care expansion, universal preschool, community college access and initiatives to combat climate change.
In June, Mr. Biden took his first foreign trip as President. Prior to departure, in an Op-Ed in the Washington Post he stated his broad agenda: “This is a defining question of our time: Can democracies come together to deliver real results for our people in a rapidly changing world?” He started by attending the G-7 summit in England alongside leaders of other major developed countries – Canada, the UK, France, Germany, Italy and Japan. Discussions centered on continuing to combat Covid-19, climate change, talks of a global minimum corporate tax initiative, as well as talks concerning Chinese economic competition.
President Biden then went on to meet with fellow NATO (North Atlantic Treaty Organization) leaders in Brussels, where China was again singled out (as was Russia) by the 30 NATO members on the basis of China’s rising military power as presenting “challenges.” President Joe Biden’s decision to withdraw troops from Afghanistan was largely backed. Then it was on to an historic summit with Russian President Vladimir Putin. Both leaders expressed afterwards that the meeting had constructive elements and emphasized the importance of keeping dialogue open.
Tensions continued to flare in the Middle East including escalated strikes between Israel and Palestine in May until a ceasefire came into effect on May 21st. At the end of June, the U.S. launched targeted overnight airstrikes in Iraq and Syria as Baghdad struggles to stop Iran-backed militias targeting American troops. The decision may, in turn, provoke revenge attacks. Meanwhile, the U.S. and Iran are moving to bring back a version of the 2015 nuclear deal that limited Tehran’s nuclear developments in exchange for lifted sanctions, which could have a marked effect on Iranian exports of oil.
OPEC+ (the Organization of the Petroleum Exporting Countries plus allies, notably Russia) has expressed optimism about the demand improvement following the recession triggered by Covid that cut global oil demand. In April 2020, WTI Crude dipped to below $20 / barrel, and started this year around $50 / barrel. It is now above $70 / barrel, a level not seen since late 2018. Indicators suggest that oil demand, a proxy for economic growth, is lifting nicely and inventories are falling.
The pandemic is not yet fully behind us, but the last fifteen months have shown that the U.S. population has shown itself largely willing to comply with aggressive Covid-19 containment practices when required. Leaders have also not shied away from strong fiscal and monetary measures and the results show that the U.S. economy has outperformed other industrial countries. Investors should feel positive about that while watching for signs of inflation and overheating. Overall, the signs are they remain confident that an expanding economy and rising corporate profits can support further gains.
We continue to look for targeted opportunities that meet our stringent criteria and believe, with current underlying divergent market sector dynamics, they will arise. Robert Buckland, chief global equity strategist at Citigroup, expressed it well recently when he said, “You’ve got lots of volatility within the market but not a lot of volatility of the market.”
We hope that whether your plans are at home, or now involve more travel, that you and your loved ones enjoy the summer! As always, we greatly appreciate you, our valued clients, and thank you for your continued confidence in us as your trusted financial advisor.