U.S. equity markets put in another good quarter and reached new highs as the S&P 500 returned 15.25% for the first half of 2021. Better than anticipated economic growth, unprecedented levels of liquidity and stimulus and strong corporate earnings proved the right mix for investors. All sectors posted positive returns with Energy stocks the top performer followed by Financials (rising interest rates and solid balance sheets for banks) and Real Estate (supply and demand). Technology companies bounced back and posted impressive gains, even in light of concern over rising interest rates. An uptick in inflation fears spurred a stock market rotation away from growth stocks during the first quarter, as the Russell 1000 Value Index outperformed its Growth counterpart. While the trend quickly reversed in the second quarter, on a year to date basis, Value is still out in front.
In the first quarter of 2021, bond yields rose sharply in response to the same encouraging economic data that drove equity markets higher. With post-pandemic demand increasing and supply chains constrained, speculation of an increase in inflation expectations pushed yields higher. The 10 year Treasury yield rose from 0.93% to as high as 1.74%. Then, yields reversed course and the 10 year Treasury fell to 1.15%. All this despite June inflation readings (Consumer Price Index) coming in at 5.4% (year over year), the highest growth readings in decades, and indications that the Federal Reserve was considering reducing its bond purchases.
Fed Chairman Powell stated there is no “single explanation” for the bond rally, but there are several views as to the reasons behind the backtrack of longer term bond yields. The treasury market is global, where about half the holders of U.S. bonds are foreign entities. Growth outside the U.S. has lagged and yields in most other major countries are significantly lower―so U.S. debt remains relatively attractive. Another theory is that potentially the bond market is signaling we have seen the peak in economic growth. The prospect that current supply and demand inequalities will be temporary and inflation will moderate under the Fed’s supervision coincides with other views the supply/demand imbalances are being felt by only a portion of the economy and is the potential reason for the Fed’s transitory view and yields moving lower.
The rebound in the economy early in the year caught many by surprise as few anticipated the vaccine rollout would happen so quickly. And with all the events that have taken place so far this year, (January 6, Brexit, the Suez blockage, meme stocks, and cryptocurrencies’ erratic trading patterns to name a few) markets have overall remained calm, extending one of the longest “quiet” periods in recent memory. Day-to-day volatility is low. With the exception of a small group of high beta stocks and the recent ‘meme’ stock euphoria, the bulk of equity markets have made advancements at a slow and steady pace.
Inflation has not been an issue in the U.S. for over a decade, but has come to the forefront with economic re-opening. There are numerous predictions and schools of thought on how this will all play out. Over the past several months, (April, May, June and July), the rise in U.S. inflation data may be validating longer term concerns. Supply chain disruptions from COVID-19 continue to weigh on heavy demand for goods. With higher prices for raw materials across multiple industries, producers have warned of price increases being passed on to the consumer. As much as half of all companies expect to raise prices this year. There will be some costs/price increases that will prove to be temporary and some that will not. Though recent data show we may have seen the peak in lumber, copper and semiconductors shortages/prices, the emergence of the Delta variant and the pace of infections is causing renewed concern that growth will slow as some countries enact new restrictions on movement and incur business shutdowns and additional labor shortages. This potentially extends the “transitory” period of pricing pressures.
Great progress has been made, but the pace of getting the nation back to work is taking longer. Factors range from matching skills with openings, continued concern over contracting the virus, child care costs and the additional benefits of unemployment insurance. Current labor shortages are leading to a more concerning issue: wage pressures. Inflationary pressures can be temporary unless wages rise and stay elevated over a longer period of time. According to the National Federation of Independent Businesses (NFIB), 60% of companies are having trouble hiring, so they expect wages to go up. Once gains in wages and compensation take place, it is extremely difficult to take those increases back, unless economic growth takes a drastic downturn. For larger companies which benefit from investing in technology and improvement in productivity, an overall rise in costs from higher wages can be absorbed. However, this is particularly difficult and troublesome for small businesses which cannot pass on these higher costs related to increase labor expenditures.
If inflation remains at elevated levels for a prolonged period of time, what effect might that have for equity markets? Inflation is not all bad. Moderate inflation is generally positive, signaling the economy is expanding and revenues and profits are growing (as they are now). Businesses can raise prices and the economy can withstand higher inflation. The effects obviously vary between sectors and styles and being invested in equities can provide some protection against inflation. The recent rotation out of growth stocks, favoring value stocks resulted, in part, from the rise in interest rates. Growth stocks have so much of their earnings expectations based on the future, when inflation and interest rates rise, it reduces the expected value of their future earnings and they tend to underperform the broad market. Stocks which pay higher dividends, like utilities and REITs, can also suffer when rates move higher as investors tend to favor bonds as a less risky alternative for income. Broad diversification will allow an investor to withstand market shifts.
Looking ahead, with so many factors driving economic growth and markets, one could envision a variety of outcomes. Recently, Federal Reserve officials have made it clear they are not looking to raise the Fed Funds rate anytime soon. But the markets (and committee members) are suggesting that the Fed will begin to taper its bond purchases sooner than originally planned. Since the liquidity the Fed has provided has been a major driver of stock prices, pulling back on some of that liquidity could have a negative effect on markets, but this too should be temporary. Reducing the amount of money injected into the economy and into financial assets has always been a cause for investor concern, but how the markets react will depend heavily on how the Fed communicates and carries out changes to monetary policy.
While economic and business cycles all have commonalities, each is unique in the outcome. Currently, the dollar is steady and the Fed has more inflation-fighting credibility with the markets. Corporate earnings estimates remain positive, which are the source of longer term returns. Bond yields reflect the expected path of the Fed funds rate plus a risk premium that reflects the longer term trajectory of inflationary pressures.
Elizabeth D. Swartz
- S&P 500 Performance YTD – Federal Reserve Economic Data.
- Sector Performance YTD – Morningstar S&P Sector Index.
- CPI – Federal Reserve Economic Data.
- 10 Year Treasury Yield – U.S. Department of the Treasury.
- Averge Hourly Wages – U.S. Bureau of Labor Statistics; Manufacturing sector in dollars.
- Number of Unemployed – U.S. Bureau of Labor Statistics.
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