The Reopening Rally marched on this past quarter. For the fifth consecutive quarter the bull market in stocks continued, yet we began to see some wavering about the glide path of this economic recovery. The impact of inflationary pressures, labor shortages, supply chain disruption, and large government spending packages all influenced the broad indexes this quarter. “Risk assets” like stocks (and housing!) led the way, but bonds also rallied after a very weak first quarter. The S&P 500 stock index gained almost 9% for the period, and the aggregate taxable bond index gained over 1.5%.
Inflation has been a key word during this phase of the recovery process. As many restrictions have been lifted, cash supply is much higher than typical, and consumers are taking action by buying discretionary items like vacations, cruises and cars. We’ve seen massive spikes in very specific items, like lumber prices. Lumber reached an all-time high, up about 300% in the past 12-months before dropping in the end of the quarter. While lumber gets the headlines, similar dynamics have played out across the economy. Copper, used rental cars, airplane tickets, restaurant workers- you name it- demand is exceeding supply and prices are up! A key question now will be whether this situation is “transitory”, as the Federal Reserve projects, or becomes a longer-term phenomenon. There is no clear answer and plenty of arguments can be made on either side, so as of now we must take a wait and see approach here.
The bond market has certainly voted for “transitory.” We saw the 10-Year Treasury yield rise along with inflation expectations to almost 1.8% during the quarter before coming back down closer to 1.5%. The Fed has reacted to higher than expected inflation metrics (the headline inflation reading reached 5.0% during June) by moving forward their consensus rate increase target to late 2022. But investor reaction to that modest “hawkish positioning” has been to buy bonds rather than continue the selloff from the previous quarter. Significant scrutiny will remain on inflation measures, but as of now the Fed seems resolute in not moving rates until at least the latter half of 2022- for better or for worse.
This positioning from the Fed has been an additional boost for stocks, which saw gains across all major indexes for the period. If inflation does remain elevated, one possible way to outpace the resulting reduction in pricing power is through stock returns. Valuations are still quite stretched for many domestic stocks, but with Fed rates remaining at essentially zero the upside for stocks is justifiable. Foreign stocks had a solid quarter, and with the reopening process improving in key markets like the United Kingdom and Germany, the upside in that asset class could remain attractive.
Amidst all this perceived volatility and uncertainty, the actual VIX Volatility indicator (the “fear gauge”) has remained quite placid. After reaching an all-time high mark of over 80 back in late March 2020, the measure has not closed over 20 since mid-May. This measure is an indicator of future expected volatility, so as of now the majority opinion is that the Fed will remain on their current course and the economic recovery will be mostly smooth. Whether this remains the case will be a key factor going forward.
Stocks remain quite expensive by traditional standards, but as earnings increase the hope that stocks can “grow into” those valuations looks more realistic. This is helped largely by consumers, who have saved up a year’s worth of cash and are eager to deploy that with new purchases. This resurgence has helped Value-style stocks’ lead over Growth for the full year to date- but in the second quarter Growth outperformed Value as investors view near-term rate rises to be unlikely and look for stocks that they believe can outpace inflationary pressures.
Looking ahead, attention will remain focused on the re-opening process, the willingness of consumers to “get back to normal” and fulfill their roles as the drivers of economic growth, and whether inflation remains higher than normal or settles to a more sustainable level. Key indicators like hotel occupancy and dinner reservations are already almost back to 2019 levels, and air travel is also picking up- though there are concerns that business travel might lag behind and cause some drag on that recovery. On top of this, we will quite possibly see the passage of a large infrastructure bill, and there are multiple proposals on the table that could have severe impacts on both current tax rates and exemption levels for estate purposes. Amidst all this flux, the Fed will remain watchful of inflation and economic data to determine whether any adjustments to their course are warranted. Certainly never a dull moment in markets or economics these days!
We have identified key data points in recent market commentaries. While these metrics remain difficult to compare to previous data given the impact of the Pandemic lockdowns, here is where they stand:
Valuations. Valuations remain high by historical standards, but we are seeing many earnings beats that can help bring those ratios down. The average valuation is now around 21 times earnings (source: JPMorgan). This remains elevated versus typical levels, but with bond yields remaining so low this can continue to help justify higher than usual stock values.
Economic growth. GDP measures continue to be very high with the influx of so much cash and the recovery in consumer activity. The GDPNow Q2 2021 estimate is right near 8% growth (source: Atlanta Fed), and 2021 full-year forecasts are currently near 6.5%. Note that these stats should be taken in full context with the massive 2020 drops, but are impressive nonetheless.
Interest rates. The Federal Open Markets Committee has shortened their projections for rate increases from 2023 back to late next year. Bond markets took this as a good sign overall, with prices increasing and the 10-year yield actually dropping following that forecast. If inflation does remain elevated, then the likelihood of further accelerations in that schedule could increase.
Currency. The dollar continued the trend of modest softening, though it strengthened near quarter-end to finish the full quarter just barely down. This softening has helped boost the relative returns for non-domestic securities.
Asset Class Review
The first quarter saw positive results from all broad stock indexes, though the gains were not quite as substantial for some indexes as they were in the previous quarter. The S&P 500 index gained almost 9% and saw positive results from each sector except Utilities. Gains were led by the Real Estate sector, with the Technology sector coming in next on a strong rally to finish the period. Growth stocks have benefitted from the lower yields, and the Growth index easily outpaced Value for this quarter (though Value retains a lead year-to-date).
Bonds had a solid quarter following significant weakness to start the year. The High Yield sector also provided very nice upside, even as credit spreads squeezed to near record lows at just over 300 bps. Commodities saw very large gains, as well, with upside for oil (recently hitting a 6-year high in the mid-$70’s/barrel after prices turning negative last year), agricultural/livestock, and many precious metals as demand increased and some supply issues driving various price spikes. Gold continued its very mediocre performance with a modest drop, again going counter to its reputation as an inflation hedge – or perhaps providing a clue toward future inflation.
Foreign stocks provided solid upside for the full period, with investors anticipating reopening in major European markets to accelerate. The Foreign Developed index gained over 5%, and the Emerging Markets index gained almost 4%. These classes continue to trade at much lower valuations than domestic stocks, but will also be impacted by respective reopening statuses, dollar valuations, and their own economic growth prospects. We continue to see nice upside potential in these markets, but as always the need for patience remains when dealing with such a variety of particular economic situations.
And don’t forget about Bitcoin! The coin-mania lost some steam in the quarter. As April began, cryptocurrencies were hitting all-time highs, with Bitcoin prices around $61,000. The subsequent drop of about 50% shows the danger of chasing performance. Cryptocurrencies remain a very speculative asset class, and one in which we are not eager to participate at Cutler.
Past performance is not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. You cannot invest directly in an index. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Source: Morningstar
The S&P 500 Index is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The Barclay’s Aggregate bond Index is a broad base, market capitalization weighted bond market index
representing intermediate term investment grade bonds traded in the United States.
Headline inflation is the raw inflation figure reported through the Consumer Price Index (CPI) that is released monthly by the Bureau of Labor Statistics.
The VIX Volatility indicator is Chicago Board Options Exchange's CBOE Volatility Index, a popular measure of the stock market's expectation of volatility based on S&P 500 index options.
The MSCI EAFE Index (Foreign Developed Index) is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index captures large and mid-cap representation across 27 Emerging Markets (EM) countries. With 1,392 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Each crypto index is made up of a selection of cryptocurrencies, grouped together and weighted by market capitalization (market cap). The market cap of a cryptocurrency is calculated by multiplying the number of units of a specific coin by its current market value against the US dollar.
All opinions and data included in this commentary are as of June 30, 2021 and are subject to change. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information