Market Commentary - Q2 2021
Market Commentary - Q2 2021
The global economy is in a state of rolling recovery as the COVID-19 pandemic eases.
While most central banks remain highly accommodating, investors have begun to ponder the eventual end of unprecedented stimulus.
In the U.S., the Federal Reserve recently began to give signs that a change may be coming, although the implementation remains many quarters out.
Six-month market performance has generally been strong, although the various pockets of market leadership have shifted from the early stages of the recovery.
Stock market performance in the second quarter of 2021 was a continuation of the four previous quarters and helped the S&P 500 achieve the longest stretch of positive quarterly performance since 2017. In the second quarter, large US stocks led the way with International Developed and Emerging Market stocks not far behind. Small US stocks lagged but still lead their large counterparts year-to-date. ‘Growth-style’ stocks have, in part, declining interest rates to thank for second quarter outperformance relative to ‘value-style’ stocks but value stocks still carry the edge year-to-date. Overall, Global Equity Markets are off to a very strong start in the first half of 2021 as the economy recovers from the disruption of the COVID-19 pandemic.
After a historically bad first quarter for bonds due to a sharply rising interest rate environment, bonds bounced back in the second quarter. The rally in bond prices was caused by the decline in interest rates. Although long-term bonds performed the best in the second quarter, they remain sharply negative on the year.
High-yield bonds have had a solid year thus far due to an improving economic environment. Additionally, municipal bonds performed relatively well as a newly democratic regime in Washington bolstered the credit outlook with future stimulus towards states and municipalities, as well as the prospect of increasing individual income tax rates. Because of the tax advantaged nature of municipal bond income, these bonds become more attractive if personal tax rates increase.
Despite the recent reprieve, yields remain very low on an absolute basis and provide for a challenging environment for fixed income investors. Should rates continue to rise, longer-term bond prices will likely continue the path downward. Portfolios skewed towards shorter-duration assets and higher yielding/lower quality bonds should remain somewhat less impacted by interest rate moves.
Global and US Economy
The global economy continues to heal from the devastation of an economic halt last spring. As mentioned above, the recovery has been uneven, with China leading the way, followed by the U.S. and Europe. Below we show the recovery path of GDP over recent quarters.
The Eurozone has been a laggard in the recovery, although it appears to be stabilizing. In the U.S., Labor Markets continue to heal as shown in the graph below. Unemployment rates continue to trend in the right direction, albeit above pre-COVID levels.
Despite the recovery in Labor Markets, the labor force participation rate remains well off pre-pandemic levels at just 61.6% as shown in the graph below. Several dozen states have started to cut off the excess unemployment benefits and according to the Wall Street Journal these states are already seeing an uptick in employment applications. Many small businesses, especially in the service sectors of restaurants and hotels, are suffering with increased demand from an economic re-opening, but not enough workers to fill positions to meet demand.
As the excess unemployment benefits come to an end, a potential boost to workers rejoining the labor forces may occur.
Financial support has buoyed assets around the world and as mentioned, the resulting outcome has been a rolling global recovery. The graph below highlights the economic surprises being seen around the globe. Currently, the biggest positive developments are in nations and regions which have been hardest hit, such as Europe.
Global liquidity has at least in part driven the Pandemic recovery. As Fiscal stimulus fades over time, monetary support will continue to be scrutinized. All eyes remain on Fed Chair Powell for indications of future direction:
“At the Federal Reserve, we are strongly committed to achieving the monetary policy goals that Congress has given us: maximum employment and price stability. Today, the Federal Open Market Committee kept interest rates near zero and maintained our asset purchases. These measures, along with our strong guidance on interest rates and on our balance sheet, will ensure that monetary policy will continue to deliver powerful support to the economy until the recovery is complete.”
- Jay Powell, June 16, 2021 press conference opening statement
At face value, the Federal Reserve (“the Fed”) reiterated that monetary support isn’t going anywhere anytime soon. As usual, the language was parsed, dissected, and ripped apart. The eventual interpretation was not quite as dovish as the initial statement. The so-called “dot plots,” essentially projections which show how each member of the Fed believes interest rates will move in the future, brought the first expected increase in rates from 2024 to 2023. The significance of beginning to talk about the reduction of monetary support is critical as market participants wrestle with price increases (i.e. inflation) and booming demand for many goods and services.
Investment Strategy – Thoughts on the Second Half of 2021
Economic growth, and corporate earnings growth, remain heavily supported by low interest rates as well as Fiscal and Monetary support. As discussed above, with the rolling impact of Covid-19 on different parts of the world at various times, geographies such as Europe appear to be poised for economic benefit if vaccinations can stay ahead of virus variants. We also continue to see value in Emerging Markets and recommend maintaining an overweight positioning. Robust earnings growth continues to aid the valuation picture. As the global economic rebound continues, the speed of earnings growth will likely dictate future market direction. A slowing of the pace of growth may lead to more volatility in the second half of the year compared to the first. Nonetheless, the current macro-economic backdrop appears to be supportive of global markets.
The graphic below provides our take on what has transcribed in the bond market so far in 2021.
As shown in the Fed’s stance from Jay Powell’s press conference on June 16, any unwind process in which the Fed steps away from monetary support is expected to take place over a prolonged length of time. The path will also be dependent on economic data (i.e., inflation data, employment, etc.). Should impediments arise to the economic growth and employment outlook the Fed appears to be on track to remain supportive.
We remain focused on minimizing interest rate risk in shorter-dated fixed income strategies to offset the impact of rising rates. We also think select opportunities remain in higher yielding bonds. As long as the future economic environment looks promising, we believe the credit risk of high yield bonds is manageable.
As we charge into the second half of the year after the worst pandemic in over 100 years, we welcome your questions and feedback. As usual, we thank you for the opportunity to serve your family.