2021 Mid-year Market Note
July 8, 2021 | Mark Borda, CPA, CFA
Halfway through 2021, the U.S. economy and stock market have continued its stunning rebound from the pandemic-related lows in 2020. Year-to-date through the end of June, the broader stock market indices have shown resilience and strong performance, with economically sensitive sectors of the market leading the way and traditional value stocks outpacing growth stocks – a rotation that has been nonexistent for years.
The yield on the 10-Year U.S. Treasury Note increased from 0.93% at December 31, 2020 to 1.45% as of June 30, 2021, with increased volatility in between. As a result, the total return, including interest received, for the Barclays US Aggregate Bond Index declined 1.60% during the first half of the year. Although it does not receive the headlines of the equity markets, the fixed income markets has seen extraordinary moves this year.
The broad story remains that the U.S. economy is in the midst of a powerful recovery from a deep recession brought on by the pandemic, and the U.S. stock market continues to follow suit. Over two-thirds of adult Americans have received either the first shot of the Moderna or Pfizer vaccine, or the one-shot Johnson & Johnson vaccine. Also, existing vaccines appear to be effective against the stronger and more contagious variants. Thus, vaccination news continues to be encouraging and there is evidence that the current trajectory of the economic “reopening” will ultimately lead to a return to “normal.” Recently, the broad-based removal of many pandemic-related protocols has produced great optimism for the future which has led to an outburst of activity at restaurants, hotels, malls and entertainment venues across the country.
This optimism is also evident in the numbers. U.S. Gross Domestic Product (GDP) is expected to increase an astounding 6%-10% in 2021. The U.S. labor market is telling a similar story with the economy producing an average net gain of 543 thousand jobs per month during the first half of the year, and the unemployment rate has fallen to 5.9% as of the end of June. Not to disregard, the American consumer is at the same time encountering severe challenges including the large number of Americans still without a job and rising prices on everything from groceries to travel to used cars, all of which could weigh on American households and impair the expansion.
Yet, market observers have shifted focus from the prospects of fully reopening to whether the strength and cadence of the reopening will continue. Specifically,
- Will GDP continue to be strong in 2022
- Will the labor market continue to improve
- Will the consumer continue its spending behavior
- Will something unforeseen undermine the overall expansion’s current trajectory
The stock market bulls are looking for a second half that’s about as good as the first, while the bears are awaiting some catalyst to cause the S&P 500 Index to fall after surging 40.7%, including dividends, in the past twelve-months through June.
The following graph is of the Chicago Fed Adjusted National Financial Conditions Index (ANFCI) which is a weekly composite index based on 100 different financial indicators and has proven to be an accurate leading indicator of financial stress. Positive values of the index indicate financial conditions are tighter than average (e.g., increasing credit risk, tighter credit conditions), whereas negative values indicate favorable financial conditions. As can be seen on the graph, there doesn’t appear to be financial stress in the broader system at the moment and this should be supportive of growth in the near-term given it encourages borrowing and spending by both companies and consumers.
For a sense of the health and trajectory of the manufacturing and service-related components of the economy, we present the following graphs from the Institute for Supply Management which is a not-for-profit professional supply management organization that collects survey-data on business activity across the country. Both graphs represent monthly survey-data (e.g., new orders, deliveries, backlogs, etc.) compiled from purchasing and supply executives across the country with the top-graph reflecting the service-related component of the economy and the bottom-graph reflecting the manufacturing component. Both are diffusion indexes whereby a reading that is greater than 50 indicates that more than half of the respondents are experiencing increases in activity. As the graphs illustrates, both surveys have produced results during the first half of the year that have recaptured the contraction seen during 2020 that was attributable to the pandemic. While both of these surveys have slightly moderated in June, both the services and manufacturing components of the economy are still clearly running at a fast pace; in fact, June marked the 13th straight month of expansion in both indices.
Additionally, we’ve observed a broad-based increase in the Conference Board Leading Economic Index for the U.S. (LEI) which tracks ten key economic factors, such as building permits, consumer expectations for business conditions and average weekly hours worked, among others. The most recent reading in May was a record high for the index and was driven by positive contributions from the majority of its components. This strength provides some confidence that the current momentum of this expansion can continue through the second half of the year.
Lastly, we would be remiss not to evaluate the U.S. consumer considering consumer spending drives over two-thirds of the U.S. economy. The U.S. personal savings rate, which can be seen in the following graph, is calculated as personal savings as a percentage of disposable personal income. In other words, it’s the percentage of one’s income remaining after paying taxes and disbursements. Since its historical high in April 2021, which was attributable to the pandemic-related restrictions as well as the government’s assistance and stimulus programs, the savings rate has decreased slightly but remains elevated at approximately 12%, or virtually double its monthly average during the last 20-years. We expect the American consumer to spend some of its excess savings during the second half of the year as the economy further reopens, which will be essential for the current expansion to continue.
As previously mentioned, the labor market has also demonstrated great improvement during the first half of the year. Notably, the unemployment rate decreased from 6.7% at December 31, 2020 to 5.9% at June 30, 2021. Additionally, there is still plenty of labor market “slack” as the share of the working-age population active in the labor force was effectively unchanged in June 2021 with June 2020, indicating that millions who dropped out of the workforce have yet to return. Also, the number of job openings are expanding at a faster rate than hiring which has forced many employers to increase the wages it both offers to retain existing employees as well as offered to attract new employees.
We think there are multiple factors, including personal savings rates, job growth, wage growth and rising vaccination rates that are giving Americans more confidence to leave their homes and increase their spending levels, particularly spending on services as people increasingly travel more, attend sporting events and visit restaurants and bars.
We admit that while we think the current environment can foster a continued “grind” higher for the U.S. stock market, it certainly won’t do so without overcoming certain increasingly significant risks. For example, a potential byproduct of combining pent-up consumer demand with a strong economy, supportive monetary and fiscal policies and robust corporate profits is elevated inflation rates, and the numbers warrant our full-attention. From May 2020 to May 2021, the Personal Consumption Expenditures Price Index (PCE), which is an index produced by the Bureau of Economic Analysis that measures the prices paid by consumers for goods and services without the volatility of food and energy prices, increased 3.9% which was above expectations (June 2021 PCE reading has not been released as of the date of this writing). This inflation outbreak has come as a surprise to many; however, monetary officials at the Federal Reserve have thus far been dismissive of the concern, describing the upturn in inflation as “transitory” rather than those on the opposite side of the debate who believe we may be in the early stages of hyper-inflation. We agree the U.S. will continue to experience inflation rates above the Federal Reserve’s 2.0% target for a certain period of time primarily due to base effects and demand-pull inflation (i.e., demand outpacing supply). Further, we view “transitory” as more drawn-out as we think it will take longer for the supply chain and other post-pandemic disruptions to resolve themselves. Thus, we expect activity from the Fed over the next several months, particularly in the form of Fed messaging and possibly an announcement this summer laying the ground work for tapering its asset purchase program. Our hope is that the markets don’t decide the Fed is behind the inflation curve.
Market observers will also be paying close attention to the upcoming second quarter earnings season which kicks off in mid-July. The second quarter earnings season will be important to the cadence of the current expansion. The two questions market observers will be looking for are: 1) will the second-quarter show peak growth for corporate earnings (i.e., peak rate-of-change rather than peak absolute growth) and 2) what are corporate executive’s outlook for the second-half of the year.
While we view higher-than-expected inflation as the most significant risk to the current expansion, we’re also monitoring
- The potential for higher corporate and personal tax rates to negatively impact corporate earnings
- A resurgence of the pandemic and variants
- Potential peak economic/earnings/sentiment conditions
Navigating fixed income markets will continue to be challenging as we expect nominal yields to slowly increase and robust economic activity to keeps credit spreads narrow. The yield on the 10-year U.S. Treasury Note rose as high as 1.7% in March although it has recently stabilized around 1.5%. Considering the unprecedented fiscal stimulus in place to boost economic growth and the Fed’s willingness to tolerate higher inflation, we see room for bond yields to move higher during the second half of the year. In addition to higher yields, the prospect for volatility ahead in the stock market is one of the primary reasons we continue to believe bonds play an integral part in a diversified portfolio.
With asset prices and valuations currently appearing stretched, we look to take advantage of situations in which asset prices become dislocated from their intrinsic values. We expect periods of market volatility during the second half of the year based on the key risks previously mentioned as well as the current level of market complacency which we believe to be elevated. The following charts illustrate the CBOE S&P 500 Volatility Index (VIX), which is one of the most recognized measures of volatility that is derived from prices of S&P 500 Index call and put options, and the CBOE Total Put/Call Ratio, which is a ratio of the trading volume of put options to call options. Both measures are used by investors to gauge the overall mood and risk profile of the markets and the higher the measures the greater the level of risk, fear and stress. We think the current low levels in both measures indicate the markets are currently in a delicate state in which investors will temporarily overreact to negative readings or changes in sentiment causing potentially significant market volatility. In such cases, we will evaluate the situation on its own merit and act in accordance with our client’s specific objectives in mind.
The investing landscape continues to be both complex and challenging. We are monitoring markets closely and believe this is the time to exhibit discipline. Therefore, we’re maintaining a balanced approach to asset allocation, remaining diversified and periodically rebalancing. In many situations we’re utilizing dollar-cost averaging when allocating cash positions. Dollar-cost averaging (DCA) is a strategy whereby capital is deployed at set intervals over time to take advantage of market fluctuations, thus focusing on asset accumulation in a systemic way rather than attempting to time the market.
We will continue to keep you apprised of our thoughts through these quarterly letters and welcome your feedback. Please do not hesitate to contact us if you have any questions or comments about anything we have written or otherwise.
*Opinion piece, please read Important Disclosure