The economic recovery from the pandemic continued and equities surged during the first half of 2021. The S&P 500 index was up 15.3% during the first six months, ranking as the second-best performance for a first half of a year since 1998[1]. The pace of the recovery in the U.S. and most of Europe has been faster than the rest of the world thanks to an abundance of vaccine supply. International markets, as defined by the MSCI EAFE index, returned 8.8% during this period.
While the S&P 500 has not corrected by 5% since October, there is great volatility beneath the surface[2]. To this point, this year’s winners have been smaller companies and cyclical stocks, such as banks, industrials and energy companies, that should benefit most from the reopening economy. However, in June, technology and many “pandemic winners” of 2020 outperformed, as it became clear that the virus will continue to mutate and penetrate unvaccinated regions of the world and that the recovery will likely be choppy.
For that reason, interest rates fell, and bonds had a resurgence in the second quarter. While still negative for the year, the widely followed Bloomberg US Aggregate Bond index gained 1.8% during the second quarter. Clearly, many investors were forecasting rising rates due to strong economic growth and possible inflation. However, this became a crowded trade and technical factors are partly to blame for the dip in rates. We still expect rates to rise over time as long as the economy recovers as we expect during the remainder of 2021.
All Eyes on the Fed
The key to the second half of the year for equities very well may be the dynamic that plays out between the strength of the recovery, inflation expectations and the Federal Reserve’s actions in response. Currently, the Fed has pegged the short-term fed funds rate near 0% and is buying approximately $120 billion per month in U.S. treasuries and mortgage bonds for additional stimulus and to keep longer-term interest rates low. This continued ultra “easy” monetary policy response has allowed risk assets to thrive and economic data will likely dictate the Fed’s path in terms of monetary policy.
Specifically, we will monitor the recovery in the labor market and inflation to determine how quickly the Fed shifts gears. June’s labor report showed 850,000 new jobs, surpassing expectations, and wages rose for the third straight month. Employment is projected to return to pre-pandemic levels by sometime in 2022. Regarding inflation, the Fed has communicated their intent to let inflation run hotter than the old 2% core inflation target. May and June inflation data grew over 5% from a year ago, which would normally sound alarm bells. But, the figures are less menacing considering that out of 200+ categories, more than half the increase came in just seven categories: new autos, used autos, vehicle rentals, admissions to events, food away from home, airfare, and lodging. The Fed is fine with elevated inflation as long as it’s “transitory”. The belief is that current inflation that is higher than normal is temporary due to rising demand coming out of the pandemic, low business inventories and tangled supply chains[3].
We expect market volatility to increase as this incredibly forgiving easy monetary policy backdrop comes to an end. The Fed will likely announce their plans to slowly taper their bond buying within the coming months and short-term rates are expected to rise as soon as the back half of 2022.
As for any additional fiscal policy provided by the government, the White House and Congress are still negotiating an infrastructure bill. It is too soon to tell exactly when a bill will be completed, how much money will be spent and any specific market implications. However, the expectation is that this is the last of any spending associated with the pandemic and economic downturn.
Earnings and Stock Valuation
Low interest rates and easy monetary policy have certainly resulted in equity valuations that are higher than normal. The S&P 500 currently trades at nearly 22 times projected earnings of the next 12 months compared to a median of only 16.5 times over the last decade. Current valuation is below the nose-bleed levels of the late 1990’s dot-com era, but infers that company earnings must meet expectations and probably even beat expectations moving forward.
Therefore, earnings growth will be the key. Earnings have continued to beat expectations as the recovery picks up steam. Even though the S&P 500 has increased by nearly 30% since September, valuation is slightly lower than back in September due to earnings growth that continues to surprise to the upside. Stock valuation is currently reasonable, but at some point, 2022 earnings will come into focus and there is still great uncertainty about a future with no stimulus.
Global Asset Allocation Strategy
The strategy continues to overweight equities over bonds given how low bond yields are at this time. In most cases, we are willing to accept the potential for greater volatility in exchange for better long-term returns of equities. Nonetheless, we did reduce equity exposure slightly in May across most accounts, with proceeds landing in short-term bonds and cash. This was the first rebalance away from equities in nearly a year. Once positive vaccine results emerged throughout the latter half of 2020, we became believers in the economic recovery and felt the need to stay more aggressive – especially in light of lower expected returns in bonds.
Equities are diversified across growth and value with exposure of over 30% to small and mid-sized companies, which have the most reasonable valuation. International exposure remains close to 30% overall.
Bonds are mostly high quality and shorter-term. While it is hard to predict interest rates with great certainty, the bond portfolio is positioned for rising interest rates. We tend to believe that robust economic growth will result in higher rates. Nonetheless, we could remain in a lower-for-longer rate environment if inflation does not become an issue and growth is less than expected in 2022 and beyond.
Finally, cash is higher than normal across most accounts given the unusually low bond yields and our desire to keep more “dry powder” due to greater equity exposure. Even though we favor equities, we have the ability to take advantage of any volatility should we see a material dip in equities anytime soon.
Focused Equity Strategy
The S&P 500 continued its march upward in the second quarter, up about 8.5% after rising 6.1% in the first quarter. Growth outperformed value in the second quarter, though value continues to hold the edge for the first half. We maintained the positioning through the quarter, with an overweight towards high quality cyclicals in financials, industrials and energy, while underweight technology. We made no changes during the second quarter, after an active first quarter, preferring to surf the recovery trade a little longer.
We did begin to make changes shortly after the quarter’s close, eliminating some positions in energy in Halliburton (HAL) and Helmerich & Payne (HP), and using the proceeds to add to our position in Barrick Gold (GOLD). Both Halliburton and Helmerich & Payne are energy service companies, providing equipment, consulting and field development services to oil companies. We were hoping to squeeze a little bit more out of those two, but with signs of trouble at OPEC+ we decided to cut and run. Our remaining energy position is small and is concentrated in the highest quality companies with the strongest balance sheets and low cost production.
Barrick Gold is a high quality gold mining company based in Canada, but with a large prolific mine in Nevada and other profitable mines in Canada and Africa. We use a net asset value (NAV) approach to valuing miners, which adds up the value of their resources under the ground using various commodity price assumptions and subtracting debt. While the value of Barrick is contingent on the price of gold, we believe it is trading at a significant discount to its NAV. Gold prices are difficult to predict, but since 1982 the metal price has exhibited modest volatility of +/-10%, except in times of extreme market dislocation, with multi-year average annual price trends drifting between -1% to +6%. Gold is best known as a hedge against inflation, though it is also usually a partially effective hedge against deflation and recession. It does not do well in a “goldilocks” economy with healthy growth, a strong dollar, and modest inflation.
Our focus continues to be on holding high quality companies with healthy growth prospects trading at a discount to their intrinsic value. It is a “buy-and-hold” strategy, with holding periods of three to five years or more as we wait for the companies to realize their value rather than jumping on fashionable trends. We do sell when a company has reached or exceeded any reasonable assessment of its intrinsic value or when the business prospects change permanently and the valuation is impaired. We also try to keep a close watch on portfolio risk, and will sometimes shift exposures to alter the portfolio’s risk profile.
Expect Volatility Ahead
Markets have remained unusually calm due to favorable monetary and fiscal policies combined with accelerating company earnings during the early phases of the recovery. However, we are transitioning from the early dynamic growth stage of the economic recovery to a stage that can be associated with greater volatility. Earnings must continue to meet (or beat) expectations. Inflation can run hot, but not too hot. And, the Fed must successfully communicate intentions of reducing stimulus programs and raising interest rates in upcoming quarters.
It is important to remember that equity markets generally correct by at least 10% during most calendar years. We anticipate more chop as this economic recovery matures, which is to be expected.
As always, please call with any questions! We’d be happy to discuss our investment thoughts and economic outlook in greater detail at any time!
Alliance Private Wealth
[1] Halfway Through 2021, the Hot Stocks are Old-Fashioned. New York Times. July 2, 2021.
[2] The Stock Market hasn’t been this Placid in Years. Wall Street Journal. July 27, 2021.
[3] The Most Important Number of the Week is 1.30%. Bloomberg. July 17, 2021.
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