Jul 08, 2021
Most broad equity market benchmarks finished the quarter at or near all-time highs. The strong gains in the quarter reflected a combination of near ideal underlying fundamentals, ranging from company-specific earnings and revenue trends to broad macro support from what have become the usual suspects – low interest rates, a financial system awash in liquidity, and over-the-top federal spending.
The visible resumption of activities has been a stunning reminder of what is possible in a vaccinated world. To think that half of Australia is under lockdown as of this writing is a sobering reminder that COVID-19 and its variants still have the potential to disrupt significantly, even if on a smaller scale.
While stocks had a great quarter, there is also a growing consensus that it probably gets harder for investors from here. In the same way stock prices anticipated a “V” shaped recovery well before that was visible to most, todays’ market prices embed a lot of good news around the reopening and now become more focused on 2022. Strong economic growth should provide a good tailwind, but stocks will also take their cues from how the Fed adjusts its timeline in reducing liquidity and raising interest rates.
Key Investment Issues
- Over the past two quarters, the Fed has gone from “not thinking about thinking about raising interest rates”, to raising inflation targets but still affirming no rate hikes through 2023, to moving up the rate hike timeline due to a stronger recovery and recent inflation data. While the implications of this will temper longer-term growth projections, the markets had begun to be more concerned that the Fed would sit tight. Maintaining the same stimulus that was initiated in the depths of the crisis for another two years to an economy on the cusp of booming now seems unnecessary. After an initial knee-jerk reaction, the markets settled down and have moved to new highs. It seems the Fed has passed its first test in what promises to be a lengthy process of normalizing.
- Q2 was the quarter where the year-over-year comparisons of earnings and revenues for most companies showed the greatest percentage increase. Year-over-year growth rates will also look very good over the next two quarters, but after the Q2 peak, deceleration in growth is a mathematical certainty. Some investors see this reduction in growth rates as a signal that markets have peaked as well. A broader view will assess how future earnings reports come in relative to expectations. This measure has exceeded targets by record levels over the past four quarters. There is reason to be optimistic that this pattern will continue, suggesting that peak optimism around earnings growth is still in front of us.
- For the better part of the past two decades, inflation concerns have been relatively benign. The Fed has targeted 2% inflation since 2012 and has seen its efforts fall woefully short, coming in at an annualized rate of 1.3%. The recent uptick in 1-year CPI to 5% has caused concerns that we may be on the cusp of a new cycle of spiraling prices. The Fed has been vocal in stating that these post-pandemic pressures are transitory, meaning we will have a short-term spike in prices of goods and services, but the imbalance in supply and demand will eventually be addressed. Prices may, in fact, settle in at higher levels, but ongoing price pressures are expected to look more like 2.0% – 2.5% going forward. Markets are basically priced for this outcome. If current inflation trends persist, this would likely chill the inflation in stock prices.
- With limited return opportunities outside of stocks for most investors, stock trading has been more about shifting from one part of the market to another. This helps to explain why the S&P 500 hasn’t had a drawdown in excess of 5% since October, while the spread between winners and losers over that period is much wider than usual. Underneath this calm over the past nine months has been a significant rotation from lower quality, hyper growth stocks to value/cyclical and small-cap stocks, and more recently, to a shift back to large-cap growth stocks. We think the shortening of these style cycles reflects a broader uncertainty around the current economic cycle. This is consistent with our positioning (elaborated below) to have good representation in both growth and value equity strategies.
- Asset mix: Maintain targeted equity weightings. Consider paring back to target where exposure is extended. The limited fixed income return outlook is unchanged – maintain shorter maturities with a bias to corporates over Treasuries. We are more tolerant of above average cash balances on the bond side or using short maturity fixed income ETFs for now.
- Valuation: The surge in earnings growth has helped overall valuation metrics, but stocks remain historically overvalued. Value stocks have closed the gap somewhat relative to growth stocks, while many of the hyper growth stocks have pulled back meaningfully. Higher bond yields would again be a risk to stocks selling at the highest multiples.
- Economy: With a large chunk of the reopening still in front of us and high capital spending supported by strong earnings, the economy should remain strong as we build back to full capacity. Upside in mobility trends, normalizing of supply/demand imbalances, increased productivity, and over 8 million people still out of work underscore the opportunity for increased output.
- Equity Styles: We expect continued back and forth between value and growth driven by the uncertainty of Fed policy, inflation, and fiscal spending. By year-end, value opportunities may shift more defensively (Utilities, Staples and REITs), while growth could serve as a hedge to a less accommodative Fed. In the longer-term, we favor a growth tilt and less cyclicality.
- Stocks: Quantitative data is signaling an opportunity in quality stocks (high and stable cash flow returns) after lengthy underperformance, notwithstanding strong profitability. The latest update to Meritage modeling emphasizes quality relative to value and adds a machine learning component that makes adjustments to incorporate the most effective factors.
It May Be Different This Time
In recent years, it’s been instructive to ask whether the Fed controls the markets or whether the markets control the Fed. Eight years ago, the Fed signaled the end of its easy money policies that followed the Great Financial Crisis. The markets panicked as interest rates gapped higher, and the Fed effectively delayed their policy actions. This became known as the “taper tantrum”. In late 2018, the Fed raised interest rates and reduced liquidity at a time when it looked like the economy was already showing signs of slowing down. Stocks dropped 20% in under three months, forcing the Fed to renounce their plans for future rate hikes, followed by actual rate cuts soon afterward. The Fed reasoned that the health of the economy was tied closely to the health of the markets. This relationship has emboldened investors to embrace risks, knowing the Fed will come to the rescue if a downturn is severe enough.
This confidence might be misplaced in the Fed’s next attempt to taper. In the previous two scenarios, monetary policy was the major tool to prop up the economy. The belief was that the wealth effect of a strong equity market would trickle down into the general economy (even though there is little evidence of this). Still, the Fed’s options were limited because there was no major fiscal policy of spending stimulus coming from Congress at the time to share the load. That is clearly not the case now with the massive spending coming out of the pandemic.
The implications of this is that the Fed may not be as beholden to the markets to assure the health of the economy, as it has been in the past. Said another way, the Fed could be more tolerant of an equity market downturn without succumbing to pressure to bail out investors. All bets would be off if the decline was truly severe or if markets became disorderly, but the safety net investors have been used to might be set a lot lower than they’ve come to expect.
- We commented briefly last quarter about the proposed infrastructure and tax reform plans, deferring to say much until we had a chance to learn more. While additional information and proposals have been offered, the eventual outcome remains uncertain. A recent bipartisan plan coming out of a Senate Sub-Committee committed $579 billion to physical infrastructure needs (roads, bridges, rail, etc.). Rather than finding broad support, this proposal serves as a reminder that there are no layups in getting legislation passed today. The House has now crafted their own proposal. Even the partisan reconciliation process looks like it will be a struggle to secure enough votes to get a more aggressive plan approved. Markets will be monitoring development closely, primarily to discern the role higher taxes will play in paying for the expenditures. It still appears the proposed changes to the tax code are too far-reaching to become law.
- Meme stocks and digital currencies continue to grab the media spotlight, while at the same time, retail investment platform, Robinhood, prepares for its initial public offering. Many of these holdings suffered significant drawdowns in the second quarter, while others continued to defy economic gravity. Beyond the fascination with a handful of individual companies, the broader story of retail investing is evolving. It is too soon to know the full impact this movement will have on markets or investing. Many still think it is one bear market from extinction. That may underestimate the resilience of an investor base that has other ideas. We expect we will be addressing these developments further in the years ahead.
For now, we observe that years with double-digit returns in the first half usually have positive returns in the second half. With the current liquidity conditions, we expect that will again be the case.