QUARTERLY MARKET UPDATE as of July 2021
The stock market maintained strong upward momentum in the second quarter. Large-cap stocks as measured by the S & P 500 gained over 8.5%. The MSCI international index increased 5.4%, and the Russell 2000 small-cap index was up 4.3%. Similar to the first quarter, there were broad gains with every economic sector moving up. Real Estate, Communication Services, and Technology each increased over 10%. The style migration from growth stocks to value paused in June, with value stocks declining in the last month of the quarter while growth stocks had a strong rebound. This is a reflection of the surprising decline in interest rates.
Despite widespread concerns over inflation, longer term interest rates moved lower in the second quarter. The 10-year treasury yield was off more than ¼ point, starting the quarter at 1.75% and finishing at 1.46%. A combination of a stronger dollar, a more infectious Covid variant, and a supply demand imbalance for bonds kept interest rates down.
In the developed markets around the world the U.S. is expected to have the largest increase in growth this year. Per The Economist, GDP is forecasted to increase 6% in 2021, but already revised down from last quarter’s forecast of 6.5%. The Euro area forecast is now at 4.3%, while Japan is expected to grow at only 2.2%. We expect the difference in growth rates will narrow next year as the rate of vaccinations in other countries accelerates, and the growth in the U.S. moves towards a long-run growth rate closer to 2%. The current disparity in growth rates has helped attract investments in the dollar, pushing the value higher during the quarter. But we expect the dollar will resume its weakening trend over the last year as more economies around the world reopen.
Bond yields in many European countries and Japan are still negative, drawing buyers to our relatively attractive rates. The Fed’s continuing program of buying bonds has also diminished supply. Foreign buyers, pension plans, sovereign wealth funds, and insurance companies, all very willing buyers, have competed to drive rates lower.
The term, transitory, has become a popular description and source of debate for the sustained level of inflation that we may see in the months or years ahead. Certainly, as yields have recently declined the bond market is not indicating that inflation will be a long-term issue. Data this quarter will be closely watched to see if the inflation trend accelerates.
A quarter or two of higher than usual inflation is within expectations with our economy reopening and supply shortages being worked out. Economic distortions have been created over the last year from the sharp decline in economic activity and the surprisingly rapid rebound back towards normalcy. A key component of a more sustainable inflationary environment rather than a temporary / transitory trend would be wage increases. There is already some evidence of wage increases in the hospitality and services sectors, which is surprising this early on in an economic recovery. A temporary labor shortage may be driving this. As schools fully reopen in the fall and unemployment benefits drop off, we may see some alleviation of this shortage. The wage data will be closely watched to gauge the potential long run inflationary implications.
The Fed’s mandate of full employment and stable prices may be particularly challenging in the upcoming months. With further potential wage pressures, the Fed may be forced to taper their bond buying program. Higher interest rates along with the possibility of a tax increase this fall will serve as a brake on the economy. In the past, the Fed had indicated a willingness to incur a short period of higher inflation in order to maximize employment. The unemployment rate in May was at 5.8%, and the Fed is now divided on this approach, raising the fears of an interest rate hike sooner than the market expects. A more hawkish Fed may shift policy, allow interest rates to increase, and derail the recovery.
In the meantime, a low interest rate environment will continue to benefit growth stocks, without regard to valuation. With the potential for interest rates to go up, the risk going forward is higher in that area. Longer term bonds and growth stocks are both trading at very high historical levels. Our theme over the last year has been to tilt equity portfolios towards stocks that would benefit from a more normalized interest rate environment. Dividend paying stocks and stocks that are still in the recovery mode should outperform traditional growth. International stocks have also lagged the U.S. equity market over the last year and for much of the last decade. We will continue to shift our allocation into a higher percentage of international equities which we believe will outperform U.S. stocks as the global economy recovers.