U.S. Markets Continue Upward Momentum
- The S&P 500 gained 8.5% during the second quarter to reach a new all-time high. Markets pushed higher as optimism about vaccination progress, momentum behind businesses reopening and ultra-accommodative monetary policy continued to support market prices.
- The second quarter saw a reversal of first quarter trends. Large growth stocks outperformed small-cap and value stocks despite slightly hawkish guidance from the Federal Reserve and strong inflation data. The small-cap Russell 2000 Value Index climbed 4.6% in the second quarter, compared to 21.2% in the first quarter. Meanwhile, the large-cap Russell 1000 Growth Index returned 11.9% in the second quarter after gaining 0.9% in the first quarter.
- While companies leveraged to an economic recovery continued to perform well, market leadership was more balanced in the second quarter. Other than utilities, all sectors posted gains, led by energy and information technology. Energy stocks within the S&P 500 gained 11.2% in the second quarter, while information technology stocks returned 11.6%.
International Markets Continue to Lag U.S. Market
- Much like the first quarter, equity markets outside the U.S. were broadly positive but underperformed the S&P 500 as a number of countries struggled to keep the virus in check. Developed international equities, as measured by the MSCI EAFE Index, finished the second quarter up 5.4%. Emerging market equities as measured by the MSCI EM Index, ended the second quarter up 5.1%.
Fixed Income Stabilizies in Q2
- Fixed income markets gained 1.8% during the second quarter, as measured by the Bloomberg Barclays U.S. Aggregate Index. The gain was driven by a reversal of rates after a spike in the 10-Year Treasury yield caused bond market jitters in the first quarter. The 10-Year Treasury rate dropped 29 basis points during the second quarter, ending near 1.4%.
- Negative yielding debt remained slightly down from the fourth quarter’s all-time high of $18 trillion, but at around $13 trillion, sits at a historically high level. Fixed income spreads also remain historically tight, while default risks appear to be stabilizing as further stimulus permeates the financial system.
- In June, the Federal Reserve signalled that policy changes may happen sooner than expected, moving the first projected rate hike from 2024 into 2023. Despite leaving its commitment to purchasing $120 billion of bonds on a monthly basis unchanged, the Fed indicated that initial discussions on when to pull back are ongoing.
Commodity Recovery Pushes Ahead
- Broad-based commodities, as measured by the Bloomberg Commodity Total Return Index, returned 13.3% during the second quarter as global economic reopening boosted demand.
- Oil prices moved higher during the second quarter, ending at $75.10 per barrel. Agriculture and industrial metals also performed strongly in the second quarter, up 12.8% and 9.4% respectively, as measured by the Bloomberg Agriculture and Industrial Metals Subindices. Gold recovered slightly from its 9.8% loss in the first quarter, gaining 3.2% in the second quarter.
After more than a year of COVID-19 dominating our lives and the headlines, vaccination rates may now hold the key to moving our collective recovery over the finish line. While the delta variant causes concerns in our individual lives, the markets continue their strong performance and pent-up demand drives both growth and inflation. As we move through the remaining half of the year, the focus will remain on our ability to continue to contain the virus and move steadily towards a global return to something resembling normal while watching for what we expect to be a steadying of temporarily high inflation.
Vaccination Rates and Death Rates Improve While Case Rates Begin to Backslide
As summer in the Northern Hemisphere began and vaccines were readily available in the U.S., the light at the end of the tunnel had become a bit brighter domestically over the second quarter. Even states that had been taking the most cautious approaches to the COVID-19 pandemic, including California and New York, relaxed most of their remaining restrictions for vaccinated people, largely thanks to high vaccination rates seeming to have tamped the spread of the virus. The effectiveness of the vaccines also allowed for case rates to begin to become uncoupled from hospitalization and death rates, as breakthrough cases typically led to much less severe illness that was less likely to require aggressive treatment.
U.S. Vaccination Drive Pushes Forward
While vaccination rates have risen steadily in all regions, international rates have lagged those of the U.S., particularly in the global south. Given that this lag is seemingly largely due to issues with vaccine access, we could see more significant increases as vaccine availability improves.
Share of People Who Have Received at Least One Dose of COVID-19 Vaccine
Expanded global vaccination is critical not just to prevent disease in those who remain unvaccinated but also to limit the rise of potentially more infectious variants that are less susceptible to the current vaccines. The delta variant has already shown us that communities can still be vulnerable to rapid spread, even in areas with relatively high vaccination rates. After lifting the mask mandate in mid-June thanks to positive trends in both case number and severity, many areas in California were recently forced to reinstate it, potentially calling into question how much control we will be able to maintain on the virus going into the fall.1 Continuing severe outbreaks around the globe also present an ongoing supply chain issue as manufacturing disruptions would be likely to have trickle-down effects in other regions that rely on those most heavily impacted by the pandemic for component parts and raw materials.
The open question at this stage is what impact a rise in COVID-19 cases and potential renewed restrictions could have on the rest of 2021.
Growth Across Sectors Spurs Continued Economic Recovery
While the initial economic recovery was uneven, with some sectors performing markedly better than others thanks to the varied impact of the pandemic, we are now seeing a broad-based domestic recovery as sectors that had been lagging begin to catch up.
U.S. Economy Has Bounced Back
Global recovery has been somewhat slower, but manufacturing has still shown demonstrable improvement and is trending towards growth. This growth seems likely to continue as global vaccine availability increases and general pandemic recovery catches up to that seen domestically.
Decreasing Unemployment Meets Increasing Job Openings
Along with this broad recovery in both the manufacturing and service sectors, U.S. unemployment rates continue to decrease. While still elevated relative to pre-pandemic levels, the jobless rate has shown continued improvement. This improvement has been combined with job openings spiking to levels not seen in decades. Some businesses may be somewhat hampered in their recovery and growth due to challenges in hiring, particularly in the service and hospitality sectors. As expanded unemployment benefits expire around the country, it would seem reasonable to expect that some of the open jobs will be filled by people who had otherwise delayed returning to work after COVID-related layoffs. We are also contending with what some have described as “reallocation friction.”2 As workers who had been laid off in the earlier days of the pandemic consider their options for returning to work, many seem to be reassessing what their priorities are and what they want in their professional lives and may be disinclined to return to the type of work they had previously.
Continuing Recovery Means Increased Inflation. For now.
Headlines warning of increasing inflation abounded during the second quarter, and for good reason. At the end of June, the Consumer Price Index (CPI) excluding food and energy stood at 4.5%, a one-month increase of 0.9%.
U.S. Consumer Price Inflation
As we have previously discussed, it is clear that we are currently experiencing inflation, but it appears likely to be on a short- to medium-term basis. A significant driver of inflation thus far has been friction between increased demand and the ability of supply to increase in response. After more than a year of depressed demand for both goods and services, businesses have required some time to ramp up production to full capacity, both due to their own limitations and those of the supply chains on which they rely. The pandemic has led to pent-up demand, in some cases requiring supply not just at pre-pandemic levels but higher. In short, there are only so many factories, so many delivery drivers or so many tables at restaurants.
Home prices have been notably impacted by this spike in demand. Understandably, increasing home supply is particularly difficult given the timeline for new residential construction and the often-limited availability of land. Historically low interest rates have also made purchasing a home that much more appealing to a wider range of individuals, creating something of a perfect storm for inflated prices.
These supply limitations, combined with continued high personal savings rates and now close to 18 months of pandemic-related restrictions, have led to an understandable but temporary conflict. As tensions between supply and demand balance out, and based on long-term historical trends, we would expect that inflation will taper off without requiring extreme intervention.
Historical Performance of CPI Indicates Recent Spikes Likely to be Transitory
Fixed Income Remains Challenging; Equities Continue Strong Performance
As the broad economic recovery continues, fixed income returns remain challenging and may stay that way for the immediate future. Inflows into fixed income have been surprisingly strong as investors continue to rebalance portfolios despite an unattractive return environment for fixed income. While rates spiked briefly in March on inflation fears, they quickly reversed course in the second quarter with markets struggling to predict Federal Reserve policy now that inflation has picked up and the economy seems to have broadly strengthened.
Because inflation seems likely to be a short- to medium-term concern, we are less concerned about a sharp increase in interest rates and will continue to be slightly underweight to fixed income while maintaining the majority of our fixed income positions as part of our long-term investment perspective.
Equity valuations remain high but underlying fundamentals at companies seem to support those valuations and economic and consumer data continues to point to continued growth. Fears remain however that a combination of inflation or failure to contain the current spike in COVID-19 cases could negatively impact equities.
While inflation seems likely to continue in the short- to medium-term, we expect the factors driving inflation to be time limited. As pent-up demand subsides and supply is able to catch up, prices would be expected to stabilize. This moderation, combined with continuing recovery from the economic impact of the COVID-19 pandemic, is likely to signal ongoing growth as concerns surrounding inflation subside. As has been the case for what feels like so long, the state of the pandemic will continue to be one of the most significant factors determining the behavior of the markets for the foreseeable future.
1“Indoor mask mandate issued in 8 Bay Area counties.” ABC 7 News. August 3, 2021.
2“It’s not a ‘labor shortage.’ It’s a great reassessment of work in America.” The Washington Post. May 7. 2021.