Quarterly Commentary

2Q 2021

With the stock market rally some fifteen months past the Covid collapse, we assess where things stand and contemplate what lies ahead. Stocks and bonds appear to be in the midst of a growth scare, which shaped the past quarter’s returns.

Q2 review

The market entered April ebullient. Vaccine adoption was accelerating and reopenings were eagerly anticipated. Democrats had just passed a hefty covid relief bill without Republican support and markets were anticipating that the Democrats would quickly enact massive infrastructure and entitlement spending legislation in the same way. Estimates for 2021 economic growth and corporate earnings were rising.

Inflation topped the list of Q2 concerns. What had been a theoretical possibility was becoming real. Raw materials such as lumber and steel were spiking. Labor shortages were appearing and delivery times were lengthening. Were these pressures to be expected given the unusual circumstances and largely one-time in nature? Or was this the start of a worrisome long-term trend?  

Bonds are far more sensitive to inflation than stocks. The ten-year US Treasury is the most-cited bond benchmark. Recall that its yield had jumped from less than 1.0% to 1.75% over the course of the first quarter, validating inflation worries. But as they say - buy the rumor, sell the news. With the core Consumer Price Index rising 2.6% during the April through June period, the largest three-month inflation measurement in many years, the bond market yawned. The yield on the ten-year bond stayed beneath 1.75% and by the end of June was below 1.5%.  Bonds were sending a message - perhaps that inflation is not a long-term concern – or that investors were too optimistic about the pace of reopening and near-term economic growth.

On the fiscal front, the infrastructure spending bill lost steam, though by late June Congress and the President agreed on an infrastructure package worth about $1 trillion (much of which isn't new spending) to upgrade roads, bridges, and broadband networks over the next eight years. The agreement, still not finalized, does not include the social safety-net spending included in April’s $2.3 trillion proposal.

The Fed’s June rate-setting meeting suggested that interest rate increases could come in 2023, a bit sooner than expected. Though subsequent comments from Fed officials were intended to reassure that monetary policy would not tighten too quickly, the “lower for longer” mantra was replaced by the acknowledgement that for the Fed, “eventually” may be less than two years away.

By the end of June, the stock market was in concert with the bond market – both were signaling reduced expectations for economic growth. Value stocks (banks, industrials) typically outperform as economic growth accelerates. Growth stocks (technology, health care) are favored when the economy is stumbling. After value’s remarkable six-month run, growth stocks had the upper hand over the course of the second quarter. 

Looking ahead

The market’s current behavior is probably best described as a growth scare. It’s not that the economy is weakening, it is just that growth will almost certainly decelerate over the balance of the year. The Delta variant is leading to more cases, particularly in unvaccinated areas. While it is reasonable to expect that hospitals in the US and Europe won’t be over-burdened, the primary justification for lockdowns, it is far from certain that restrictions won’t return in one form or another. And it is natural to wonder at what level the economy will find its footing as the prospects for continuing monetary and fiscal stimulus moderate. 

There is another explanation for the somewhat puzzling recent performance of both stocks and bonds – human psychology. As investors navigate immense uncertainty, they are encouraged to prepare for the next big thing and follow the popular narrative. “Inflation is heating up – better buy A, B and C and sell X, Y and Z.” Then they hear, “The stimulus has worn off and the economic growth is slowing – buy X, Y, Z and sell A, B, C.” The concepts by themselves might be reasonable but are less likely to be effective if everyone else is making the adjustments at the same time, creating a “crowded trade.”

An objective observer might wonder what needs to happen next to justify the recently recorded 1.25% yield on ten-year Treasury bonds - nothing good, that's for sure. Once investors are “all in,” any move in a different direction is magnified as the crowd repositions with urgency. Should the future unfold somewhat better than markets are currently implying, the second half may see more surprising swings.

Inflation scares and growth scares – are they warranted, or do they merely provide a rationale for investors who rush to be in the right place at the right time? Our answer is a little of each. We won’t know for sure until well after the fact.

We believe that wage inflation may prove to be persistent while many of the pandemic-sensitive price increases will moderate or reverse in the months ahead. There are many economic tailwinds, including delayed yet still likely fiscal stimulus. We are inclined to think the concerns about growth will pass.

Enjoy your summer!