Market Review
July 2021
Market Recap
Global stock markets continued to surge in the second quarter. Developed markets led the way, with the S&P 500 Index gaining 8.5% and developed international stocks gaining 5.7% (Vanguard FTSE Developed Markets ETF). Emerging-market (EM) stocks rose 4.9%, held back by mixed news on the COVID-19 front and a tightening in China’s financial conditions (Vanguard FTSE Emerging Markets ETF).
In fixed-income markets, the 10-year Treasury yield dipped below 1.50% in June, ending the quarter at 1.45%, down from 1.75% at the end of March, despite higher inflation readings during the quarter. This contributed to a solid 2.0% return for the core bond index (Vanguard Total Bond Market ETF). However, core bonds are still down 1.6% for the year.
The Macro Backdrop
This is an extraordinarily unusual time, and we really don’t have a template or, you know, any experience of a situation like this. —Federal Reserve chair Jerome Powell, June 16, 2021
The U.S. economy has been very strong this year, but it looks like U.S. GDP growth peaked in the second quarter and will decelerate going into 2022. However, global GDP growth is likely to strengthen in the second half of the year, driven by accelerating growth outside the United States.
The U.S. economy has led the global growth parade so far this year and will continue to grow at a well-above-trend rate. But this strength is now largely discounted in consensus expectations and so probably more susceptible to a negative surprise.
The Fed now expects U.S. real GDP to grow 7.0% this year, up from its 6.5% growth forecast in March. The Fed left its 2022 GDP growth forecast at 3.3%. Most economists and the Fed estimate the U.S. economy’s longer-term potential GDP growth rate, which is a function of labor force growth and productivity growth, is around 2.0%.
We believe the Fed and monetary policy are still likely to remain accommodative for a long time, although increasingly less so at the margin. Before starting to raise the fed funds rate, the Fed will need to wind down its $120 billion per month quantitative easing (QE) asset purchasing program that it started last March. The consensus seems to be for the Fed to start QE “tapering” in early 2022 and end QE by the end of 2022. The Fed is afraid of upsetting the financial markets—it does not want another 2013 “taper tantrum”—and says it will give plenty of notice before beginning tapering. Then, after tapering is complete, it will allow some time before it starts signaling it is preparing to begin to increase the fed funds rate.
Therefore, we think a reasonable base case is that we are still at least a couple of years from Fed rate hikes—an eternity for the financial markets. But we acknowledge a wide band of uncertainty around our base case. And we expect market volatility as markets react to each and every Fed governor utterance.
The other policy pillar—fiscal policy—is also more uncertain as the American Rescue Plan and other emergency pandemic programs lapse later this year, including the $300/week enhanced unemployment benefits that expire nationally in September (and sooner in Republican-controlled states).
The U.S. economy is about to shift from getting a large fiscal boost to facing a meaningful fiscal drag—a negative impact on GDP growth—in the latter half of 2021 into 2022 from the expiration of the pandemic programs.
Our Take on the Inflation Question
This brings us once again to the macroeconomic topic du jour: inflation. More specifically, whether the recent surge in U.S. consumer prices is transitory or a macroeconomic “regime change” to a high-inflation environment.
At its core, our current baseline view on inflation is driven by evidence that the U.S. economy still appears to have significant slack before aggregate demand would start overwhelming the economy’s productive capacity (the supply side), leading to the economic “overheating” that could cause significant, sustained, and broad-based inflation. The labor market is a key supply-side indicator, and the one the Fed is most focused on as part of its dual mandate. More than 9 million people are currently unemployed and potentially available to work immediately.
While there have been recent reports of businesses unable to hire enough workers, this looks to be temporary as enhanced unemployment benefits expire by early September. As long as there is slack in the labor market, wage inflation is unlikely to surge. This means there is low risk of a wage-price spiral that becomes self-reinforcing via “unanchored” inflation expectations, such as the United States experienced in the 1970s.
Meanwhile, longer-term consumer price index (CPI) inflation expectations have increased from their pandemic lows, but also remain well within their 20-year historical range and consistent with the Fed’s long-term 2% core inflation objective.
We agree with this summation from Ned Davis Research: “As supply chain issues and production bottlenecks ease over time and as consumer demand shifts toward more services that were foregone during the pandemic, goods price inflation should moderate, easing the pressure on overall inflation.”
As multi-asset portfolio managers and risk managers, we remain open to a higher inflation scenario outside of our base case. If the Fed continues on its current stated policy path (as we expect) and the global recovery continues, we do expect U.S. inflation over the next five-plus years to exceed the 1.7% average core PCE inflation of the past 20 years. But that is far from saying we expect to see a high-inflation regime (say, on the order of 4% to 5% or higher sustained annual CPI inflation). In any case, we hope to get more clarity on this question over the next few quarters as additional wage, price, and inflation expectations data come in.
Base Case
Along these lines, absolute valuations for U.S. stocks are historically very high and embed a lot of good news/high expectations for continued strong U.S. corporate earnings growth. This raises the potential for a typical “mid-cycle” market correction (a 10%-plus decline) should actual S&P 500 earnings growth fail to meet such lofty expectations. The fiscal drag heading into 2 It is a good reminder that stocks typically deliver lower-than-average returns once earnings growth has reached elevated levels. We are there now.
However, absent a recession—and barring an unexpected external shock, the probability of a recession seems very low over the next 12 months at least—any market correction shouldn’t be too severe or too lengthy, although it certainly won’t feel good as it happens.022 could be a catalyst.
Our reflationary base-case scenario should also be positive for our private credit and non-traditional bonds. Broadly speaking, these strategies have exposure to corporate credit and collateral that benefit from stronger economic conditions. These funds generally are also not too sensitive to rising Treasury bond yields (within reason), as compared to the core bond index’s high duration. We think low- to mid-single-digit total returns are reasonable to expect for our private credit vs. very low single digits for the core bond index.
But we also are cognizant of risk on the other side of our base case: unexpectedly weak economic and earnings growth in the coming quarters. As we’ve noted, a lot of good economic news is baked into U.S. stock market prices and valuations. To provide some insurance against that type of event we maintain positions in defensive, tactical and alternative strategies that provide portfolio ballast.
Closing Thoughts
As we move further into the U.S. earnings cycle, the odds of a typical mid-cycle market correction increase. But despite elevated S&P 500 valuations and a likely deceleration in S&P 500 earnings growth, we believe global equities have additional return potential in this cycle. More specifically, we continue to see superior shorter- to medium-term return prospects in international and EM equity markets, where earnings have more room for positive surprises and valuations are more reasonable. As always, though, equity investors should be prepared for a bumpy ride.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Guardian Financial Partners, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
