Much of the uneasiness stems from what the bond market is potentially signaling. Yields have rallied dramatically (moved lower) with the bellwether 10-year bond back down to 1.30%. There are technical factors, primarily a lack of available bonds, driving much of this move. Beyond these factors, the overriding interpretation is that the bond market is starting to buy into the thesis that inflation could prove transitory, which would allow for a slower and less aggressive Fed tapering. This outcome is not all good news however, since growth could fall short if the economy is not as healthy as initially believed or if virus variants further interrupt global reopening.
For the first half of the year, Treasury bond returns were still negative across most of the curve despite the rally to finish the quarter. Investment grade corporate bonds, high yield debt, municipal bonds, and other bond sectors finished the first half with returns ranging from -2% to +4%. The S&P 500 was up 15% (total return) with the Nasdaq trailing slightly at 13%. International stocks (as measured by the MSCI World All Country ex-US Index) were up 8%.
Diversification remains prudent as evidenced by diversified commodities being up 13% for Q2 and 21% for the first half of the year, outperforming stocks and bonds. Losses for gold were more than offset by strength in metals (copper +22% for the first half) and agriculture up 20%.
Market Outlook and Q2 Summary
Overall Asset Allocation
Our baseline recommendation is to be slightly overweight equities, underweight bonds, and modestly overweight cash with some of that cash reallocated into gold and diversified commodities.
We are truly in a transition period. The markets are priced optimistically on the belief that there is a genuine recovery taking hold, despite hiccups along the way. One of the first true tests for the health of “Main Street” will be to see how the expiry of some of the supplemental unemployment benefits impacts consumer spending and the labor market. The bigger test for “Wall Street” will be when the first material tapering of central bank stimulus, liquidity injections and bond buying starts to be priced into asset markets.
In Q2, the S&P 500 was up 8.6% and the Nasdaq was up 9.7%. Growth stocks (as measured by the Russell 3000 Growth Index) were up 11.4% while value was up only 5.2%—a gap that developed primarily in June. Generally, this rotation back to growth helped our portfolios and their quality growth holdings. Information technology and communication services were back among the top performing sectors, along with energy and real estate. These sectors returned 11-13% for the quarter. Industrials and materials were the laggards, though still positive at +4%.
Quarterly earnings season is underway. Earnings estimates have been rising. Two key factors being monitored this quarter are: 1) pricing power (or not) to maintain profit margins during supply shortages and demand shocks, and 2) how labor market dynamics are playing out across industries.
International markets were up 4.8% for Q2, lagging the US. Europe was a relative winner at +6.4% with Asia ex-Japan up 3.7% and Japan down -0.5%. Though the tactical turn in international equities performance is frustratingly difficult to predict, we recommend maintaining global exposure for the long term.
Bond performance for Q2 varied across a range of 0% to 4% for the major sectors, and the longest dated US Treasury bonds were up 7% for the quarter after being up 4% in June. Credit spreads have remained tight and stable. Some of the nervousness in other asset classes has not yet impacted credit markets in any material way.
Most of the fixed income asset classes continue to benefit from a mix of factors, including limited supply, buying/reinvesting by central banks, dedicated buyers like insurance/pension/foreign accounts buying into any weakness, shorter-term buyers worried about global growth and short covering from those tempering their expectations for more aggressive inflation.
Other Asset Classes
Commodities were the top performing major asset class in Q2 with +13% return to complete a first half at +21%. Commodities are volatile and will not go up as relentlessly but remain attractive long-term holds. Items like an infrastructure bill and global reopening should help hard assets while agriculture positions are strategically appropriate considering the climate change issues facing the world.
The arc of market mood has evolved from re-opening and reflation excitement (Q4) to inflation and overheating worries (Q1), and finally to worries of lost momentum and headwinds to growth (Q2). The stock market and US Treasury bonds have been going through this process. The credit markets have not (yet) been nervous and have carried on mostly unaffected. As a PIMCO article put it, we are in a period of “Peak Policy, Peak Inflation, Peak Growth”. Consensus has also been shifting to a belief that we are passing “peak macro” of exceptionally good and rebounding statistics to an era of less exciting and potentially underwhelming numbers as we move forward. This change is not to say that numbers will be poor but rather that maybe optimism got too far ahead of itself. Similarly, year-over-year comparison earnings and growth statistics that were “easy” to beat coming out of the pandemic will get harder to sustain and replicate going forward. Some examples of this changing arithmetic are being seen in the losses in lumber prices and the moderation of rental car prices.
Overall, we remain cautiously optimistic, although near term virus disruptions are possible. We believe positive trends are underway, yet we remain humble about the relatively expensive valuation for many markets and expect volatility in the coming months. As always, the list of concerns is long and varied, including items such as virus variants, cyber attacks, geopolitics, excesses in private equity markets, US debt ceiling negotiations and possible tax hikes. However, company fundamentals are generally healthy, and a resolution of supply chain bottlenecks and a basic return to normalcy once the virus is better controlled around the globe would be positive catalysts.
Client portfolios in our Sustainable & Responsible Investing strategy did not participate in the commodities trade, but we are actively evaluating renewable energy and other related opportunities.
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