Second Half Outlook 2021
The first six months of the 2021 economic landscape has been interesting to say the least. As the post-Covid recovery continues, there are a few notable market risks to be aware of heading into the remainder of the year. Our expert team of financial advisors and financial planners dive into some of these risks, so please continue reading to hear their complete analysis and recommendations going into the second half of 2021.
"The Stock Market is designed to transfer money from the Active to the Patient." Warren Buffett
It’s amazing what a year can do!
Actually, it was about 15 months ago that our economy came grinding to a halt and the markets hit their recent lows. Since that time, we’ve seen continued improvement on most fronts. The combination of massive government stimulus, extremely low interest rates, and improving conditions relating to Covid have all contributed to the robust economic recovery.
As 2020 wrapped up, our outlook for the first half of 2021 was cautiously optimistic. Although valuations were a bit high, the government stimulus, the very accommodative Federal Reserve (“Fed”), and the improving economy gave us optimism that the markets could continue to move forward. The old adage, “Don’t fight the Fed” has proven true once again.
As a result of the pandemic, the U.S. economy and corporate earnings essentially went from a depression-like bust to a wartime-like boom in the span of a year. Companies cut operations to the bone amid the early phase of the pandemic—then, amid record-breaking monetary/fiscal stimulus, the economy quickly found its footing.
The question as we head toward the second half of the year is whether we’re facing a long-lasting boom, a boom-bust scenario, or something in between. At this point, it appears we may land “in between”. On the positive side, we’re poised for strong growth rates for both the economy and corporate earnings. Following the shut-down during the second quarter of 2020 where U.S. gross domestic product (“GDP”) shrank by -31.4% on a quarter-over-quarter annualized rate, GDP rebounded with an eye-popping +33.4% in the third quarter of 2020. This was followed by more moderate, but still strong growth of +4.3% and +6.4% in the fourth quarter of 2020 and the first quarter of 2021, respectively. Growth in the second quarter of 2021 is expected to jump to +9.4% as the economy further reopens.
However, looking ahead to the second half of 2021, we think there are some notable market risks associated with Federal Reserve policy, higher inflation, and equity market valuations.
Federal Reserve Policy & Inflation
The Fed has been trying to establish “hotter” inflation to counteract the negative effects of inflation having run “cold” for so long. The inflation rate, as measured by the Consumer Price Index, was up 4.2% in April, 5% in May and 5.4% in June, all well above the Fed’s 2% target. The question, are these higher inflation rates permanent or transitory? If deemed permanent, then the Fed would likely act more aggressively in tightening monetary policy (i.e. raise interest rates) to counteract increasing prices, which, in turn, would slow economic growth. However, the Fed has repeatedly said that they believe recent higher rates of inflation are “transitory”, and due to the combination of Covid-impacted supply chains (i.e. low supply) and a robust economic recovery as the economy re-opens (i.e. high demand). As both supply chains and economic growth get back to “normal”, the Fed believes inflation will also decline. In addition, this very unique period where global economies were literally shut down and then re-opened may also help explain the increased inflation rates as significant pent-up demand is unleashed.
The Fed’s second mandate is full employment. With unemployment levels still relatively high, the Fed has indicated that they will not raise short-term interest rates until they see the unemployment rate drop back down to pre-pandemic levels, which may be late 2022 or perhaps even 2023.
There are a number of valuation metrics that suggest that the equity markets are fully valued. Price-to-earnings (P/E) ratios, for example, are near the higher end of their historical range. The concern is that when P/E ratios get high, they often revert back to their average over time. One way in which that happens is through a drop in prices, i.e. a correction in the market. However, the other way for P/E ratios to come down is through an increase in earnings. Thankfully, we’re currently seeing the latter. Although the market has been climbing higher through the second quarter, earnings have been growing at a faster pace and bringing down those multiples.
As mentioned, the U.S. economy and corporate earnings went from bust to boom in the span of a year. Trillions of dollars in government stimulus and massive pent-up demand from consumers that were locked in their homes for over a year has resulted in a swift recovery. The most impacted industries such as airlines and hotels, as well as other cyclical sectors have rebounded as the economy has re-opened. Earnings in the first quarter of this year were significantly better than expectations, with growth coming in at +52% year-over-year. The expectation for the second quarter now sits at more than +62%. By the end of the year, analysts are expecting full-year earnings to be more than 20% above the prior peak.
Regarding our equity allocation, we’ve maintained our bias towards U.S. stocks over International as the U.S. leads the rest of the world in the vaccination/re-opening process. However, we have some International exposure as a number of foreign markets have more attractive valuations compared to the U.S. We access the international markets through our Global strategies which allow for flexibility in U.S. vs. International allocations depending on where the fund managers find opportunity.
Although it seems like any oxymoron, one of the more interesting topics of discussion this year has been fixed income investments. Longer-term interest rates, as measured by the 10-Year Treasury, have increased significantly since the beginning of the year, which has had a negative impact on fixed income investments. One school of thought is that the massive amounts of stimulus, increased money supply, supply/demand imbalances, and a robust economic recovery will ultimately lead to higher inflation and higher interest rates. Conversely, some believe the economy only “re-opens” once, supply/demand will get back to normal, inflation is transitory, and interest rates will stay low. Either way, we are witnessing a growing economy and declining unemployment, both of which will contribute to the Fed’s decision to raise interest rates at some point in the future.
To help mitigate the impacts of rising rates, we have several tools available. One is to shorten the duration of our Core Fixed Income investments. Shorter duration bonds have less sensitivity to movements in interest rates, and this move should help reduce volatility if interest rates continue to move higher. Earlier this year, we reduced the duration of a portion of our Core Fixed Income allocation. Additionally, we diversify our fixed income holdings by using less interest rate sensitive investments. We call this category Alternative Fixed Income. It is designed to complement our Core Fixed Income investments by increasing yield and reducing interest rate risk. At this point, we are closely monitoring the Fed’s comments and longer-term interest rates to help us navigate through this challenging fixed income environment.
We will continue to focus on the core tenets of our investment process - long-term risk adjusted returns and constructing durable diversified portfolios. We thank you for the confidence you have placed with us and we look forward to continuing to serve you. As we mentioned last quarter, we look forward to seeing all of you more this year – hopefully face to face!!
Finally, if you have friends or family that could benefit from working with us, we’d love to help and would appreciate the referral.
Your ISG Team