Second Quarter Market Commentary – July 2021
July 7, 2021
There was a broad rally across all major equity indices in the second quarter. The S&P 500 was up 8.55%. Large cap stocks outperformed small cap, and growth outperformed value, both reversals from the prior two quarters. International equities were also higher, though they trailed most comparable US indices. Gold was up slightly, while Bitcoin (which some think is a store of value) fell over 40% in the quarter. Most hedge funds had positive returns. Distressed credit funds had another solid quarter.
In the first half of the year, almost all major US indices were up double digits, with the exception of small cap growth (up 8.98%). The S&P 500 was up 15.25%. Value indices returned +17% to +27% in the first half of 2021, while growth indices returned +9% to +13%. Both developed foreign and emerging markets indices were up less than 9%. Gold was down, while Bitcoin was up 21%. Broad based hedge funds had positive returns, while some industry focused funds had negative results.
Treasury, corporate, and municipal bond yields fell as most bonds rallied in the quarter. The flattening of the yield curve reflected the stronger returns of longer-term bonds over short-term bonds. The following are Treasury yields for various maturities, including the trailing inflation index (CPI).
* Inflation is US Consumer Price Inflation Index, All Items, % change from one year earlier, using the most recent data available on the date above. (6/30/21 reflects the May 2021 CPI report.) Source- FactSet
Inflation concerns have returned to the forefront of economic discussions. May’s 4.93% year-over-year inflation number is the highest it has been since the third quarter of 2008 and the fifth highest since May 1991. Sharply higher oil prices defined all these periods. Oil was $66/barrel at the end of May 2021, up 87% year over year, but was still less than half 2008’s high of $145/barrel. The early stages of the pandemic created other price distortions which should normalize as time passes.
Depressed prices in the spring of 2020 do not explain everything. Over the past two years, the CPI (Consumer Price Index) is up 5.2%, or 2.5% per year. There are shortages of countless goods, which mainly stem from three factors: atypical consumer spending strength in a recession (both before vaccines were deployed and even higher spending since); depleted inventories due to reduced orders in 2020; and long lead times required to replenish stock. Businesses were whipsawed. Consumer spending estimates in May were 5% higher than the pre-pandemic peak. The automobile industry is facing a shortage of semiconductor chips. Automakers ordered fewer chips in the spring/summer of 2020, anticipating reduced demand because of COVID, but demand surged as the economy reopened and public transportation was shunned. Automakers first sold down inventory, thinking it was a temporary spike. They eventually ordered more chips, but the one-year lead time has resulted in a shortage of new cars. Used car and truck prices are up 28% from the end of 2019. Shortages have been seen in other areas as well, including lumber, steel, kitchen cabinets, and other goods with long lead times.
There has also been an acute shortage of labor. At the end of May, there were still 9.3 million open jobs in the US, up 2.6 million from the end of 2019. This is driven by many factors: some people fear they could get sick if they go back to work; many do not have appropriate child care options; some may be less motivated to return to work because of enhanced unemployment benefits; accelerated retirement; skills mismatch. The shortage of workers has led to higher wages. The two-year increase in non-supervisory employee per hour wages was the highest since 1983. While it may be difficult to roll those wage increases back, the pace of wage increases is not expected to continue.
Federal Reserve governors are on record saying that significant price increases should be “transitory.” They believe the shortages of consumer goods will end as the world gets back online and price increases ease or reverse. The bond market seems to agree, and/or is signaling lower growth next year. There is little doubt that bottlenecks like the ones affecting the auto industry will clear over time. Wages and prices will continue to rise until workers and supplies are drawn back into the market. As of the end of May, there were still 7.1 million fewer workers in the US economy than at the end of 2019, despite the 9.3 million job openings sited above. If they do return to work, the economy may not get the typical boost from rehired workers given how generous unemployment benefits have been. Amazingly, US GDP is higher now than before the pandemic without those workers. Yet there is still the possibility of a political and/or monetary policy mistake. Federal debt ceiling limits are likely to be tested again this fall. Congress, Treasury and the Federal Reserve have rescued the US economy but are still in uncharted territory. Unintended consequences of well-meaning programs are difficult to predict.
We believe the Fed is correct and inflation is likely to decline. A critical question is how traditional investments (stocks and bonds) will react if inflation were to persist over the next twelve to eighteen months. Both growth and value stocks would likely face headwinds, though high-quality companies with pricing power should outperform. Rising inflation over long periods has historically been negative for bonds, though PSG portfolios are relatively well positioned for such a scenario.
Our research is focused on finding investments which can provide diversification and reasonable risk-adjusted returns in varying economic environments (including higher and lower inflation). We recently identified a non-traditional, income producing investment in the renewable energy space. While this particular investment may not belong in all portfolios due to its limited liquidity and risk profile relative to a traditional equity investment, we continue to search for other opportunities to complement and deepen our best of breed investment strategies.
The Portfolio Strategy Group