Equity markets reached new all-time highs in 2Q as the global economy continued to reopen. With widespread global vaccine rollouts investors are now looking past COVID and its impact on markets. To that extent the key concerns now are easing policy support and lingering inflation. To date inflationary concerns have largely been ignored by investors but between rising manufacturing costs and upward wage pressure we think inflation could linger. We suggest investors review portfolio position and rate exposure into year-end, especially given rising stock and bond correlations and the potential for knee-jerk market volatility
Exhibit 1: 10 Year US Treasury vs. Nasdaq
Vaccinations and reopening drive stocks to record highs
- Equity markets brushed off inflationary concerns and reached new all-time highs in 2Q, driven by earnings growth as valuations contracted.
- As widespread global vaccinations continue investors have stopped expecting further COVID-related market weakness.
- Inflationary concerns led to yield spikes mid-quarter, but yields retracted sharply by quarter-end as investor concerns faded.
- Manufacturing bottlenecks, labor market shortages, and upward wage pressure drove input prices higher and are likely to cause consumer price inflation.
- Policy support likely peaked, with the Fed on track to announce asset purchase tapering in 2H.
Economic activity rebounded sharply in the first half of 2021 with the economy growing at its fastest pace in decades. Equity markets reached new all-time highs as corporate earnings (and expectations) surpassed their pre-COVID levels and valuation concerns somewhat subsided. Despite lingering concerns over COVID variants (e.g. Delta) most investors expect global vaccinations to continue, and no longer view COVID as a significant threat to global growth. To date the US has led the developed world in reopening momentum, but we expect the rest of world to catch-up in 2H21 as global vaccine access improves.
Looking ahead economic activity should remain robust and corporate earnings should continue to grow (even as margins face pressure from higher input costs and wages), both of which we expect to help drive markets higher in the back half of the year. Historically when the S&P 500 rose over 10% in the first half of the year, full-year returns finished positive 28 out of 30 times (this is since 1928, the exceptions being 1929 and 1987). And while valuation pressures weighed on markets in 2Q, most have subsided as investors appear to OK with above-average valuations going forward (especially given technology-centric concentration of markets).
As we discussed in our 2021 Midyear Outlook we believe inflation represents the largest potential headwind to investor portfolios today. Manufacturing activity continues to face constraints from supply bottlenecks and backlogs, creating pricing pressure, while tight labor markets are driving up labor costs. To date investors have largely shrugged off inflationary spikes as transitory (the 10 Year Treasury surged over 80bp in 2Q but finished up under 60bp at 1.5%), but the downside risks of persistent inflation on portfolios are significant enough to warrant continued focus. For investors, this means examining portfolios today and preparing for higher rates.
This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy, sell or hold a security or an investment strategy, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor’s objectives and circumstances and in consultation with his or her advisors.
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A word on risk
All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Equity investments are subject to market risk or the risk that stocks will decline in response to such factors as adverse company news or industry developments or a general economic decline. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, and income risk. As interest rates rise, bond prices fall. Non-U.S. investments involve risks such as currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. This report should not be regarded by the recipients as a substitute for the exercise of their own judgment. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.