The second quarter was characterized by encouraging economic data and solid corporate earnings amid the broadening of the nation’s reopening juxtaposed with growing inflation fears and a simmering anxiety over potential changes in Fed monetary policy.
Building on the first quarter’s gains, Q2 started strong with stretches of sideways trading and incremental increases that led to multiple record highs over the course of the three months. But many investors were troubled by an acceleration in the rate of inflation. Stocks tumbled following a Fed announcement that interest rate hikes could begin in 2023 – sooner than anticipated – and that it had raised its inflation expectation. However, the Fed remained steadfast in its position that above-target inflation would be transitory, making some investors particularly anxious for the future ramifications of this assessment.
The quarter closed out on a strong note, nevertheless, as investors welcomed the announcement of an apparent agreement on a $1 trillion infrastructure spending bill and reports that banks had passed Fed stress tests. The news was enough to send stocks to new all-time highs in the final trading days of June.
U.S. – Improving Employment
GDP: The U.S. economy continued its remarkable recovery in the second quarter, aided by a substantial pick-up in the pace of COVID-19 vaccinations nationwide, an increase in economic reopening at state and local levels, and by government stimulus spending.
According to the Federal Reserve Bank of Atlanta, which tracks economic data in real time, their model is pointing toward a 8.3% real rate of GDP growth in the second quarter.2 July’s release of the Q2 GDP will reveal if the first quarter’s gains truly continued through June.
UNEMPLOYMENT: The labor market recovery, which has lagged behind other parts of the economy such as consumer spending and manufacturing, saw meaningful improvement in the second quarter. The weekly initial jobless claims fell below400,000 for the first time since the pandemic began, while job openings reached 9.3 million – the highest number ever recorded by the Department of Labor’s Job Openings and Labor Turnover Survey (JOLTS). [7,8]
HOUSING: New home sales dropped 5.9% to a seasonally adjusted annual rate of 769,000 units last month, the lowest level since May 2020. April’s sales pace was revised down to 817,000 units from the previously reported 863,000 units. The median new house price jumped 18.1% year over year to $374,400 in May.
INTERNATIONAL: Turning the Corner
After a decline in output in the first quarter, economic activity in Europe picked up in the second quarter thanks to widening vaccination distribution and a relaxation of economic restrictions. Despite its slow start to the year, the Euro area economy is projected to grow by 4.3% in 2021, powered by consumer spending, fiscal support, and exports. Unemployment levels are expected to fall to near pre-crisis levels. 
The U.K.’s return to normalcy has been quicker than on the continent as their vaccination rate hit 70% during the second quarter. This, coupled with accommodative fiscal policies, is expected to lead to a 7.2% growth in GDP this year. 
China’s vaccination rollout has only recently gathered steam, with its slow start limiting full recovery from the pandemic shutdown. Nevertheless, China’s recovery has been strong, with economic growth this year projected to be 8.5%. Investment has led the recovery, with consumer growth rebounding more slowly. Imports and exports have seen a solid improvement. 
After finding early relative success in recovering from the pandemic’s economic impact, Japan declared a state emergency in April due to rising infection rates in certain prefectures. The economic containment measures subsequently implemented were insufficient to stem the virus’s spread, resulting in muted economic growth in the second quarter. Despite this, Japan’s economy is anticipated to expand this year, albeit at a tepid 2.6% rate. 
U.S. Continues to Lead
U.S. EQUITIES: As mentioned above, record earnings and robust economic data drove the three major U.S. exchanges to all-time highs yet again in Q2 despite increasing worries about rising inflation. After lagging the three major US indexes in Q1, the tech-heavy Nasdaq Composite index regained leadership, returning 9.49% in Q2, followed by the S&P 500 at 8.17% and the Dow Jones at 4.61%.
DEVELOPED INTERNATIONAL EQUITIES: After early setbacks, accompanied by a surge of new COVID infections and some renewed lockdowns earlier in the year, major Eurozone countries rapidly scaled up their vaccination programs and now appear on pace to match or surpass U.S. vaccination levels in Q3. The MSCI-EAFE Index, which tracks developed overseas markets, rose 4.37% in Q2.
EMERGING MARKETS: Emerging market equities registered a strong return of 5.18% over the second quarter. This was despite a sell-off in May as higher-than-expected U.S. inflation renewed concerns over the timing of global monetary policy tightening. Brazil was the best-performing market in the MSCI Emerging Markets index, with currency strength amplifying gains. Central bank actions to tighten policy in the face of rising inflation, an acceleration in vaccine roll-out, an easing in fiscal concerns and renewed reform progress all boosted sentiment.
U.S. FIXED INCOME: Despite strong economic growth and rising inflation during the quarter, interest rates in the U.S. actually fell. As we will attempt to explain further in our Quarterly Focus, the 10-year Treasury yield dropped from 1.745% to 1.469% during the quarter. The Aggregate Bond Index rose 1.96% as a result.
DEVELOPED INTERNATIONAL FIXED INCOME: European government bonds underperformed the U.S. amid growing optimism about the region’s recovery and accelerating vaccination rates. Data points – particularly for manufacturing – were strong through the quarter. The German 10-year yield rose from -0.29% to -0.20%, France’s from just below zero to 0.13%. The Italian 10-year yield rose from 0.67% to 0.82%. The U.K. 10-year yield fell from 0.85% to 0.72%, following a sharp rise in the previous period.
Interest Rate Conundrum
With robust growth in both inflation and GDP expected over the next few quarters, one would expect (as many have) that interest rates would move higher as they usually follow economic activity and inflation up the scale as demand for cash and credit increase. Furthermore, most analysts’ forecasts for the 10-year yield hover around 2% at year-end. Looking at the chart below, however, we see a different picture. The 10- year Treasury has moved from almost 1.80% earlier in the year down below 1.30% as of this writing – which accelerated more recently after the Fed’s June meeting. The bond market reaction has many asking if the market knows something that we don’t: is it signaling a slowdown that we are not seeing?
Up until now, the perception was that the Fed was going to let things run hot by keeping rates at zero for the foreseeable future. As long as we still had work to do to get back to full employment, they would let the party continue and allow inflation to rise above their 2% target.
But the Fed is apparently not doing that. It was clear from Powell’s press conference that while he’s optimistic about the recovery, he’s anxious about constraining inflation. The Fed may be a long way from literally raising rates, but they are watching the speed and heat of the economy and letting people know they’re paying attention. And this explains some of the moves that we have seen in treasury yields noted above: while the current easy money Fed party should continue into the foreseeable future, the bond market now senses that the chaperone has awoken and is ready to act should things get too wild.
DPWM 2021 OUTLOOK:
Watching Out for Unknowns
Investors have enjoyed strong gains so far this year as stocks have responded well to rising vaccination rates, economic reopening, fiscal stimulus, and an accommodative monetary policy. If the market is to build on these gains over the next quarter and through the year-end, it may depend on how several important questions are answered over the coming months:
1. Second-quarter GDP growth is expected to come in very strong, perhaps the strongest in decades, leaving investors to wonder if this represents peak growth. In other words, how much will the economy continue to expand absent further fiscal stimulus and with the prospect of Fed tapering? There is a case for above-trendline economic expansion as consumers spend their accumulated savings and people begin filling open jobs once schools reopen and their comfort level with the safety of returning to work rises. Nevertheless, economic expansion appears set to slow, and that’s a potential hurdle for the market.
2. Then there is the matter of the Fed’s classification of the recent acceleration in inflation (the fastest pace since 1991) as “transitory.” Is that three months? Six months? Longer? The ambiguous and non-technical economic term may be defined differently by investors than by the Fed, which could lead to future market dislocation. Furthermore, the impact on consumer spending due to inflation has yet to emerge. While inflation may be “transitory,” price increases are generally sticky. Thus, it remains uncertain if increases in overall consumer prices will dampen discretionary spending, something investors may be anticipating to drive future economic growth. The months ahead should provide a clearer picture of whether inflation does indeed prove fleeting or instead becomes a more sustained feature of a post-Covid economy. 
3. The Fed’s easy-money policies have been a contributing factor in the market’s sharp recovery from its pandemic lows. Consequently, investors are expected to continue to focus on Fed signals about the timing and degree of its plans to taper its monthly bond purchases (its June meeting was silent on this issue). Tapering is a concern, but given the excess liquidity worries of many investors, any start of Fed tapering later in the year may turn out to be a welcomed development.
4. Another market headwind is stretched investor sentiment. Though markets are hovering around all-time highs, market breadth has not been exceptionally strong, which suggests investor enthusiasm has moderated. A weekly survey by the American Association of Individual Investors reflected a 10% decline in bullish sentiment and a concomitant rise in bearish sentiment in the month of June. With potentially fewer positive economic surprises ahead and muted buying sentiment, the market may mark time until a new catalyst emerges. 
The economy appears in good shape, and most economists expect it to remain strong into 2022. This portends a positive second half of the year, but investors shouldn’t lose sight that the market is currently priced above historical average.
We have often acknowledged that projections rarely play out as forecasted, with the recent moves in the bond market illustrating that point. As such, it is important to maintain a diversified portfolio despite your convictions about where markets are headed. That is not to say that we don’t make calculated moves as we see favorable risk-reward setups unfold: our portfolio positioning has remained consistent over the last several months as we continue through the year with a measured approach. With our expectations of rising inflation and higher growth over the next few quarters, we remain defensive against rising rates (especially now) within our portfolios.
U.S. economic growth should continue to be strong while vaccination rates rise and economic stimuli continue. This type of environment is very supportive of our continued allocation to small cap and value-oriented stocks. While we acknowledge that the pro-cyclical/reopening party will not last forever, we believe that there is further room to run, while mindful of the now attentive chaperone.
1. factset.com, June 4, 2021
2. atlantafed.org, July 1, 2021
3. ismworld.org, July 1, 2021
4. ismworld.org, July 1, 2021
5. conference-board.org, June 29, 2021
6. kansascityfed.org, April 29, 2021
7. dol.gov, July 1, 2021
8. cnbc.com, June 8, 2021
9. federalreserve.gov, June 16, 2021
10. oecd-ilibrary.org, July 1, 2021
11. oecd-ilibrary.org, July 1, 2021
12. oecd-ilibrary.org, July 1, 2021
13. oecd-ilibrary.org, July 1, 2021
14. msci.com, July 1, 2021
15. bloomberg.com, June 10, 2021
16. aaii.com, July 1, 2021
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