Hello, everyone, and welcome.
Returns in the second quarter extended the run of strength for risk assets, leading the S&P to one of its best first half starts in 23 years and further adding to the extraordinary recovery from the lows of last year. And that success makes sense.
With one of the strongest vaccination efforts in the world, the US was largely able to avoid the most recent wave, and hospitalizations and deaths are at very low levels. Which in turn drove the high rate of reopenings and return-to-normal activities, which, by some measures, have revisited pre-pandemic levels.
Developed-market households are flush with cash and their confidence has been rising. And on the corporate side, US earnings in the second quarter exceeded expectations as analysts continue to increase their earnings forecast for 2021.
And yet, underneath the surface, market behavior indicates that there are questions. Indeed, the majority of gains in the first half were driven during the most aggressive phase of vaccinations and reopenings. And until the final week of the quarter, the price level of the S&P had struggled to find clear direction.
The center of those concerns are likely three-fold. Number one, if the reopening strength is produced, sustained inflationary pressures and a Fed that may tighten more quickly than anticipated. Number two, if all of that exceptional expectation that we have for growth have already been priced in. And number three, possible concerns about the impact of the delta variant on the world economy.
As to the first, at its June meeting, the Fed’s dots chart and QE comments suggested a faster pace of tightening. While we do believe that the Fed will move toward reducing its purchases later this year, it will be gradual and the dots chart still implies the first increases won’t be until 2023, mirroring the Fed’s view of current inflation as transitory, and largely, we would agree.
Certainly business inventories have fallen and supply bottlenecks have surged. We’ve all seen that, which in turn does correlate to an increase in inflation.
However, while CPI has jumped, longer-run inflation expectations have been much more benign.
We believe this is because the drivers have been those directly related to reopening, while the standard drivers have been much more subdued.
As to multiples, valuations are clearly elevated. Thus far in 2021, though, earnings have driven gains, in effect, holding valuations at the same level. In short, should valuation stumble, markets would be challenged. However, should they remain closer to current levels, given low bond yields and a patient Fed, as we would expect, markets can continue to rise, if at a more moderate pace.
But the opportunities are varied inside of markets. Despite its year-to-date strength, value remains inexpensive versus growth, and the growth backdrop suggests there’s further room to run over time, as is the case for international equities and for small cap. But as I mentioned before, I wouldn’t suggest radical changes in portfolios. Rather, I would advocate for thoughtful rebalancing, if you will.
Particularly given the uncertain path of a post-pandemic recovery. Classically, recovery supports cyclical value. However, expansion and moderation favor growth. The nature of the recovery, though, has blurred these lines. And in some cases, divided the behavior of specific measures of growth in value versus others, as well as the behavior, of course, of constituents inside of those segments based on the reopening.
Which is why I would like to direct your attention to another fact: quality. Note the consistent behavior across the cycle. We’ve talked about the benefits of quality before and believe that today it should be an area of focus.
A look at global equity returns over time illustrates this. Despite the index’s strength, the quality component of the index has had significant outperformance with significant downside protection.
For a market with growing questions about future market gains, we believe a focus on quality is warranted regardless of style, cap or geography.
Another broad equity surrogate to consider, and one we’ve spoken to often, is high-yield credit. High-yield spreads today, like equity valuations, are rich. However, the economic backdrop suggests the risk of credit problems is also lower and yields can be augmented today by adding segments to the credit world that have been slower to recover, such as securitized and emerging-market debt.
By paying attention to this credit rotation trade and balancing exposures, investors can increase yields meaningfully.
And for income seekers, credit today is not just about producing higher or more efficient income. Given the very low levels of government bond yields, it’s a survival tool needed just to produce yields above the rate of inflation.
As always, I’m focused on portfolio efficiency, and today, as simple as it seems, first and foremost, that means balance to me. That balance suggests taking the opportunity to thoughtfully rebalance where portfolio exposures, maybe for some time, might have been underexposed or concentrated, but at the center of that balance is a focus on quality and efficiency. And given richer valuations, the cost to embed that is low, in my opinion, and valuable as we continue throughout this very, very unique recovery. As always, thank you all so much for joining. And we’ll see you next quarter.