Summer 2021 Market & Economic Commentary
The continued strength of global equity markets makes all the sense in the world…. in a world that has lost its sense of reality. Yes, we are seeing meteoric growth in earnings and revenues almost everywhere we look, but that is to be expected as economies recover from one of the most severe and potentially the most abrupt displacements in global GPD in modern history. The question is, how long with this growth spurt last? And when it does ebb, what will the following period look like? These questions seem logical to ask, but on a day-to-day basis, it seems like very few people care to ask them. Instead, equity investors continue to pile into one area of the market or another, depending on the investment fad of the day. Yesterday airlines were hot, today they’re not. Tech was overblown and flatlined in Q1 and it was cyclicals’ turn to shine. Come Q2, tech takes the lead again. In the end, almost everything is advancing. And as fast as stocks earnings can climb, their stock prices and sky-high valuations climb just as fast, or even faster.
Who is driving this erratic buying? Certainly not long-term focused 401(k) investors or institutional buyers. According to JP Morgan, the retail trading giants Schwab, TD Ameritrade, E-Trade, and now Robinhood account for between 20% and 25% of all U.S. monthly equity trading volume. Investment inflows are coming from a shocking (and seemingly inexperienced) pool. Since the beginning of 2021, the largest investor in equity markets has been people under the age of 25 and people who make less than $50,000 per year. In fact, the largest group is people who make less than $20,000 per year! Wondering where those stimulus checks went? A lot of them went into Robinhood. Many have said this continued buying is bolstered by novice investors not wanting to miss out on the big gains of the last year. However, with the economic winds at our backs, both the economy, corporate earnings, and stock prices have a tremendous amount of momentum behind them. That said, like all forces of nature, eventually the tide must go out.
How the Markets Fared
Globally, stocks advanced across the board in Q2. Here in the U.S., technology-led large-cap growth stocks posted double-digit returns after treading water in Q1. Value sectors, which had such a strong first quarter (and last two months of 2020, as well) saw their gains muted, as concerns of the Delta variant of COVID-19 rose. Large-cap stocks, in general, outperformed their mid-and small-cap brethren, with the S&P 500 nearly doubling the performance of the small-cap index (the Russell 2000). However, in small-caps, we did not see the same dispersion between growth and value names. The same was true internationally, where most indices rose mid-single digits. The one standout was the resurgence in Latin American emerging markets stocks, which saw over 15% increases. We commented last quarter that the lag in resource-focused Latin stocks had been odd with commodity prices on the rise; normally they move in tandem. Clearly, the markets were listening. Commodities again tacked on impressive double-digit returns in Q2, so there may be more gains to be had in the Latin American markets.
On the fixed income front, markets also zigged after Q1’s zag. As concerns about the Delta variant rose, intermediate- and long-term yields declined, with the bellwether 10-year treasury dropping 20 basis points from 1.68% at the end of Q1 to 1.48% to end Q2. This helped high-quality bonds post modest gains of a point or two during the quarter. High yield paper saw slightly better returns but generally, most bonds, both foreign and international, added a point or two net to portfolios. The drop in interest rates was somewhat surprising as inflation pressures continued to mount. Even the Fed indicated that they may be inching closer to tightening short-term rates. Here too the question is not a matter of if, but when. Nonetheless, interest rates once again boggled the pundits, dropping during the quarter and continuing even lower as Q3 began.
A Peak at the Numb-ers
The equity markets may be growing numb to the fears about inflation. Or perhaps investors think that owning equity is a life raft of value if the dollar were to depreciate. Any way you look at it, markets have not flinched in the face of soaring costs. Material costs and increased labor expenses have forced the Producer Price Index to climb over 7% year-over-year. Prices to consumers, as measured by CPI, have climbed over 7% in just the last six months. The real debate isn’t whether we have inflation, we do. It is whether it is transitory while the global economy restarts, or if it is secular and this is just the beginning of a long trend. With over $10 trillion in stimulus spending and expansion of the Fed’s balance sheet (essentially printing money), our bet is that inflation will be here for a long visit and not a short stay. If that’s true, the Fed will be forced to raise interest rates, perhaps aggressively. For now, the equity markets seem to be comfortable with the higher inflation rates in a generation.
The Great Opening
No, I’m not talking about the ‘opening’ of the economy. We have the advantage of working with heads of finance and human resources from companies from all industries across America. The one thing we keep hearing is…we have a labor problem. Even though there are still 5.4% of American’s unemployed, there are over 10 million unfilled job openings, an all-time record. With enhanced unemployment benefits disincentivizing some from returning to work and COVID fears stifling others, there simply isn’t a large enough pool of willing workers to fill all of those openings. This labor shortage is causing further strain on an already stressed global and domestic supply chain. And it’s also adding to inflationary pressures due to wages that have risen 4% year-over-year and are likely to continue to climb as competition for talent increases. Both present headaches and challenges for business leaders as they try to plan ahead and maintain growth.
One area of the economy that is booming is the red-hot housing market. By every measure, it’s good to own a home in America right now. Whether you look at the Case Shiller Index (for May, the latest report) which posted a record-breaking 16.6% year-over-year gain in price, or the NAR existing home sales numbers that show that median home prices soared by over 23.4%, homeowners are seeing their equity expand and there is no end in sight. The NAR reports that there is still a paltry 2.6 months supply of homes on the market (less than half of the 6-month supply considered to be equilibrium). With mortgage rates edging down again and supply low, there is likely much more room ahead for housing prices to run.
With jobs aplenty, wages on the rise, and equity in our homes climbing as fast if not faster than the value of brokerage accounts and 401(k)s, it’s no wonder that consumers are in some of their best moods since COVID hit in 2020. As measured by the Conference Board, Americans are feeling chipper about their current situation, as well as future prospects, at levels not even seen before the housing bubble burst in 2007. That comparison shouldn’t be of much concern as this time, consumers have been saving at a breakneck pace, unlike the exuberant overspending that happened leading up to 2007/2008. Back then, the savings rate was negative. For the last year, it has averaged double digits.
Get Down, Get Down, Get Down, Get Down, Get Down to Business…Woo-Hoo-Woo-Hoo-Woo-Hoo-Woo-Hoo!
Consumers aren’t the only ones feeling groovy right now. American businesses are optimistic on every front. The latest Institute of Supply Management Report on Business (ROB) for the services sector came in at a booming 64.1 (readings above 50 indicate expansion). The Manufacturing ROB posted a strong 59.5. These readings are encouraging, as both service industries and manufacturing are dealing with supply chain, transportation, and labor shortage challenges. If these headwinds continue, will that dampen the mood? Or is there even more pent-up desire that could take us higher still?
Surprise, Surprise, Surprise!
With all the positive factors influencing the economy, it is not surprising that earnings have been coming in strong. Even though analysts have been revising their estimates higher and higher, with nearly nine out of ten S&P 500 companies reporting as of the date of this writing, 87% of those reporting have surpassed both earnings and top-line revenue estimates! That said, even with these higher-than-expected earnings reports, the forward 12-month P/E ratio for the S&P 500 is over 21 times earnings. That represents over a 30% premium to the historical norms of approximately 16 times earnings. We are enjoying strong comparisons to last year’s COVID-effected quarters that occurred during the depths of the shutdowns. What happens when the year-over-year numbers are based on the improved recovery quarters? At some point in time, the laws of gravity will kick in and valuations will regress back to norms…or perhaps even lower.
Come Fly with Me, Let’s Fly, Let’s Fly Away
As encouraging as the trend has been here in the United States, it’s actually international equities that merit our focus. It deserves note that U.S. and international stock markets have routinely traded dominance in performance every 2-10 years. The present U.S. run has lasted nearly 14. It’s easy to get myopic when U.S. indices are setting new highs month after month. And with all the upside surprise in earnings, it would be a reasonable guess that domestic equities were the best game in town. However, both emerging markets companies and European companies are expected to see stronger earnings growth in 2021 (50% and 44%, respectively) than the U.S. (37%). Further, both of those international markets are trading at far more reasonable valuations than those in the U.S. in both actual and relative terms.
The U.S. enjoyed benefits from an earlier economic reopening than foreign markets, predominately due to quick rollouts of vaccines domestically. However, the EU and other foreign markets have now caught up, with Germany and France at similar vaccination rates as the U.S., and the U.K. and China substantially higher. Further, new cases in those countries due to the Delta variant have already peaked; in the U.S. we are still on the climb. The pendulum may be nearing its apex on the U.S. side of equity performance, and conditions are ripe for quite a regression.
There is no question that the winds are blowing steadily and strong at our backs, and forward momentum is solid, both domestically and in international markets. As long as revenue and earnings continue to expand at eye-popping rates, more money will likely pile into global equities. However, at some point in future, investing dollars will grow more discerning. And with retail investors, especially young inexperienced ones at that, contributing to much of today’s inflows, one could see how they could quickly sour on the idea of plowing more money into sky-high valued stocks….especially if they begin to falter in earnings performance or simply stock prices. At that point, what happens is anyone’s guess. If the early 2000s repeat themselves (remember the end of the dot-com bubble?), those dollars will flow out of U.S. markets into international ones. But history seldom repeats itself, at least how and when you expect it. Until the next chapter plays out, our pierspective is to make sure portfolios are adequately diversified. With the average investor in the U.S. investing just 15% of their equity portfolio in international stocks versus 40%-50% for the typical institution, there is a lot of room for improvement in allocations before things start swinging the other way.