2021 Mid-Year Report – Looking Back, Looking Ahead
Paul Tarins, RICP®,WMCP®,CSRIC™
Stocks have been on a relentless tear this year as the global economy continues to roar back from last year’s pandemic closure. In fact, US equities recorded their strongest first half performance in over twenty years (Markets Insider, “US Stocks Close Mostly Higher to Finish One of the Strongest First Halves of the Year since 1998,” 6/30/21). However, the tranquility seen among the major indices masked several waves of violent rotation among the styles and sectors that comprise them. These fluctuations were driven by uncertainties surrounding growth versus inflation, and the future policy direction of the US Federal Reserve. In this article, we will look back on the first half’s top classes, styles, and sectors, take stock of the current state of the US economy, and conclude with some “crystal ball” predictions for the balance of the year.
Global Class, Style & Sector Performances
US large-cap stocks finished the first half higher by +15.2% (‘SPY’ ETF Proxy). Overseas equities underperformed somewhat, held back by a strengthened US Dollar with much of the world further behind in vaccinations and the prospect of higher US interest rates in play. Bonds finished flat to lower after a relatively poor start to the year, recovering somewhat as growth expectations moderated late in the second quarter and as the Federal Reserve reiterated its patience towards raising rates despite increasingly hot inflation reads. Still, the US Aggregate Bond index fell -2.4% (‘AGG’). More dramatically, global real estate advanced +17.1% (‘RWO’) on lower rates and healthy demand, while commodities rose a whopping +31.0% (‘DBC’) as supply chains backed up.
Source: Based on time-series data from CSI Data, Inc using ETF proxy data (tickers available by request). Data deemed reliable, but not guaranteed. Past performance is no guarantee of future performance or profitability.
Focusing in on US sectors, we can see that energy was the largest beneficiary as the economy reopened and oil moved significantly higher, up +45.1% (‘XLE’). While all sectors finished higher, financials were the next highest mover, up +25.5% (‘XLF’) as an initial beneficiary of higher rates. Utilities rose the least, up +2.4% (‘XLU’), hampered by higher interest rates and higher energy costs.
Source: Based on time-series data from CSI Data, Inc using ETF proxy data (tickers available by request). Data deemed reliable, but not guaranteed. Past performance is no guarantee of future performance or profitability.
Finally, below we can see that small-cap value stocks were the major winners among factors during the first half, up some +30.4% (‘IJX’) as participation in markets broadened beyond the large-cap growth stocks that led the way last year. This rotation was highlighted by the relative underperformance of momentum factor stocks, up “just” +7.6% (‘MTUM’).
Source: Based on time-series data from CSI Data, Inc using ETF proxy data (tickers available by request). Data deemed reliable, but not guaranteed. Past performance is no guarantee of future performance or profitability.
Naturally, there are always leaders and laggards among these various leaderboards, but it is true that many of the differences have been especially stark this year. Take for instance, the tremendous disparity between stock and bond performances. In addition, while we can see clear winners and losers for the first half, were we to present the tables above in two-month increments, you may be shocked by the shifts among the categories. The flux of market themes has been especially fast moving, and often self-contradictory. Picking stocks this year has thus not been nearly as easy as the point-to-point first half results might otherwise suggest.
Indeed, astute market watchers will have noted how many of the attributions stated above have already faded as we head well into July. For example, interest rates have again been driven into the bargain basement as fears surrounding new Covid strains have come to the fore, raising concerns once again about future growth prospects. As a result, the advantage of financials has all but evaporated, pushing money flows back into technology where the ability to exercise pricing power has been touted. And that brings us to today’s state of the markets, discussed in the next section.
Current State of Affairs
Markets are always working to see beyond the current situation to discount the future. At the midpoint of the year, there is a sense that we may soon be seeing a peak in recovery growth. This could be a problem given elevated valuation levels and a perceived threat of inflation.
The Cyclically Adjusted Total Return Adjusted Price/Earnings, or “CAPE,” ratio moved higher this year to a whopping 41.6, now well within “dot.com,” 1998-2001 levels. Real earnings also fell to a rare negative -2.1%, as consumer prices rose at an annual +5.4% pace, the fastest rate in 13 years. As for the reopening, over one-half of the eligible US population has now been vaccinated. While concerns persist over the emergence of new variants, the reopening trade has supported growth in the +6-7% range, a level not seen in a generation (International Monetary Fund, “USA Concluding Statement…,” 7/1/21).
When Federal Reserve quantitative easing tapering concerns consequently surfaced, Chairman Powell again maintained that "it would be a mistake to act prematurely” with current inflation seen as “transitory,” meaning he believes it should subside based on labor slack and as inventories are replenished (Reuters, “Fed's Powell Keeps to Script...,” 7/14/21). Acceptance of this narrative and concerns about peak growth has subsequently driven treasury rates back near annual lows.
The good news is that the National Bureau of Economic Research recently declared the pandemic-induced recession was the shortest in history, ending April 2020, and early second quarter earnings are again surpassing expectations by a wider than average margin (Factset, “Earnings Insight,” 7/16/21). Further, analysts expect double-digit earnings growth to carry forward into the second half. So, although growth may eventually slow, that is not to imply a negative outlook ahead as the economy continues to simply renormalize.
Higher Volatility Ahead?
In better internally aligned markets, we would build our second half outlook around the relative strength readings presented above. Momentum is an immensely powerful force in markets; simply stated, what has done well recently tends to continue to outperform. However, in this year of powerful and rapid rotations, relying on this approach is likely inappropriate. Unveiling our “crystal ball,” while our broad outlook remains positive, with the prospect of slower growth on the horizon and the rising uncertainty that will precipitate, only greater volatility is predictable at this time. Markets have elevated valuation levels to contend with and the fact that we have yet to see the typical -6.5% minimum annual retrace. Add that to lower summer volume and we have a recipe for choppier markets ahead. It is also a good bet that returns will be more subdued in the second half after such a tremendous start to the year.
Finally, with turmoil among the underlying styles and sectors, focusing on the major indices with a weather eye out toward risk may ultimately be the best move for individual clients. It could also be a very opportune time to visit with your adviser to review your portfolio’s diversification and capital protective components while volatility remains low. We will remain vigilant towards these points, meanwhile, enjoy your summer and keep cool during this season of unusual weather extremes!
