Market and Economic Commentary and Outlook
- Debbie Grose
- Jul 9, 2021
- 13 min read
Stocks are near new record highs. Strong second quarter stock returns built on very strong first quarter returns and double digit first half returns are a good omen for the rest of the year. The S&P 500 has never finished with an annual decline if the first half is above double-digit returns; and history shows second half gains can be sizeable. Corporate earnings and jobs growth are strong and interest rates have declined, which has allowed large cap tech stocks to lead during the second quarter.
However, several inflation pressures, including supply constraints, increased demand and increasing wages could cause interest rates to increase in the future. So far, the Federal Reserve is still providing strong support for stocks and bonds, but at its last meeting, signaled its first rate hike in 2023, one year earlier than before. Is inflation we are witnessing in our lives temporary, or will it be more persistent than expected? The Fed has a difficult task to keep prices contained and the economy at full employment.
The new asset class trends that emerged last October are taking a short pause this quarter as the lower interest rates this quarter support growth stocks. Lower interest rates help growth stocks more, since their large future cash flows are worth more as they are discounted at a lower rate. We don’t expect to see the current low interest rates remain for long, as the Fed slowly tapers its monthly bond purchases and continues to auction more paper to support deficit spending. And, oh yeah, no one is talking about funding the government when the debt ceiling is reached on July 31st. Could be an exciting second half if the capital markets continue to be resilient, but we believe now is not a time to be complacent. There are several risks that could cause a return of volatility, including high valuations in the U.S., the threat of new global lockdowns from Covid variants, the threat of inflation not being temporary and the potential of the Fed to turn hawkish.
For those who would like a deeper dive into the details, please continue reading…
World Asset Class 2nd Quarter 2021 Index Returns
U.S., International Developed, Emerging Market and Global Real Estate stocks were all positive in the second quarter, a continuation of the bull market trend that began during the reversal on March 23rd of 2020. U.S. Bonds were up 1.83% , while Global Bonds were up 0.35%, as the level of interest rates decreased across all maturities, except for the very shortest, which are anchored to zero by the Fed. For the broad U.S. Stock Market, the second quarter return of 8.24% was well above the average of 2.4% since January 2001. International Developed Stocks returned 5.65%, which was well above the long-term average quarterly return of 1.7%. Emerging Market Stocks returned 5.05%, also well above the average quarterly return of 3.1%. Global Real Estate Stocks returned 10.17%, much greater than the asset class’s average quarterly return of 2.6%. Here is a look at broad asset class returns over the past year and longer time periods (annualized):
The U.S stock market (as defined by the Russell 3000 Index) led all categories with a strong 44.16% return in the last year. Emerging Market stocks were just behind the U.S., with a return of 40.9%, International Developed stocks were up 33.6% over the past year, while Real Estate stocks closed the gap a bit during the quarter and were up 34.83% for the past year. The decline in interest rates, constrained supply of homes and strong opening of the U.S. economy helped the real estate sector during the quarter. Over the past five years, U.S. stocks were up 17.89% annually, while Emerging Market stocks were up 13.03% annually, International Developed stocks were up 10.36% annually, and Global Real Estate stocks were much less positive, up 4.62% annually, since real estate much more affected by the global pandemic. Over the past 10 years, the U.S. stock market (up 14.7% annually) is well ahead of International Developed (up 5.7% annually) and Emerging Market (EM) Stocks, which are only up 4.28% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years. We also know the relationship between the U.S. and the rest of the developed world is cyclical and given the long run of U.S. outperformance, the next decade favors international outperformance.
A larger sample of global asset class returns during the second quarter shows the strong returns of Real Estate stocks (REIT Index), which have lagged in previous quarters. Value and small-cap stocks were mixed during the quarter. Small value outperformed small growth, but large value underperformed large growth. Small cap stocks underperformed large caps in the U.S. and non-U.S. developed markets but outperformed in emerging markets.
Taking a closer look within U.S. stocks in the second quarter, we can see that value underperformed growth in the U.S. across large stocks but value outperformed growth across small cap stocks; and small cap stocks underperformed large cap stocks.
As we have been pointing out in our previous quarterly commentary (https://www.laketahoewealthmanagement.org/news-notes/2021/4/9/market-and-economic-commentary-and-outlook, since the end of October last year, U.S. Small Cap Value has performed the best, and now it has the best one-year return (up 73.28% below). And it is the best performing asset class over very long periods of time (last 90 years).
International Developed Stocks were positive during the second quarter (below), outperforming Emerging Market Stocks, but underperforming U.S. stocks. Looking closer, the value premium (value-growth) was negative; along with the size premium (small cap stocks underperformed large cap stocks). The currency effect served as a tailwind to international stock returns during the second quarter, as US currency returns were higher than local currency returns. Our investment funds are priced in U.S. dollars.
While Value is better than growth YTD and one year for International Developed Stocks; over longer time periods, the value premium (value-growth) is negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is positive in the past two quarters and over the past 1, 3, 5 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.
The U.S. economy appears to be in the early stages of a new business cycle, adding significant jobs each month with a declining unemployment rate and increasing employment wages. The Conference Board’s Economic Index of leading indicators has been positive for the past year, signaling expectations of continued strength in the business cycle. Consumer demand is strong for long term purchases, including appliances, autos and residential homes. The recent spike in prices should moderate as more supply constraints from reopening are removed. The euro area is a bit behind the U.S. with reopening but will likely be driven by a strong consumption rebound in the next quarter. The latest inflation reading for the Eurozone was 1.9%, which is still below the ECB target of 2% and supportive of continued easing. In Asia, Japan’s economy is improving, with better readings for business and consumer confidence, which reached levels prior to the pandemic. Emerging markets did well in the past month of June, as it appears Latin America is performing well with small cap and large cap. While Covid infection rates are still high in Brazil, the economy appears to have turned a corner. Brazil’s GDP growth has come in above expectations for the past two quarters, the benchmark interest rate has moved from 2% to 4.25% so far this year and is expected to go to 5% later this summer. China is well positioned with high expected growth and low valuations, trading at 18x earnings, which is a 40% discount to the U.S. equity market.
Shifting the commentary to fixed income, bond market returns around the world were positive due to a shift down in yields and a tightening of spreads during the second quarter. The yield on the 5-year Treasury note decreased by 7 basis points, ending the quarter at a yield of 0.88%. The yield on the 10-year Treasury note decreased by 28 basis points, ending the quarter at a yield of 1.46%. And the 30-year Treasury bond yield decreased by 35 bps to 2.304%. Here is the U.S. yield curve, and you can see how yields have fallen over the past quarter (current yield curve in green, one quarter ago in blue, and one year ago in grey):
Notice below, the highest second quarter bond return is for the longest maturity bonds (up 6.43%), then TIPS (inflation protected bonds, up 3.25%), then the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 2.74%, which means investors are not worried about inflation or economic weakness yet. With high yield spreads down around 3%, which is the lowest level since 2007, expectations for a strong economy are high. High-Yield spreads should reverse and start to widen when investors expect economic weakness. Here are the period returns:
With the 10-year Treasury Bond at 1.46%, down from 1.74% at the end of the first quarter, it allowed growth stocks to outperform value stocks. Low interest rates are inversely related to the P/E ratio and other valuation measures. So, low rates support high valuation ratios. The Federal Reserve has the delicate task of balancing inflation (price control) with economic growth to make sure interest rates don’t rise too quickly, given all the proposed government stimulus. Any intervention by the Fed to increase short term rates earlier than expected or taper bond purchases may send stock prices down. We will keep a close eye on inflation and Fed policy over the next quarter.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines; and often the headlines of the day have very little to do with the direction of stocks.
CONCLUSION
Strong portfolio results were achieved during the second quarter and first half of 2021, and if history is a guide, the strong results should continue through the second half of the year.
Right now, in July, stocks in the U.S. have already reached numerous new record highs. So too, are multiple valuation measures of U.S. stocks. We do see more reasonable value across the globe and believe globally diversified portfolios will reward patient investors over the next few years.
Interest rates are contained but inflation pressures are now stronger than deflation, causing the Fed to signal rates hikes earlier than previously expected. The inflation battle is still worth keeping a close eye on.
While we remain cautiously optimistic about the economic future, the best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are watching the potential tax changes closely and will be ready with recommendations. Please reach out to us with any questions or concerns.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody’s, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody’s, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, “global” securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,
ICE BofAML Explains the Construction Methodology of this series as:Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.
ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.
