I love money. I love everything about it. I bought some pretty good stuff. Got me a $300 pair of socks. Got a fur sink. An electric dog polisher. A gasoline powered turtleneck sweater. And, of course, I bought some dumb stuff, too. –Steve Martin
SECOND QUARTER 2021 REVIEW
The United States equity market, broadly measured by the Russell 3000 Index, returned +8.2 in the second quarter and 15.1% for the year to date period. Notable strong performance came from the real estate and information technology sectors, which, as measured by the S&P Select Services Index family, returned +13.1% and +11.1%, respectively, in the second quarter. All sectors save utilities posted positive returns in the quarter. The divide between large-cap growth and large-cap value performance reversed yes again with the Russell 1000 Growth and Value returning +11.9% and 5.2%, respectively.
The second quarter earnings growth rate for the S&P 500 is expected to be +64.0%, the highest year-over-year earnings growth rate reported by the index since Q4 2009 following the great financial crisis. Considering that most companies report positive surprises, results are likely to exceed this record-breaking level. Revisions continue higher. The greatest number of S&P 500 companies issued positive EPS guidance since FactSet began tracking guidance in 2006. This is clearly reflected in valuation with the forward 12-month P/E ratio for the S&P 500 at 21.4. To put into perspective, the 5-year average and 10-year averages are 18.1 and 16.2.
Billionaire Leon Cooperman describes himself as a “fully invested bear.” The world awash in liquidity seems to have pulled demand forward along with valuation of almost all assets. Rarely have we seen elevated values across such a broad spectrum of asset classes. Equity returns have been very strong, and some might say surprisingly resilient. But markets rarely react to what is happening in the moment, rather what is anticipated to happen. So while markets reacted last February to the prospects of the havoc COVID would wreak on the US and the world, by April the focus turned to the massive government response both fiscally and scientifically in finding a vaccine, largely rallying unabated since then. Just as the markets factored in and anticipated an end to COVID, so too will they start looking at growth prospects for 2022. We have always maintained this pandemic exposed the weak underbelly of the current economy rather than destroyed it. Structural themes like debt, employment and demographics have arguably been masked by an historically accommodative Fed. Even complete eradication of the virus doesn’t necessarily mean the economy will be on stable footing.
So what may the post-COVID 2022 look like? Gross Domestic Product (GDP) possibly returns to the tepid levels we’ve seen over the last decade. Slow growth and excess valuations keep a lid on interest rates. Federal and corporate debt levels remain well beyond any historical levels. Inflation is transitory but regressive, affecting the weakest participants in the economy driven by shortages rather than demand. Record levels of savings are not likely easily spent as consumers gird for what had been the unimaginable. Corporate margins benefit from hybrid work environments and less business travel with the acceptance of virtual collaboration. Fed policy is unlikely to become any more supportive and fiscal and regulatory tightening could be a risk to the overall economy in 2022. In fact, economic tightening has already begun as some states have ended federal unemployment benefits early.
In terms of inflation, which seems to be on everyone’s mind, we see it as transient. The distortions brought about by both the virus and the Fed’s interventions will be felt on both sides of the reopening. Currently, it’s stoking record high GDP growth, labor dislocations, and supply chain disruptions, and we feel that the absence of it will reverse those distortions. And you can already see it in interest rates -there is a saying, “the bond market knows all.” As rates move lower, it is signaling inflation is transient and growth estimates are overstated. The unprecedented rounds of stimulus following the Great Financial Crisis did not have the expected impact on growth and added to debt levels, which impeded growth. Given the magnitude of spending you would expect a more robust business cycle. One only has to look at Japan and decades of negative rates and stimulus, which resulted in really nothing in terms of economic activity. Dialing back stimulus is prudent but what happens when they take the punch bowl away? Again we look to 2022.
The reflation trade has fizzled. Market breadth has narrowed, the dollar has rallied off lows, interest rates moved lower, and growth regained leadership relative to value almost in unison from May levels. Higher rates, higher inflation and strong 2022 growth seem to be a foregone conclusion among most economic strategists. But consensus rarely gets it right and markets are reacting to signs that things may not play out as commonly anticipated. And while we remain circumspect and vigilant, we fully acknowledge that as investors we should not fight the Fed. As long as Federal Reserve Chairperson Powell is committed to supporting markets with any and all tools at his disposal, we will continue our current course. In looking
towards 2022, the “soft landing” discussion is likely to resurface. Again, it is not so much about what the growth is now, but what it is expected to be and, more importantly, what its drivers are and the macro-economic landscape. Key questions remain – how will consumers respond? Will Corporate America finally invest in people and capital? How can we achieve the productivity increases required for GDP growth? Where are interest rates headed? Is Inflation under control? And most importantly what will Washington and the Fed do about it, if anything? While things are more likely than not to be OK, should something unexpected like a COVID resurgence, inflation, or political turmoil (China) occur, it would likely be unsettling. Add to that tax increases that the markets deem growth unfriendly and there may be digestive problems, as this is not perceived to be currently “priced in.” Soft landings do happen, but not always, and the reasons, excluding policy mistakes, have a way of surprising. At GLOBALT, we believe this set- up still supports cautious positioning in investment portfolios.
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