Second Quarter 2021: Market Review & Outlook
Stocks ride the wave of uncertainty to strong gains
A reversal of a reversal of a reversal of style leadership in the second quarter made the markets as tough to follow as the beginning of this sentence. The S&P registered its fifth consecutive quarterly gain as growth and value stocks alternated leadership each month. After digesting a bevy of economic reports, Fed speak, and corporate earnings commentary, the market seemed committed to grinding higher despite doubts arising on the durability of the economic recovery. Vaccine progress, strong earnings, and improving economic fundamentals helped growth stocks lead an April rise to start the quarter. Persistent headlines about inflation worries in May led to a rotation back into value stocks with the added volatility restraining market gains to a modest 0.7%. Signs that inflation pressures were beginning to ease emerged in June triggering a depression in bond yields that boosted growth stocks, namely the tech and communications sectors, to impressive late quarter gains.
Inflation sprints out the blocks but has yet to go the distance
The primary reason for the flip flop in leadership between growth and value stocks during the quarter was the uncertainty surrounding inflation. Headline Consumer Price Index numbers for May came in at a much-greater-than-expected 5% year-over-year rise – the largest such gain since summer 2008. A tightening labor market, supply chain issues, and skyrocketing raw materials costs were all (rightfully) lobbed out as reasons for the spectacular upward pressure on prices. However, debate soon ensued over the sustainability of such pressures. The coming end of enhanced unemployment benefits, positive corporate commentary on supply chain management, and late quarter declines in prices of lumber all suggested that Fed Chair Powell’s consistent ‘inflation is transitory’ soundbite is actually more bite than bark.
Fed finally thinking about thinking about being hawkish
Speaking of the Fed, the most powerful gang of economists in the nation surprised everyone by throwing up hawkish signs during the June FOMC meeting. The number of participants expecting hikes of the federal funds rate in 2022 jumped from four in March to seven in June. Thirteen of the total eighteen members envision two hikes in 2023, up from only seven in March. Certain regional bank presidents were outspoken on the potential for currently observed inflation stats to force the Fed to alter its monetary policies sooner than expected. Even Chair Powell, the adopter of the ‘not even thinking about thinking about raising rates’ catchphrase, admitted that discussions about tapering have logically begun among committee members. Despite the slightly hawkish takeaway from the Fed meeting, longer-term yields sold off suggesting that investors still have concerns over economic growth.
Peak growth or a peek at potential growth?
Discussions about economic growth during the quarter centered on whether the US had achieved peak growth from the lows of the pandemic or if the economy has further to run once the labor market and supply chains normalize. Corporate commentary supported the latter notion as conference calls relayed expectations for continued growth based on pent-up consumer demand. As an exhibition of their faith, 66 S&P 500 companies issued positive guidance – the highest amount in 5 years. On the other side of the growth debate, multiple research firms pointed out that peak growth usually occurs 12-18 months after a recession. Supporting this notion is data from the Bureau of Economic Analysis showing that Consumer Durables spending is already 120% of pre-covid February 2020 levels. Both sides of the peak growth debate could be right if growth were to slow but still remain elevated relative to historical trends.
Modest gains are possible, less modest volatility is likely
Setting aside fundamentals for a brief moment, the strength of the market during the first half of 2021 suggests that more gains could be in store. Barron’s research shows that when the S&P gains more than 10% in the first six months, its chances of making second half gains are nearly 80%. However, those gains tend to be more modest than the first half (6% on average) and the market has yet to experience its historically annual 10% pullback. Bringing fundamentals back into the conversation, peak growth and inflation concerns are legitimate issues that the market will need to digest in the second half. The Fed’s reaction to either of those issues is likely to introduce significant amounts of volatility into the market no matter how well they telegraph their actions. Investors will need to be comfortable in a persistent haze of uncertainty if they commit to riding the market higher for what will likely be muted gains.