Key Points Remain:
- Vaccines combined with strong fiscal and monetary policy remain tailwinds for the economy and markets
- Excessive optimism, stretched valuations and potential for higher interest rates and inflation are possible challenges
- Given probable tradeoffs, most Sequoia strategies remain generally neutral equities/fixed income, with modest tilts toward higher quality U.S. equities and lower fixed income duration than broad indices
As we’ve discussed in recent Review and Outlook pieces, the combination of widespread vaccine administration and extraordinarily accommodative fiscal and monetary policy is a potent stimulative cocktail providing strong tailwinds for the economy and financial markets. For the second quarter of 2021, economists estimate that U.S. GDP grew north of 9%1 and the S&P 500 jumped by 8.5%2. For the year through 6/30/21, the S&P 500 is up 15.3% and the MSCI All Country World Index IMI (global stocks) is up 12.7%2.
In a reversal from Q1, bond yields fell during the quarter with the 10-Year Treasury Note yield falling from 1.74% to 1.45%1. As a result, bond averages were mostly positive for the quarter with the Bloomberg Barclays Aggregate Bond Index (Agg) up 1.8%, which helped reduce the losses from Q1. For the year through 6/30/21 however, the Agg is down -1.6%2. A summary of major asset class and sector performance as well as changes in key rates are below.
Inflation also heated up in Q2 as witnessed across many data points. Consumers now face strong price increases with many products and services such as lumber, rental cars, bicycles, gasoline, and food to name just a few. Manufacturing and service sector manager surveys released during Q2 indicated that most businesses are also grappling with higher input costs and supply chain issues, leading many to expect higher prices in the future1. Official inflation measures such as Core CPI and Core PCE saw some of their largest gains in many years in Q21. The Federal Reserve has been clear that they expect such price gains to be “transitory.” What we don’t know is what “transitory” means in terms of time. In Q2, the fixed income markets seem to price transitory as a very short time given how yields fell. However, prices did increase enough for the Federal Reserve to mention, during their June meeting, the possibility of reducing the amount of emergency accommodation perhaps later this year, and they moved up expectations of when they may actually raise interest rates.
We continue to expect the economy to perform quite well for the balance of 2021 and into 2022, even though the pace of growth is likely to slow from its recent torrid pace. The solid economic performance is likely to lead to strong earnings growth for businesses as well. However, we believe solid economic growth may continue to push inflation higher, which likely means a less supportive Fed. We think the recent June meeting was the start to this process. As such, we continue to anticipate rising interest rates again at some stage in the second half of the year, even though they’ve fallen quite dramatically recently, to reflect a stronger economy and potentially stickier inflation than many expect.
Q3 has historically been the weakest quarter of the calendar year1. Investors are entering Q3 2021 with most U.S. stock market averages at record highs, higher than average stock market valuation metrics and signs of excessive optimism on the part of investors (i.e. record number of IPOs, enormous inflow into equity markets, meme stocks, sentiment indicators). A correction at some stage in the second half of 2021 would not be surprising as a result. If a correction occurs, we think it would likely be both healthy and an opportunity to add to equity exposure given our view on economic strength and corporate earnings into 2022.
Clearly, a key risk during the balance of 2021 is the newer Delta Coronavirus variant that is spreading rapidly. We will monitor this situation as more information is available, but for now we think large scale vaccinations are likely to protect most of the U.S. population and allow the economy to remain open and growing.
Balancing the ledger between the potential opportunities and challenges, we do not want to be too far out on a limb in any direction as we start Q3 2021. This is the same conclusion we drew to start the year, and at the start of Q2. As such, most Sequoia strategies remain broadly balanced (neutral) relative to equity/fixed income targets, with modest tilts toward US higher quality equities and lower fixed income duration (interest rate sensitivity) than broad indices. For example, our 70% equity/30% fixed income strategies are generally in-line with these “neutral” points (i.e. not materially greater than or less than 70% equity). Also, within fixed income allocations, several strategies hold managers that have flexibility to adjust duration and look for yield globally where interest rates may be more attractive. Throughout Q2, we maintained an overweight to U.S. smaller companies which typically do well in rising inflationary environments. We also modestly increased our exposure to equities in Europe and many developed nations in Q2, which offer compelling valuations relative the U.S. as they reopen their economies. Generally, this positioning allowed us to perform reasonably well compared to our benchmarks net of fees, while not taking on excessive risk in a still uncertain environment.
Our goal is to provide diversified, long-term focused strategies that are consistent with our clients’ financial plans and objectives. As investors, we want to remain patient and disciplined until we better understand Federal Reserve policy as data around the Delta variant, corporate earnings, inflation, and economic growth change. For now, we are on guard for the U.S. economy to remain quite strong, which may create questions about the Fed’s highly accommodative monetary policy. Large-scale fiscal stimulus efforts may also create questions about tax policy, which may also pose a risk later in 2021. For now, we think investors need to balance what has been the major tailwinds of vaccines and supportive policy with the likelihood that supportive policy may need to change.
As always, thank you for your confidence in our team,
Asset Management Department
Sequoia Financial Group
Sources: 1. Bloomberg 2. Morningstar Direct 3. Treasury.gov