‘Inflation’ is the word of the quarter
Just like last year’s shutdown was unlike anything we have seen, it should come as no surprise that the recovery has also been unlike any other. With tremendous amounts of fiscal stimulus being pumped into the economy, consumer spending has been a major driver of activity. Combine that with the vaccination effort, the backdrop we started the quarter with was expectations of a strong recovery including higher yields and higher inflation. Later in this section we will show how this actually played out.
If you have been a regular reader of this quarterly piece, you know that inflation is something we have been talking about for a while now. Well, apparently we aren’t the only ones. The word ‘inflation’ seemed to be the only thing being discussed during the quarter. Here is a fun fact: per Bloomberg, journalists delivered over 100,000 stories on inflation in just May alone (around double the average number of inflation-related stories in previous years). With all these stories on inflation, we have to ask ourselves whether they are just fanning the flames or whether the concern is really warranted.
Let’s take a step back for a second and realize that when people refer to high inflation, they are often referring to 1970’s style inflation, when it reached levels in the teens. However, looking at Exhibit 1, the reality is we need to go back to the 1990s to see inflation near or above 3% with any consistency.
Source: Payden & Rygel, Bureau of Labor Statistics
So what is all the fuss about? Well, back in April, the March CPI figures showed significant year-over-year increases. But remember, this was not terribly surprising as we were dealing with multiple factors including the base effect (last year’s numbers were low due to the shutdown) and strong consumer demand as the economy slowly reopened. The Fed quickly labeled the increase as transitory, or temporary, and stated they were more focused on inflation readings later in the year when the base effect would be more muted, and repeated they wanted to see “substantial further progress” toward their stated goals of maximum employment and 2% average inflation before they started to reduce their bond purchases, also known as tapering, which would likely precede any increase in short term rates.
Fast forward to May and CPI’s headline year-over-year reading (4.2%) was the highest since 2008. The Fed provided a similar response to the one they had the previous month.
And finally, in June, we learned headline inflation rose by 5% year-over-year for May. While these figures were widely expected, the Fed finally stated they were open to “talking about talking about tapering” with the likelihood their goals would be met sooner than previously expected, a clear change in tone from previous months. This was welcome news which the market took as a signal that the Fed was closely watching inflation figures and wouldn’t let them get out of control. As a result, longer term yields began to fall through the rest of the month while short term rates rose, with the expectation that the Fed would increase rates sooner than previously expected.
In the end, 10-year breakeven inflation expectations (Exhibit 2) ended the quarter (2.32%) just slightly below where they started the quarter (2.37%). Given the Fed is looking for average inflation of 2%, these expectations are not unreasonable.
Source: YCharts 10 Year TIPS/Treasury Breakeven Rate
Source: Federal Reserve, based on projections of 17 officials in 4Q 2020 and 18 in 1Q and 2Q 2021
At the same time, Fed officials have signaled they expect to increase short term rates sooner than they were suggesting even just last quarter (Exhibit 3).
One main question is where we go from here. Did inflation really peak in May or is this just the calm before the storm? Remember, the Fed has stated many times that they believe the current inflation is transitory, or temporary, and that we will see signs of more normal inflation towards the end of the year. The next question is what happens if inflation isn’t transitory? What if demand or wage growth continues to drive inflation up? Inflationary psychology can become a self-fulfilling prophecy, because, at least in part, as consumers spend more on goods they expect to be more expensive in the future, the speed in which money changes hand (i.e. velocity of money) increases, further boosting inflation.
U.S. equities have now put two consecutive strong quarters together to start 2021. For the quarter, small cap growth had the lowest returns gaining 3.9% while large cap growth led the way earning 11.9%. Overall, large cap US equities outperformed their small cap counterparts. Even in large growth, April and June were both strong (6.8% and 6.3% respectively) while May saw negative returns (-1.4%).
While large cap growth was the leader for the quarter, small cap value (26.7%) is still well ahead of other US equity benchmarks year-to-date.
With the rally that has taken place in indexes like the S&P 500 over the last several years, the concern has been, at least in part, that there were only a handful of stocks that were driving the market upward. These stocks are affectionately known as FAANGM (Facebook, Apple, Amazon, Netflix, Google (now known as Alphabet) and Microsoft). A positive sign for this year is that it the other stocks in the S&P have also been supporting the market’s upward trajectory. This is positive news because a market rally is often considered to be stronger when more stocks participate. Exhibit 4 show the year-to-date return of an equal weighted version of the S&P 500 vs. a traditional market cap weighted version; the better performance of the equal-weighted index implies that there were stronger performers with lower market capitalizations than the FAANGMs.
Source: Morningstar, as of June 30, 2021, ETF tickers used were VOO and RSP, past performance is not indicative of future results
Similarly, while investors often focus on US large cap stocks, we wanted to provide some perspective on US small cap stocks as well. Exhibit 5 shows how small cap stocks, which tend to be more cyclical vs. their large cap counterparts, have actually rebounded more strongly for the 12-month periods following major recent recessions.
Source: JP Morgan Asset Management, The S&P 500 is used for large cap, Russell 2000 for small cap. Market drawdowns during the Tech Bubble, Global Financial Crisis and Covid-19 were calculated for the periods 3/24/00-10/9/02, 10/9/07-3/9/09, 2/19/20-3/23/20.
From an S&P sector perspective, ten of the eleven sectors were positive for Q2 2021 (only utilities were slightly negative) with four generating 10%+ returns. Exhibit 6 shows the quarterly and year-to-date returns for each S&P 500 sector. As you can see, sectors that were hardest hit during the Covid shutdown (energy, financials, real estate) are the best performing sectors so far in 2021.
As we like take a balanced approach to writing this quarterly commentary, we thought it was important to point out that the current year-to-date US equity returns are generally well above what we might expect for an entire year. And while a continued upward trajectory is certainly possible, it is normal for there to be at least one intra-year decline. Investors should make sure they manage their expectations.
Developed large cap, small cap and emerging market stocks all performed within a relatively tight range for the quarter, roughly around 4-5%. Year-to-date returns are also quite positive, gaining roughly between 7-9%. Frontier markets gained 14.1% for the quarter, most of its 15% year-to-date gain.
While these outcomes are positive, they are still mainly below that of their US counterparts. At the same time, there are some positives for non-US equities. For one, if you believe that valuations still matter (we do), the current valuations for Europe and Japan remain below their US counterparts. Plus, as the levels of immunization across the globe begin to catch up to the US, the governments will be happy to loosen Covid-related restrictions, supporting the case for a post-pandemic economic recovery.
From a country perspective, some of the countries with the largest weight in the MSCI EAFE index (Japan, UK, Germany) underperformed the US on a relative basis while others outperformed (Switzerland, France).
In the emerging markets, China remains the largest country exposure (37.5% of MSCI EM Index as of 6/30/21) but returned only 2.4% for the quarter. Other countries with large exposures in emerging market indexes performed better, including Taiwan (8.3%) and India (8.0%). Brazil (23.6%) and Poland (19.5%) led the way in emerging markets while Peru (-9.1%) and Chile (-13.6%) lagged.
Global REITs, as represented by the Dow Jones Global Select REIT, generated a 10.2% return for the quarter (outpacing Q1’s return of 7.7%), with U.S. REITs (11.8%) outperforming non-U.S. REITS (6.9%). Over the last 12 months, global REITS have bounced back by 37.6%.
On a YTD basis, self storage (36.4%), retail (32.8%) and specialty (28.0%) REITS were the top performing sectors of the FTSE NAREIT All Equity REIT index. Even the much-maligned office space sector has gained 15.1% over the first six months of the year. What makes the office space so interesting is that the easy narrative is that more companies will require fewer employees to come back to the office full time, which you would think would negatively impact office REITs. However, what if that narrative is incorrect? Some economists are suggesting the office sector may be ok, simply because employees who come back to the office may expect more space, so the lower density of people in an area may actually create the need for a similar amount of space. Clearly we will learn more as companies start to bring employees back to the office later this year.
Global Fixed Income
In a bit of a surprise from where we started the quarter, the yield curve actually flattened during Q2 with short term yields slightly increasing and intermediate/longer term yields declining (Exhibit 7).
The flattening yield curve was largely a result of changes in Fed policy expectations. Specifically, during their mid-June meeting, Fed officials suggested they expect to increase interest rates by late 2023, which is sooner than they had stated back in March. This change in expected policy pushed short term rates higher towards the end of June (but really only by a few basis points), reflecting the idea the Fed would start raising short term rates from their current near zero levels. Of course, this means the Fed will probably start tapering their bond purchases as well, which is a likely precursor to actually raising rates.
On the intermediate/long end, yields came down, pushing up prices. Yields declined as expectations for more fiscal and monetary stimulus also fell. Plus, the Fed’s statement reflects their willingness to not let inflation really get out of control, which is also a positive sign.
Overall, all fixed income indexes shown were positive for the quarter with corporates outpacing their Treasury counterparts. On a YTD basis, fixed income indexes were generally flat to negative as the flattening of the yield curve mostly occurred from mid-June through the end of the month. Highlighting investors inflation fears, short term TIPS has been the best performer on a YTD and last 12-month basis.
As we discussed in previous quarters, in order to generate more return, investors need to assume more risk. In fixed income, that means either extending duration or lowering credit quality. There are tradeoffs that have to be weighed very carefully before implementing either strategy. From a duration standpoint, extending duration too far out can be a risky move in a period of rising rates. Similarly, lowering credit quality means investing in high yield, or junk bonds, which generally correlate much more with equities and therefore don’t provide the diversification benefits we expect from fixed income.
Municipals generally underperformed corporate bonds for the quarter but have outpaced them on a year-to-date basis.
We continue to view fixed income as a method of reducing overall portfolio risk (as measured by standard deviation), given that equities are expected to have much higher volatility. Our portfolio’s focus will continue to be on high quality bonds with an emphasis on short to intermediate duration government and corporate bonds, where default risk has historically been relatively low. For some investors, muni bonds are attractive for their tax-free income.
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