Domestic stocks closed out the first half of the year with strong gains. The S&P 500 index return was 8.6% during the second quarter and 14.4% year to date. It was the 5th consecutive quarter the index returned at least 5%, a rare and remarkable performance by historical reference.
Coincidentally, the last time the index performed this consistently well was the five quarters immediately following Jack’s birthday in August 1953 (Q4-1953 through Q4-1954). Since the pandemic low in March 2020, the S&P 500 index is up 92%.
Following these strong gains, what should we expect for the remainder of the year?
Although we will not know the answer without the benefit of hindsight, there are a few pros and cons to consider.
Since 1945, the S&P 500 index has returned 10% or better in the first half of the year 23 times. In the 22 occurrences prior to 2021, the median second half return was an additional 10% return with gains over 80% of the time. Historically, the trend is our friend.
Factors supporting continued optimism for the domestic equity market include:
- Very high levels of household liquidity and consumer spending from expanded unemployment and economic impact payments;
- Strong consumer demand and surging capital expenditures have been very positive for domestic manufacturers, including the ability to pass through price increases;
- Highly accommodative monetary policy, with short term interest rates near zero and suppressed long term rates near historical lows; and,
- Recent inflation of ~6% has probably peaked and will likely recede later this year as the economy and supply chains normalize.
Factors supporting cautious pessimism for the domestic equity market include:
- The market is “top heavy” with mega cap technology stocks;
- Labor shortages are impeding economic growth, contributing to higher inflation;
- The economy is growing, but momentum is declining;
- Investor sentiment is very bullish, which historically is a contrarian indicator and precedes lower returns;
- There is potential for tax reform, including increases to US corporate tax rates and an international minimum effective tax rate, which could adversely impact future earnings; and,
- There is potential for a Federal Open Market Committee (‘Fed’) policy error, either tightening too soon and reducing economic growth or too late and risking higher inflation.
It is difficult to assign a probability to any one of these individual factors. In our view however, they seem somewhat balanced in the aggregate. Earnings need to continue to grow and interest rates need to remain low in order to justify valuations. Longer term, higher inflation, corporate taxes and wage pressures could each be headwinds to earnings and future market gains.
Of all the factors concerning today’s domestic markets, the risk of a monetary policy mistake is a relevant topic for discussion. The Fed controls monetary policy by a dual mandate:
- Maximize sustainable employment (4.1% unemployment rate target)
- Maintain price stability (2% inflation target) over the long run
These goals often conflict with each other, and with inflation and unemployment both currently about 6%, the Fed’s choices are to tighten monetary policy (raise rates) to address high inflation to the detriment of employment, or ease monetary policy (lower rates) to promote employment to the detriment of price stability.
It is noteworthy that aggressive Fed policy was a contributing factor in 6 of the last 13 domestic equity bear markets (2007, 1980, 1968, 1966, 1956 and 1937). We are glad thus far they have erred on the side of easy policy, but the Fed stance has not been without consequence.
If we wind the clock back to before the onset of the pandemic recession, inflation had been stubbornly low for over a decade. Since then, inflation signals have heated up significantly as a surge in consumer spending collided with supply and labor shortages across major sectors of the economy. Meanwhile, the Fed has been consistent in its message that it regards near-term spikes in inflation as transitory. However, after years of dormant inflation, a powerful economic rebound coupled with rising wages could put the Fed’s new framework to the test.
In response to the pandemic recession, the Fed has been buying an extraordinary amount of bonds to suppress interest rates. In theory, at some point in time the Fed will have to cease buying bonds and reduce its holdings. This situation creates an inherent conflict due to its dual mandate. Federal Reserve Bank Credit, or interest bearing assets controlled by the Fed, reached $8 trillion last month, up 9.5% year-to-date and 96% from March 2020.
In spite of 6% GDP growth, commodity shortages, housing price inflation, labor shortages and rising wages, the Fed is continuing to buy $120 billion of securities each month ($1.44 trillion annually), effectively favoring employment and ignoring rising inflation. Bond purchases by the Fed last fiscal year indirectly financed the entire growth of the federal deficit. Prior to the financial crisis in 2008, the Fed’s balance sheet was $870 billion.
Concurrently, tight labor markets and difficult hiring conditions create additional incentives for companies to invest in capital assets to automate business processes and reduce the need for employees. There’s a wide expectation that labor markets will “normalize” later this year. If it does not, more companies will invest in equipment, build out their technical automation capacity and operate with fewer, higher skilled, employees, further complicating the Fed mandate on employment.
The degree to which transitory factors—generous unemployment benefits, child-care issues, Covid-19 concerns and supply chain disruptions — are driving up costs temporarily or more structurally won’t be clear for months to come.
While about two dozen states either started cutting or are about to cut the extra $300 a week in unemployment insurance ahead of the federal program’s Sept. 6 expiration, the labor participation rate is considerably below its pre-pandemic level in spite of a large number of job openings and higher wages. As noted in the above chart, labor force participation has not recovered and is contributing to the current 5.9% unemployment rate.
So as we head into the second half of the year and contemplate what might go wrong with monetary policy, there are a few questions on our minds.
- Is the recent acceleration in inflation transitory, or the start of a longer-term trend that might force the Fed to accelerate its pace of interest-rate increases?
- Is monetary policy an effective method for reaching sustainable maximum employment, or is fiscal policy more effective?
- If the Fed continues to buy bonds, will interest rates remain low? If the Fed stops buying bonds, will interest rates rise?
- Can the government afford higher interest rates with the amount of outstanding debt?
Conversely, it is just as important to consider what could go right. The U.S. has the largest and strongest economy in the world, and it would be a mistake for long term investors to be pessimistic about our future.
Shifting to capital markets abroad, international equity returns have also been strong on an absolute basis. Emerging market and developed international equity returns during the second quarter were +5.1% and +5.2%, respectively, and +7.5% and +8.8%, respectively, year to date. As noted in the following chart, international equities are valued at approximately the same level as in 2008 and at a considerable discount to domestic equities.
There are a few issues that explain some of the performance and valuation differences. The growth of the internet and online commerce during the last decade has been more favorable to U.S. companies. Technology companies account for 22% of the domestic equity market, which is double the exposure compared to international markets. The chart is also price return only and excludes dividends, which are 1.2% higher for international equities. In addition, the euro zone struggled with its sovereign debt crisis for much of the last decade and was not as aggressive as the U.S. in providing economic support during the global pandemic.
International stocks offer both cyclical and long term opportunities. Vaccination progress is gaining momentum in the rest of the world and lower trade tensions should contribute to a global post-pandemic economic rebound. In addition, secular market cycles have persisted between domestic and international equities. The current cycle is the longest and strongest U.S. dominant cycle in 50 years. At some point, the tide will likely turn.
Our final chart below illustrates a traditional portfolio allocating 60% to domestic stocks (S&P 500 Index) and 40% to domestic bonds (Barclay’s U.S. Aggregate Bond Index). The long term average return of this hypothetical portfolio is 6.2%. Using the current forward earnings yield of the S&P 500 index and the current yield of the Barclay’s U.S. Aggregate Bond Index, the expected return for this portfolio is 3.2%, the lowest level in our data set since 1985. Consequently, it is reasonable to expect very modest returns from these broad asset classes going forward.
When interest rates are near zero and equity prices are elevated, disciplined investing is very important. We continue to have high conviction that globally diversified multiple asset class portfolios are the best method for managing risk in pursuit of investment objectives. There are also specific merits and limitations to both index based investing and active investing at this stage of the market cycle. Related to this matter, we are tilting portfolios towards foreign equities and other diversifying investments.
We are grateful for your trust and confidence. If you would like to review your financial plan or investment portfolio please do not hesitate to reach out to us. We welcome your questions and will be responsive.
The JRM Investment Counsel Team
Jack, Phil and Lauren