With the summer in full swing, we’ve closed the book on the first half of 2021. It was a strong start for the economy and the stock market, but the investment landscape is changing as the recovery has transitioned into expansion.
Last week offered a bit of everything for investors, from labor market readings to Federal Reserve minutes to rising uncertainties around COVID variants and their implications for global growth. Stocks logged another solid week, touching new highs. But the headliner was the move in interest rates, which have pulled back notably from their highs earlier this year.
Here’s a look at how the year started and our views on what lies ahead:
Economy: The Rebound Rolls On
How It Started:
Employment conditions continue to heal, but the pace of improvement has stalled recently, as shown by last week’s uptick in initial jobless claims. New jobless claims have been cut by more than half since the start of the year but are still more than 80% above pre-pandemic levels.
After falling from 14.8% to 6.1% between April 2020 and April 2021, the unemployment rate has ticked down just slightly in recent months1. This reflects decent job growth but a mismatch between the supply of and demand for workers.
GDP has recovered pandemic losses in record time, with first-half output rising at the fastest clip in 80 years.
How It’s Going: Source: U.S. Department of Labor
We expect the labor market to regain some momentum in the second half. Back-to-school season, expiring extended unemployment benefits and rising wages should impact the labor shortage.
We think job growth should accelerate and the unemployment rate should fall from here. This, combined with elevated household savings, should provide the octane for above-average consumer spending growth, which we believe will power an extended economic expansion.
Quarterly GDP growth rates may have peaked in the first half of the year. But U.S. GDP growth should remain historically strong in the second half, with expectations for roughly 6% growth in the next two quarters. The emergence of COVID variants threatens to delay what we expect to be a period of catch-up for the global economy. But we still anticipate global GDP to accelerate later this year as restriction headwinds begin to fade in Europe. A surprise policy move in China last week to increase monetary stimulus suggests the world’s second-largest economy may also benefit from central bank tailwinds.
Inflation: Not the 1970s but Not Going Away
How It Started: Source: Bloomberg
The markets focused on rising inflation earlier this year, with consumer prices rising at the fastest rate in three decades1.
Inflation has spiked amid a surge in consumer demand that outpaced supply. We saw supply chain disruptions and labor shortages, sharp increases in commodity prices such as lumber, and the base effects of year-on-year comparisons to the depths of the shutdown.
The Fed has maintained its view that this jump in inflation will be temporary, reiterating its commitment to keeping stimulus in place to support an enduring economic rebound.
How It’s Going: Weekly Wrap July 9 Chart 4 Source: Bloomberg
We don’t think inflation is headed back to the runaway levels of the late ‘70s, nor do we think we’ll return to the consumer price regime of the last expansion. In the 2010s, inflation failed to rise to the Fed’s 2% target1.
We do think a good portion of this spike in inflation will prove temporary. The pullback in commodity prices, strong manufacturing activity, global supply chains rebooting, a reopened services sector and the passing of the base effects will, in our view, help rein in inflation. But we expect it to settle in at a higher level moving forward.
Real rates (nominal 10-year rates minus inflation) are still deeply in negative territory, signaling to us that the market is complacent about the prospects of higher-than-expected inflation ahead. We don’t think inflation will be sustained at levels that would require the Fed to quickly tighten the policy screws. But with real rates signaling a sanguine attitude toward lingering inflation pressures, this suggests potential knee-jerk reactions to consumer price readings in the second half.
Interest Rates: Pullback Doesn’t Look Permanent
How It Started: Weekly Wrap July 9 Chart 5
Source: Bloomberg, past performance does not guarantee future results.
Interest rates didn’t quite come full circle in the first half, but the moves were noteworthy. After beginning the year below 1% for the first time in history, 10-year yields rose sharply to near 1.75% in March1. Since then, rates have trended lower, including a drop last week that saw yields fall below 1.25%1.
Rising rates in the first quarter were a function of increasing inflation worries and concerns the Fed would have to ratchet down stimulus sooner than expected. The more recent pullback in yields has stemmed from fears the global recovery will be derailed by the ongoing pandemic. News last week that Japan has declared a state of emergency and rising cases of the Delta variant added to the dip in rates.
How It’s Going: Source: Bloomberg, past performance does not guarantee future results.
We don’t think we’ve seen the last of rising rates this year. We don’t anticipate a sharp jump in yields, but we do think longer-term rates will finish the year higher than they are now. U.S. economic growth should remain strong, and we think the global recovery is delayed, not derailed.
We expect the yield curve to steepen as we advance. The Fed is likely to begin laying out a timeline in the coming months for tapering its bond purchases (stimulus) next year. This should release a bit of pressure on longer-term rates, but we doubt the Fed will hike its policy rate until 2023, meaning the yield curve could steepen. Currently, the spread between 10-year rates and 3-month rates is half of where it peaked during the expansions of the last three decades1. Traditionally, equities have performed well during steepening periods.
Even if rates rise from current levels, it should not be lost that yields remain near historic lows. We think there is plenty of room for rates to rise before they begin to undermine the economic expansion or bull market. Further, we think any increase in long-term rates will be more gradual than sharp, which in our view should help prevent dramatic volatility in the fixed-income markets.
Equities: Bull Market Has Legs but Likely to Stumble
How It Started: Source: Bloomberg, past performance is not a guarantee of future results.
U.S. large-cap equities posted a strong start to the year, logging the 10th-best first half in the last 40 years. U.S. small-caps did even better amid historic GDP growth. International equities delivered solid gains (+9% for developed market large-caps and +6% for emerging markets) but trailed due to lagging economic rebounds overseas1.
Volatility remained low, with just two 4% pullbacks. An accommodative Fed, encouraging economic readings and healthy corporate earnings provided a sturdy foundation for sizable upside and limited downside for equities1.
How It’s Going: Source: Bloomberg, past performance is not a guarantee of future results.
We expect equity markets to endure more volatility in the second half than they did in the first. We suspect the prospects of reduced Fed stimulus will be a primary catalyst for bouts of anxiety in the markets. But with plenty of life left in this economic expansion, we believe 5%-10% market pullbacks can be viewed as buying or rebalancing opportunities. Since 1990, U.S. large-cap equities have averaged a total return of 18.1% during the two years preceding the Fed’s initial rate hike1. U.S. equities outperformed bonds by an average of nearly 6% during those periods1.
We think there is still upside, but we expect more modest stock market gains ahead. Since 1980, when the S&P 500 gained 15% or more in the first six months of the calendar year, the second-half return averaged 5.7%1.
Corporate earnings are expected to rise more than 30% in 2021. This should help alleviate current elevated valuations while still supporting stock market gains. Over the past 40 years, periods of accelerating earnings have often seen outperformance from value investments, which are linked to economic momentum. We suspect the market may churn a bit under the surface as we advance, with declines in interest rates and worries over the speed of the economic expansion helping growth and defensive stocks. The pendulum swing back toward optimism will, in our view, favor value and cyclicals.
Source: 1. Bloomberg
