June 15, 2021
Global stock markets advanced during the second quarter of 2021 as the global economy continued its re-opening in the wake of vaccinations against COVID. The relative stock market performance for the major economies was correlated to their population vaccination rates. The U.S. led with over 65% of the adult population fully vaccinated by the end of June. The vaccination rate was slower in Europe, but the pace picked up by quarter’s end. The Far East and Australia lagged. During April and May, cyclical stocks benefitting from the re-opening led, as had been the case since September of 2020. In June, there was a reversion back to growth areas such as technology. The growing level of COVID mutations and communication of the Federal Reserve led to some questioning in the pace of recovery and sustained inflation. The U.S. market recaptured its long-term record of outperformance during the second quarter:
Strong economic recovery is expected to continue in the U.S. during the remainder of 2021, extending into the following year. The recovery is reflected in favorable trends in consumption, capital spending, and employment. This pattern is likely to be reflected in solid gains in corporate earnings, which will provide a catalyst for higher share prices. Highly stimulative monetary policy will also remain through quantitative easing at an unprecedented pace and short-term interest rates held at zero. Fiscal policy also remains stimulative due to the multiple anti-COVID relief programs enacted since last year the favorable prospects for enacting additional programs to increase spending on physical and human infrastructure.
Higher rates of inflation are accompanying the recovery. In addition to rising raw material prices, this acceleration shows up in wage gains, particularly for lower-paying positions in hospitality and restaurants. The critical question is whether accelerating inflation is a temporary phenomenon or will become endemic. Between policy meetings and statements by Federal Reserve governors, there is increased discussion over when to begin to taper the pace of quantitative easing through the gradual reduction in the level of bond purchases. These discussions seem to be easing fears that the Federal Reserve will allow inflation to become entrenched before acting, reducing the potential for an abrupt tightening of monetary policy, which would jeopardize the overall economic recovery. Long-term yields have actually declined in recent months, reflecting an easing of concerns over inflation. We remain optimistic that the bond market perception of an easing inflation threat will prove correct, enhancing the prospects for an extended period of economic growth in the U.S. in the coming years. This favorable trend should support higher share prices, focusing on the shares of companies that can deliver in terms of top and bottom-line results.
For this first time in at least fifteen years, labor shortage and associated wage inflation is a significant concern of corporations, particularly in the Travel & Leisure, and Manufacturing industries:
Outside of the U.S., economic recovery should accelerate overall in the coming quarters as COVID vaccination rates pick up. Europe trails the U.S. by several months. Even with the emergence of new COVID variants, the European economies should gradually re-open during the second half of 2021, resulting in a solid economic growth rebound. The pace of a rebound is slower in Asia and Australia as countries in these regions were slow to begin aggressive vaccination programs. This situation is evident in Japan, where the Olympics will be held without spectators in late July and August. Eventually, economies in Asia will exhibit the type of rebound observed in the U.S. Even in India, which was the country hardest hit by COVID, industrial production in May recovered by over 29%. With equities outside the U.S. lagging, we are evaluating opportunities in companies where fundamentals will strengthen, and share prices appear undervalued in terms of longer-term potential.
Within the upward trend of the global stock markets over the past several quarters, sector and style leadership has been “dizzying” day-to-day. There has been a tug-of-war between Small, Cyclical, and Value stocks vs. Large and Secular Growth stocks driven primarily by macroeconomic factors. Faster economic growth, higher inflation, and higher interest rates favor “Value,” while economic uncertainty, lower inflation, lower interest rates favor “Growth.” Since mid-May, Large Growth stocks have decisively led due to the rise of COVID-19 mutations and the Fed’s more vigilant stance on near-term inflation:
We believe the recent “subsurface” volatility reinforces the importance of having a diversified portfolio. We are focused on beneficiaries of the economic re-opening for new portfolio additions, particularly beneficiaries of pent-up consumer spending, recovering employment, and infrastructure capital spending. We also favor companies that have increased productivity during the pandemic and can manage inflation risks. We are less focused on macroeconomic-based trades and dramatic style and sector shifts, and maintain a quality, multi-year focus for all new investments and current holdings.
It appears the global stock market has entered the next phase of the post-recession bull market. The first phase was characterized by a rapid recovery with higher valuation multiples, where resilient investor market participation was critical. Future market returns will be driven by earnings growth and cash returns to shareholders, while equity valuations are unlikely to push higher.
Accommodative monetary policy (low yields) supports current equity valuations, but stocks are fairly valued at best.
Source: Bernstein Research
Dividend growth remains a high-conviction trait for our stock holdings and new additions. Across corporations, there have been numerous dividend cuts and many significant increases since the pandemic commenced. We are focusing on notable dividend increases believing they signal management’s confidence in their companies’ prospects. Also, long-term empirical data indicates dividend growers have outperformed with lower risk. In the current market phase, dividend income is likely to be a more essential component of stocks’ total return:
During the second quarter, the differential between short and longer-term interest rates narrowed (or the curve flattened). The yield on two-year U.S. treasury obligations increased from 0.16% as of March 31 to 0.25% during the three months ended June 30. In contrast, the yield on thirty-year Treasuries declined from 2.41% to 2.08% during the quarter, ten-year from 1.74% to 1.47%, and seven-year Treasuries from 1.42% to 1.24%. The decline reflects an easing of concerns that the Federal Reserve will allow inflationary expectations to become deep-seated, necessitating a more abrupt reversal of the highly stimulative policies which have been carried out since last March in response to COVID.
Even with this increased optimism over inflation risks, current interest rate levels fail to compensate investors for inflation levels that remain low by historical standards. As reflected by rates on inflation-adjusted securities, an inflation rate in the 2.0% to 2.5% range seems likely to prevail in the future, and yields on longer-term Treasuries provide no premium over this expected pace. The differential in yields between Treasuries and Corporates, both investment grade and high yield, is a historic low. At the same time, the potential return on tax-exempt securities across the quality spectrum seems unattractive as well. Given this assessment, we continue to prefer short duration in our taxable and tax-exempt fixed income portfolios, awaiting more attractive yields before beginning to extend maturities.
A “traditional” bond portfolio with extended maturities and duration has significant price risk to increasing interest rates. Hence our preference for “short” fixed income holdings, including a higher than typical allocation to cash and equivalents:
Princeton Global Asset Management, LLC
This report is for informational purposes only and contains data based on information from Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data.
Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security.
It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.