As we head into June, it’s an opportune time to take stock of the market’s big picture themes. We’ll be at the 2021 halfway point before we know it, so here’s a quick update on the big market drivers so far this year, as well as what I’m watching as we move into the summer and the back-half of the year.
Several months ago, we started drawing attention to the fact that the year-over-year comparisons for economic data and corporate earnings would hit their low point (easiest-to-beat) in the second quarter of 2021. That was largely due to the "basing effects" of the 2020 shutdowns that created incredibly low starting comparisons in April, May, and June of 2020. The timing of the U.S. vaccine rollout this year furthered those expectations of a big re-opening recovery.
Sure enough, the second quarter opened with a series of explosive economic growth and corporate earnings reports. Economic growth data, inflation, and corporate earnings have all shown strong growth in the April and May data. That strength is just starting to dissipate a bit now, but overall conditions seem likely to remain strong through the end of the quarter.
Expectations game
However, just as it was easy to forecast these "easy comparisons" for Q2, it’s also been easy to see that the second half of 2021 will be more challenging in terms of economic data and corporate earning comparisons. The Citigroup "Economic Surprise" index, which measures the degree to which economic data is exceeding forecasters’ expectations, has been in steady decline for a year now and has leveled off at close to zero. That doesn’t mean the data isn’t strong, but simply that it is no longer catching experts by surprise. The data is now coming in largely as expected, with a few disappointments mixed in (like the last jobs number).
As investors, economic and earnings data is always interpreted through this "versus expectations" lens because the markets are always looking ahead to the future. A report that economic growth (GDP) increased 4% over the past year is going to be met with a totally different market reaction if forecasters were expecting 2% than if they were expecting 6%. Same number, totally different implications.
That setup for tougher comps in the second half of this year, plus the fact that markets are always trying to anticipate changes to the investing landscape in advance, are why I’ve been 1) quite optimistic about the markets so far this year, and 2) somewhat leery as we looked ahead to the summer and fall. With valuations at historically extreme levels, the idea of economic and earnings numbers starting to surprise by coming in weaker than expected, or even just appearing weak relative to the incredibly strong Q2 numbers, seemed like a recipe for a pullback or correction.
Interest rates hold the key
I still think some sort of pull-back/correction later this summer or fall is reasonably likely, though I’m less concerned about it than I was earlier in the year.
What changed? The biggest thing was the benign reaction of interest rates to the huge inflation numbers released a few weeks ago. The April inflation data came in way hotter than expected but the bond market didn’t react at all — interest rates actually fell modestly in the days/weeks that followed. That’s exactly the opposite reaction interest rates had to increasing inflation concerns during the first quarter of this year. In the first quarter, rates spiked higher. But this time around, pfffft.
This has a couple of important implications. One, it seems pretty clear that the bond market is taking a wait-and-see attitude regarding inflation. Bond investors are, at least for now, willing to let this inflation story play out before pushing bond yields higher. That’s consistent with the message the bond market has been sending for some time via "break-even yields" that measure inflation expectations at various intervals into the future. After a modest increase in inflation expectations in the short term, these break-evens have consistently receded as one looks further into the future. In other words, the bond market has been agreeing with the Federal Reserve that the most likely course is to have a relatively brief bump in inflation, followed by it dissipating and inflation returning to low levels as we move out to longer (5-year or 10-year) forecast periods.
Now, of course, this doesn’t mean that’s how events will actually play out. But those expectations are important because the level of interest rates is very important to the whole spectrum of investment options. If inflation proves to not be as "transitory" as expected, this dynamic could shift. (That would be another risk to stock prices as we move through the 3rd and 4th quarters of this year.)
The second implication of these mild bond yields is markets have recently been enjoying the best of all worlds — high growth with low rates. It’s hard to imagine a better investing environment than what we’ve had lately, with economic growth booming yet bond yields remaining ridiculously low. Those two things don’t usually go together. Layer on the incredible stimulus coming from the government (as well as the continued support from the Federal Reserve) and this has been one of the most supportive investing environments imaginable (which is why stocks continue to set new highs as we hit the 15th month of this recovery).
More specific to my thinking, rising interest rates hurt riskier assets badly in February/March. When rates failed to respond to the surging inflation data in May, some of those riskier growth stocks started to bounce back. Value stocks (led by financials and resource companies) have stayed hot, but now growth stocks have started contributing gains again as well. I assumed that interest rates would continue rising in the face of strong inflation data and those higher rates would eventually threaten the broader market. That could still happen, but obviously, that narrative seems less potent now than it did during the first quarter when rising rates were already punishing growth stocks significantly.
It doesn’t usually pay to be pessimistic in a "goldilocks" market environment like this. Hopefully, SMI’s process has given you the confidence to stick with your plan and reap the benefits of these rising markets.
Those second-half dynamics are still looming and market conditions could change as we move through the summer. Interest rates are usually at the heart of most bull -> bear market transitions, so if we see rates starting to react again and move higher, that will be a warning sign. But I suspect the next surprise the market serves up might be to remind skittish investors how strong returns can remain for as long as the market stays in this sweet spot of high growth with low rates. We’ll enjoy it however long it lasts.
