Diversified portfolios generated solid gains in the second quarter as the stock market rally continued and bond prices rose. The gains in asset prices were unusually broad-based – in addition to rising stock and bond prices, home prices continued to register strong gains and commodities, including oil, grains, industrial metals, and gold, all logged price gains during the quarter.
U.S. stocks posted another strong quarter – the S&P 500 Index1 representing large company stocks returned 8.6% while the Russell 2000 Index2 of small company stocks gained 4.3%. Within the S&P 500, Real Estate and Information Technology were the best-performing sectors, and all but one (Utilities) of the eleven sectors generated positive returns.
Foreign stocks also recorded strong gains during the quarter – the MSCI ACWI ex-US Index3 representing developed country and emerging market stocks returned 5.5%. Most major countries’ stock markets generated positive returns, and aggregate returns were similar between developed and emerging markets.
U.S. bond returns were also positive in the second quarter. Yields of intermediate and longer-term bonds declined, reversing the trend of rising yields in the first quarter. The yield of the benchmark 10-year Treasury note declined from 1.74% to 1.47% as of the end of June. The Barclays Aggregate Bond Index4 returned 1.8% during the second quarter, offsetting some of its losses in the first quarter and ending the first half of the year down 1.6%.
Support for Asset Prices
Stocks and other “risk” assets, such as real estate and commodities, benefitted from a confluence of factors in the second quarter. On the economic front, published data reflected strong U.S. growth, as higher COVID-19 vaccination rates unleashed pent-up demand for activities and services. The U.S. economy grew at a 6.4% annualized rate in the first three months of the year, and economists are forecasting second quarter growth in the 9% – 10% range.5 Outside of the U.S., many foreign economies also benefitted from higher vaccination rates and the further lifting of restrictions.
Asset prices were also buoyed by the Federal Reserve’s ongoing zero interest rate policy (ZIRP) and its continued purchase of substantial amounts of U.S. Treasury and mortgage-backed bonds.6 The Fed’s policies are designed, in part, to raise asset prices by lowering borrowing rates and reducing the incentive to hold cash. While one can debate the overall soundness of this approach, it is clear that the Fed has been successful in its narrow goal of raising asset prices. Some members of the Fed made rumblings during the quarter of slightly modifying their current policies, but investors concluded that the Fed is unlikely to make substantive changes anytime soon.
Another likely driver of asset price gains during the quarter was investor optimism. Overall investor sentiment cannot be measured precisely but there are some useful indicators. The American Association of Individual Investors (AAII) has published a weekly survey of investor sentiment for the past 34 years, and its recent survey results suggest investors are optimistic, although not wildly so. Considering survey results during the second quarter, 44% of respondents expected the stock market to rise over the subsequent six months compared with an average of 38% over the survey’s history.7 An alternative measure of investor sentiment, margin debt outstanding, continued to reach record levels8 during the quarter.
Strange Times in the Bond Market
It is fairly easy to identify plausible explanations for the gains in risk assets such as stocks and real estate in the second quarter, but the explanation for the gains in bonds is not nearly as straightforward given the news on the inflation front.
Consumer prices in the U.S. were suppressed last year by the COVID-19-induced contraction in global economic activity; for calendar year 2020, the Consumer Price Index (CPI) rose just 1.4%. Entering this year, some increase in inflation was expected given the price distortions created by COVID-19 and expectations of stronger economic growth. That said, few forecasters predicted that the headline CPI rate would reach the 5% level recorded in May and that the core CPI rate, excluding the more volatile food and energy categories, would reach 3.8%, its highest rate in nearly 29 years.9
Among investors, inflation is considered the enemy of bonds. Higher inflation typically causes bond prices to decline since inflation erodes the current value of the future fixed payments (interest payments and principal) that bonds provide. So why didn’t bond prices decline in the second quarter in the face of the high inflation readings?
The primary reason is that investors and the Federal Reserve believe that the higher inflation rates recorded this spring will subside as the year progresses; in other words, that the current high inflation rates will turn out to be transitory. There are good reasons to support this optimistic assessment. For one, the recent spike in inflation was driven partly by comparisons with the same time last year when price levels were suppressed by the pandemic. As an example, the price of oil plunged from $61 per barrel at the beginning of 2020 to below $9 per barrel10 in April of last year before turning higher. As we proceed through 2021, the effect of these distorted price comparisons on the inflation rate will dissipate.
However, a return to pre-Covid inflation levels in the 2% range11 is no sure thing. Other factors could contribute to continued price pressures and higher-than-expected inflation later this year and into 2022. For example, many employers are encountering difficulty hiring qualified workers. If companies are forced to raise wages to attract workers, they may try to pass along these costs to their customers in the form of higher prices. More generally, inflation rates are notoriously difficult to predict, as evidenced by the Fed’s poor forecasting record in this area since the financial crisis.
While it seems likely that investors and the Fed will turn out to be right that inflation will subside later this year, it is worthwhile to consider what would happen if the consensus forecast on inflation turns out to be wrong.
The impact of sustained higher inflation on investment markets could be quite negative. Persistently higher inflation would likely cause a significant increase in interest rates, which would cause losses on bonds and likely trigger a stock market selloff. Since 2009, extremely low interest rates have been a tailwind for stock prices, helping drive the major U.S. indices to record levels – if interest rates were to rise, this tailwind could become a headwind.
From an investment strategy standpoint, the key to navigating a high inflation environment would be to avoid severe portfolio losses that could derail long-term investment plans. Considering our clients’ portfolios, we have various strategies in place that should help moderate losses if higher inflation persists. On the bond side, we keep bond maturities relatively short with average maturity (duration) in the 3 to 4-year range. We also allocate a portion of our clients’ bonds to inflation-protected bonds (typically in the range of 10%-15%). On the stock side, we tilt portfolios towards lower-priced value stocks which should hold their value better than growth stocks (not decline as much) based on investment theory and actual experience. Investments in hard assets such as real estate (through Real Estate Investment Trusts) and in certain instances, commodities or gold, can also help mitigate the impact of higher inflation on portfolio values.
When constructing investment portfolios, we recommend planning for a range of potential outcomes rather than going all-in on any single forecast. As it relates to the current inflation debate, if the consensus forecast for a return to low inflation turns out to be right, great. Our clients’ portfolios should be positioned to continue benefitting from some of the same factors that have supported asset prices recently. On the other hand, if inflation turns out to be higher-than-expected, the strategies noted here should at least mitigate the magnitude of any portfolio losses, which is one of the key factors for long-term investment success.
1. Standard & Poor’s 500 Index: A market capitalization-weighted index that generally contains the 500 largest publicly traded stocks in the U.S., subject to certain restrictions. The index includes the reinvestment of dividends. An index is unmanaged and not available for direct investment.
2. Russell 2000 Index: A market capitalization-weighted index of U.S. small cap stocks that consists of the 2,000 smallest publicly traded stocks in the Russell 3000 Index. An index is unmanaged and not available for direct investment.
3. MSCI All-Country World ex U.S. Index: A market capitalization-weighted index that captures large and midcap companies in developed and emerging market countries excluding the U.S. An index is unmanaged and not available for direct investment.
4. Barclays Aggregate Bond Index: A broad-based bond index that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government agency bonds, corporate bonds and securitized fixed income securities. An index is unmanaged and not available for direct investment.
5. Source: Atlanta Federal Reserve website
6. Per the Wall Street Journal, the Fed has been purchasing $80 billion of U.S. Treasury bonds and $40 billion of mortgage-backed bonds every month since June of 2020.
7. Source: American Association of Individual Investors website
8. Source: FINRA website, data through May 2021
9. Source for inflation data: St. Louis Federal Reserve website, core CPI was most recently as high as 3.8% in June 1992.
10. Source St. Louis Federal Reserve website: spot price of West Texas Intermediate oil. On April 20, 2020, the oil price ended the day with a negative value due to disruptions in the oil futures market.
11. CPI inflation averaged a 1.8% annual rate in the five years preceding the pandemic.
Written by Rich Golinski, CFA, Chief Investment Officer; [email protected]
|Index12||Market||03/31/21 – 06/30/21||Year-to-Date – 06/30/21|
|Standard & Poor’s 500||Large Co. U.S. Stocks||8.6%||15.3%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||5.2%||17.1%|
|Russell 2000||Small Co. U.S. Stocks||4.3%||17.5%|
|MSCI All-Country World ex U.S.||Foreign Stocks||5.5%||9.2%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.3%||-0.3%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||1.8%||-1.6%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||0.3%||0.3%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||0.2%||-2.2%|
Key economic indicators compiled by Jeffrey Blanchard, CFA, Director of Research; [email protected]
12. Index Glossary:
Standard & Poor’s 500: A market capitalization-weighted index that generally contains the 500 largest publicly traded stocks in the U.S., subject to certain restrictions. The index includes the reinvestment of dividends. An index is unmanaged and not available for direct investment.
Russell 1000 Value Index: A market capitalization-weighted index composed of constituents in the Russell 1000 Index with low price to book ratios and lower forecasted growth rates. An index is unmanaged and not available for direct investment.
Russell 2000 Index: A market capitalization-weighted index of U.S. small cap stocks that consists of the 2,000 smallest publicly traded stocks in the Russell 3000 Index. An index is unmanaged and not available for direct investment.
MSCI All-Country World ex U.S.: A market capitalization-weighted index that captures large and midcap companies in developed and emerging market countries excluding the U.S. An index is unmanaged and not available for direct investment.
Barclays 1-5 Year Gov’t/Credit: A broad-based bond index that measures the non-securitized component of the US Aggregate Bond Index and targets bonds with maturities between 1 and 5 years. An index is unmanaged and not available for direct investment.
Barclays Aggregate Bond: A broad-based bond index that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government agency bonds, corporate bonds and securitized fixed income securities. An index is unmanaged and not available for direct investment.
Barclays 1-5 Year Muni Bond: An Index that covers the USD-denominated tax exempt bond market with maturities of 1-5 years. The index includes state and local general obligation bonds, revenue bonds, insured and prerefunded bonds. An index is unmanaged and not available for direct investment.
JPMorgan Global Ex-U.S. Bonds: An index constructed of government bonds issued from developed countries outside the U.S. with the currency exposure hedged backed to the U.S. dollar. An index is unmanaged and not available for direct investment.
13. Bloomberg Commodity Index: This index reflects the return of a broad basket of commodity futures contracts with the collateral invested in 3 month Treasury Bills. An index is unmanaged and not available for direct investment.
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