Little has changed over the past quarter, as equity markets continue to make record highs amid an economy rapidly reopening from its COVID-induced slowdown. Positive market drivers remain intact, as aggressive fiscal and monetary policy, substantial levels of savings and a strong economic rebound, especially in the U.S., drive earnings higher. Stocks of all sizes, styles and geographies posted gains again this quarter. However, the recovery theme got a little stale in the second quarter, as investors began to worry about peak growth, peak inflation, and peak policy initiatives, resulting in a shift in market leadership away from the more economically-sensitive sectors and back toward more organic-growth names. While inflationary pressures have become quite prevalent, the nature of the inflation wave remains unclear.
U.S. stocks, as measured by the S&P 500 Index, posted a gain of 8.5% in the quarter, with five consecutive record highs to finish the period, and the fifth consecutive quarterly gain following the 1Q20 market meltdown. All market sectors posted gains for the quarter, save for Utilities. Organic growth-oriented sectors such as Communication Services and Information Technology led. But Energy also remained strong among the continued rally in oil prices. Real Estate led the pack amid an improving rental outlook and the market’s search for yield. Economically-sensitive cyclical sectors such as Industrials and Materials lagged, as did the more defensive Utilities and Consumer Staples sectors.
Among small caps, the Russell 2000 Index posted a 4.3% quarterly gain, with similar sector leadership as shown by large caps. Still rebounding from last year’s near-death experience, Energy gained another 20%, and has now risen a whopping 70% year to date.
As investors questioned the durability of the economic expansion and interest rates dropped, the more value-oriented cyclical/economic recovery plays reversed course in the quarter, contributing to Growth’s substantial 7% outperformance versus Value among larger cap names. Nonetheless, Value maintains a solid 4% advantage over Growth year to date. Among small caps, however, Value managed to further extend its lead over Growth in the quarter.
Little has changed fundamentally over the past few quarters as the combination of stimulus and reopening has driven the economy upward. ISM surveys in both Manufacturing and Services remain in expansion territory. Employment figures remain robust, as the unemployment rate continues to drop, while job creation is strong, job openings are in record territory and labor rates show impressive gains. Consumer spending also remains solid, while the Consumer Confidence survey remains strong. Housing demand is off the charts, while prices rise at double-digit rates in many markets. And this strength is being experienced before further fiscal spending plans make their way through Congress and the rest of the world catches up with our recovery.
With everything seemingly moving along swimmingly, what is the market worried about? The answer is clear: the three “peaks” mentioned previously: peak economic growth, peak policy initiatives, and peak inflation.
Our view is that we are indeed peaking in the rate of growth, but that is off the depths of last spring’s slowdown. Slower growth does not mean we are in decline, and we expect a sustained period of moderate economic growth in 2022 and 2023.
We would welcome seeing a peak in fiscal and monetary policy initiatives, as a reduction in deficit spending would be good for the long term, while less dovish monetary policy would also return corporations to a more normal capital allocation decision making process.
Peak inflation is the more divisive issue. On the one hand we see inflationary pressures in nearly all inputs: energy, raw materials, labor and transportation. We also see businesses successfully passing on these cost pressures to customers in the form of price increases; readily accepted by buyers due to shortages caused by supply chain disruptions. Consumers, flush with cash and savings, receiving healthy government benefits and holding higher paying jobs, are also willing to pay higher prices for their goods and services, especially after a year of pandemic-induced quarantine. While supply chain issues will ultimately be resolved, their impact on prices in the out years is less predictable. Similarly, as labor rates increase, will inflationary wage pressures ease as demand slows to a more normal level
Despite strong market gains, valuation levels have not moved up meaningfully, as earnings expectations rise in line with the market. We believe our Strategies have a good balance between cyclically exposed companies that will benefit from this current economic cycle and those with organic growth less impacted by the economy. But the common theme with all of them is quality. We rely on well-positioned companies with strong management teams to guide their businesses toward long-term success regardless of economic outlook.