The past three months have given us more time to watch the COVID-19 recovery unfold. Progress is being made each day, not only medically, but economically, as well. Let’s examine the various areas of this recovery:
Economy — AAFMAA Wealth Management & Trust LLC’s (AWM&T) GDP forecast of 3.5%+ for 2021 remains on track. The most recently reported quarter was over 6%, signaling the expected COVID rebound is moving forward. The labor market continues to mystify economists, as it shows uneven improvement, with weakness in some areas and strength in others. For example, while the unemployment rate dropped to 5.8%, the labor participation rate fell to 61%, indicating fewer people in the labor market. Jobless claims are falling, wages are rising at a 3.4% annual rate, but available job openings continue to expand — and go unfilled. The only dark spot in labor force data is the fact that workers over 55 years old are permanently leaving the workforce in higher than expected numbers. This means that the most experienced and productive labor is gradually diminishing. It remains to be seen if this trend will reverse or diminish, but when that age group drops out of the labor force, it is usually permanent.
Inflation — The inflation scenario, as predicted by the Federal Reserve, has thus far unfolded according to their script. As the economy has reopened, the pent-up demand and supply bottlenecks have brought on inflationary pressures, both at the producer and retail levels. The Fed believes, as do we, that this surge will be temporary (their word is “transitory”), probably lasting until the 4th quarter of this year. When supply chains normalize in many industries, competitive pricing should return. In the meantime, a number of commodities that experienced outsized price increases (copper, oil, lumber, grains), have already retreated significantly from their recent highs. This would indicate that supply imbalances are beginning to dissipate. We are forecasting a return to a 2 – 2.5% annualized inflation rate by year end. In a recent interview, Chairman Powell once again stated the Fed’s inflation picture for the remainder of the year, and it has not wavered from their original outlook. Skeptics have criticized the Fed for this so-called “rigid” stance in the face of higher inflation data. AWM&T disagrees with that viewpoint and we believe that eventual modest inflation is the most likely scenario over the next 6 – 18 months.
So, while it is true that raw material prices have increased significantly and supply bottlenecks are occurring, retail price inflation should remain reasonable due to productivity gains. Simply put, temporary demand-driven inflation should be offset, long term, by technology efficiencies. On July 8, AWM&T Senior Portfolio Manager and Credit Strategist Gary Aiken delivered our mid-year market outlook webinar. Be sure to watch the archived recording, as Gary went into more detail on inflation, commodities and our outlook for the remainder of the year.
Interest rates — The Federal Reserve has made it very clear that they will not only keep short-term rates low through 2023, they will continue to provide credit liquidity through (corporate/mortgage) bond purchases. Despite this unprecedented Fed transparency, the bond market has reacted quite emotionally at times, as investors try to discern when Fed bond purchases will end. Additionally, there is also some skepticism from bond investors that the Fed is wrong in its assessment of inflation. The 10-year U.S. Treasury Note topped out recently with a 1.75% yield, yet it has declined to the 1.5% level, signaling some level of comfort in the Fed’s inflation outlook that the 1970s are not returning. We continue to believe that intermediate and long-term rates will advance modestly for the remainder of the year, reflecting a modest increase in inflation.
Bond Markets — The risk/return profile for bonds continues to be unfavorable. With interest rates at historically low levels, bonds have little yield safety cushion for principa, should rates rise. Year-to-date, the intermediate bond index is down approximately 1.5%, with longer duration bond indices down over 6%. Complicating other areas of this market is, first, the fact that credit spreads (the yield difference between high yield bonds and U.S. Treasuries) are historically very low. Second, international investors continue to invest in U.S. Treasuries due their high relative yield and a weaker U.S. Dollar. These factors, along with our inflation view, have convinced us to return to a very defensive fixed income position. We have a large position in short term treasuries, have eliminated high yield bonds completely and have added to floating rate positions. This has enabled portfolios to lower duration (2.97 yrs.), increase credit quality (66% is now AAA) and remain somewhat yield competitive (approx. 2%). The modest inflation forecast from the Fed calmed the bond market for the time being, but spreads remained wide between short- and long-term interest rates. This reflects some of the anticipated inflation levels that Chairman Powell referred to. AWM&T believes that interest rates will move modestly higher during the year, as inflation trends higher, reflecting global economic growth. The Fed has said in years past that this is a good thing. Modest inflation, as currently anticipated, reflects renewed economic growth for which we are all hoping.
Stock Markets — Overall, equity markets remain very strong as the economy rebounds and credit conditions remain favorable. The growth versus value tug of war continues on an almost daily basis as investors struggle to determine future inflation and interest rate levels. Corporate earnings, on the whole, have not disappointed, although year-over-year comparisons will become more challenging as we get closer to year end. Manufacturing bottlenecks are a challenge for short-term earnings growth, but that issue should be repaired by year end. Market valuation concerns have subsided somewhat as sector rotation takes center stage. This growth/value rotation has kept a bit of a lid on the overall market indices, as some stocks advance, while others decline, resulting in a moderate valuation. In other words, not all stocks are being lifted equally in this bull market, at least for now. Our portfolios, while emphasizing earnings growth, have a significant segment in the value area. We are comfortable with this mix through the end of this year as we believe so-called value stocks (energy, financials, industrials) will continue to perform well.
The equity markets began the quarter with an upward jolt, with the S&P 500 index hitting record highs during the month of April. Since then, market sentiment continues to ebb and flow as opposing camps square off daily concerning valuation, inflation, interest rates and sector allocation. This makes for an enormous amount of short-term noise, but the longer term scenarios are still intact. Our opinion is that valuations are not stretched as earnings surprises for the S&P 500 are averaging 24% above expectations. This should have the eventual effect of lowering the P/E ratio significantly below trailing 12-month levels.
All in all, low interest rates, increased economic activity and moderate inflation make for an excellent equity environment. AWM&T continues to be fully allocated to equities and relatively defensive in fixed income duration. Unless the Federal Reserve drastically alters its outlook (and they have given visibility through 2023), we expect to remain status quo for the foreseeable future.
Unfolding for the remainder of 2021…
The equity markets continue to operate in the favorable environment of low inflation and low interest rates. As markets adjust to the recent, sudden interest rate move, we believe growth companies will resume their outperformance of so-called value type companies. We continue to look for U.S. outperformance versus the world and a resumption of large cap versus small cap outperformance. Keep in mind that on any given day, week or month, strong sector “rotations” can occur. It has not been unusual to see institutional investors move large funds from one sector to another. This reflects an investor uncertainty and volatility that is historically short term in nature. In the longer term, we look for reduced volatility and strong corporate fundamentals from our equity allocation.
The bond market has struggled due to increasing rates, and we anticipate a tough year for bonds. Already in the first six months of this year, the intermediate bond index was -1% on a total return basis. As economic data unfolded during the quarter, AWM&T made portfolio adjustments to reduce interest rate risk. Additionally, we took advantage of very narrow credit spreads to reduce both investment-grade and high-yield positions, replacing them with short-term U.S. Treasury and adjustable rate securities. While we cannot promise a positive return for the year, we can say that we have taken steps to reduce the level of interest rate and credit risk to the portfolio. This could benefit portfolios from a risk-return standpoint.