Fed Provides the Backstop and Markets Take Off - but Have They Rallied Too Far?
The front half of 2021 sustained the trend experienced in the back half of 2020 as equities moved higher on prospects for a rebounding global growth story and continued accommodative monetary and fiscal policy. As we enter the back half of the year the broader macroeconomy should continue to strengthen, albeit realizing lower levels of growth as the sugar high from the reopening burst wanes and lapping of significant amounts of accommodation and support begin to challenge year-over-year comparisons. The ongoing Q2 earnings season should confirm this, showing robust results, though likely at cycle highs and then begin to moderate in the coming quarters. Concerns around the Delta variant, inflation, interest rates and tax policy will drive market action through the rest of the year and into 2022 as the heavy lifting sets in and a reconciliation of how far equity markets have moved in the past year is contemplated.
Our predisposition is to slightly overweight equities (down from modestly overweight to begin the year) as the recovery continues to unfold at a moderate pace. Within equities, we view continuing accommodation, a rebounding global economy and the persisting low interest rate environment as positives which should allow for modest returns in the back half of the year. Further, we see opportunity in emerging market equities (relative valuation discount to U.S. equities), value stocks (improving macroeconomy and style reversion) and more specifically those in sectors tied to a cyclical recovery including energy, financials, industrials and materials. Finally, long-term secular growth areas of the market are likely to continue to be rewarded given their scarcity. Fixed income on the other hand looks expensive from a valuation lens (especially Treasuries – impacted significantly by the low interest rate environment and susceptible to pricing risks when rates move higher). We see opportunities within core fixed income areas including high-quality mortgage backed and mispriced investment grade securities along with senior loan, high yield and emerging markets categories.
As always, we believe a properly risk-allocated portfolio is one that is well-diversified across asset classes and is mindful of the risk inherent in these underlying assets. This past year or so provided a strong reminder of why portfolios should adhere to asset allocation and why we do not try and time the market. Staying the course and properly diversifying provide the best chance of succeeding even in the most turbulent of times.
Although inflation may settle between 2-3% over the next several years rather than the 2% or below we’ve seen over the past decade, consumers, economists, and the markets seem to agree that we’re not heading towards a sustained surge.
- Meera Pandit, Global Market Strategist, JP Asset Management.1
Domestic equities produced strong returns during the first half of the year aided by continued monetary accommodation, additional fiscal support and the potential for a broad rebound in global macroeconomic activity as vaccine rollout allowed for the beginning stages of a return to normal. Cyclical stocks, many of which had fallen into the value camp began to perform much better in September and continued to work during the first half of 2021. Perceived to benefit significantly from a rebound in activity as the economy reopens, investors flocked to many of these sectors and industries while paring back a bit on growthier, less cyclical companies like those in the technology sector which had performed admirably during 2020. The move higher across these cyclically sensitive areas of the market provided a backdrop for the broader market’s continued rally during the front part of the year as evidenced by the strong returns through the end of June.
With the average broad domestic equity index advancing approximately 15% during the first half of the year, observers may be wondering if markets are fully pricing in the expected economic rebound and if future market returns are coming to fruition ahead of schedule. Might we be eating tomorrow’s returns today? From a valuation perspective we think the broader equity market is pointing to this, as forward multiples are at elevated levels against historical averages but opportunity to achieve a higher equity market may be in earnings estimates which continue to trend higher as analyst and market observers play catch up as the economy rebounds.
From a style perspective, value recovered some of its 2020 underperformance versus growth during the first half of the year. Small cap value was the standout performer through the end of June, returning nearly 30% and widely outperforming its growth counterpart by ~13%. Large cap value, while outperforming its growth counterpart, experienced a smaller gap of just 1.4%. Heading into the back half of the year and with the recent Delta variant becoming a bigger threat, it looks like value outperformance is consolidating and may be pulling back awaiting a further all-clear with regards to COVID-19. The best performing sectors during the first half included energy, real estate, financials and communication services, while the lagging sectors were consumer staples, utilities, consumer discretionary and healthcare. Energy benefited from prospects for a reopening economy and a decent amount of mean reversion given 2020’s weak performance. Consumer staples is experiencing significant commodity pricing pressures and the challenge of comparing against strong volume trends experienced a year ago.
Within international equities, developed markets (+8%) modestly outperformed emerging markets (+7%) during the first half. Relative underperformance of international equities to domestic equities can likely be traced to more promise from economic recovery as the U.S. vaccine rollout took hold at mostly quicker rates than seen in foreign countries. We continue to believe that the current valuation disparity favors emerging markets over developed markets especially when global growth fully rebounds (expected at nearly twice as quickly in emerging nations versus developed nations).
As we look to the back half of the year, we view equities as fairly valued to slightly overvalued in certain areas and believe that market multiples are likely to cresting in the near-term. Further lift in equities will be dependent on rising earnings which should provide support, and we feel Q2 and Q3 earnings are likely to be the most expansive in quite some time as year over year comparisons are quite favorable. Moving into Q4 and 2022, the year over year percentage change in earnings will become more challenging and with this risk mitigation, more important. Stock selection should become a greater concern and is likely to be rewarded going forward. From an allocation perspective, we are slightly overweight equities given the still significant accommodation present, the rebounding global economy and continued low interest rate environment. We see opportunity in emerging market equities (relative valuation discount to U.S. equities), value stocks (improving macroeconomy and style reversion) and more specifically those in sectors tied to a cyclical recovery including energy, financials, industrials and materials.
After a significant rise in yields through the end of March, a consolidation period during April and May was met by declining yields throughout June and into July. Whether this backup in yields is fundamental in signaling more challenging times ahead or technical in that many foreign buyers continue to step forward to buy viewing U.S. Treasuries as a safe haven remains to be seen. Either way it did allow fixed income returns to recover after a challenging first half and save face heading into the back half of the year. The aggregate bond category ended June with year-to-date returns in the -1% range well above earlier levels.
Within domestic markets, high yield categories (corporate and municipal) performed best increasing 4% through June. Other top-performing categories included bank loan and inflation protected bonds which both increased approximately 2%, benefiting from the steepening yield curve earlier in the year while losing some ground on a relative basis and the curve flattened in late May and June. The corporate investment grade category was challenged, declining approximately 1%, though better than medium-term and long-term bond categories which fell 2% and 7%, respectively. On the international front, developed markets were challenged, declining 2.3% during the first half while the emerging markets category experienced declines in the 1% range, modestly outperforming on a relative basis.
Credit spreads remain low, after narrowing dramatically throughout the back half of 2020. Market participants seem to view the Fed’s backstopping as necessary protection for now, but as something that needs continued monitoring in accessing the broader health of the bond market. While transitory inflation has pushed real yields for a good bit of the fixed income complex to negative levels, we see this trend mostly reversing later this year with yields likely to rise again as we get back to normal. A recovering economy, coupled with accommodative global central banks and manageable inflation (once past this transitory timeframe) point to a mixed outlook for the broader asset class with returns likely below historic levels. Collectively our predisposition on the margin is toward modestly higher exposure in the high yield, senior loan and emerging market categories.
KbC Equity and Allocation Strategy Model Portfolios
KbC equity strategies performed well during the first half of 2021 benefiting from a rebounding macroeconomic backdrop and security selection. As signs of economic reflation took hold early in the year, our strategies that tilt towards value/cyclicals responded well, capturing alpha against their respective benchmarks while all strategies produced solid absolute performance given the broader equity market’s continued move higher. Aided by a slight skew towards value and outsized gains in core holdings including Blackstone (BX), Goldman Sachs (GS), Rent-A-Center (RCII), Exxon Mobil (XOM) and Microsoft (MSFT) our Dividend strategies performed best. Alpha Tax/Qualified benefited from the shift towards value/cyclicals as its equal weighted approach provided significant alpha, reversing the trend of fewer, mostly larger weighting companies driving much of last year’s performance within the S&P 100.
Strategic Asset Allocation continued to outperform against its blended benchmark as its modest tactical overlay strategy and fixed income proxy position in the Vanguard Russell 1000 Value ETF (VONV) coupled with a risk-centric approach of allocating to mainly index ETFs produced solid relative and absolute returns. Alpha Leaders which tilts slightly to modestly more growth performed well as stock selection, specifically in Applied Materials (AMAT), NVIDIA (NVDA), Microsoft (MSFT) and Exxon Mobil (XOM) drove alpha. Finally, our Market strategies held serve during the first half, modestly lagging its benchmark, the Vanguard Total Stock Market ETF (VTI).
Morningstar Market Barometer YTD, ending July 31, 2021
Exhibit 1, 2, 3: Data source Morningstar Office.
Exhibit 4: Morningstar Market Barometer provides a visualization of the performance of Morningstar Indexes. ©2020 Morningstar.
The information provided herein is the opinion of Knightbridge Capital and subject to change without notice. It is not to be construed as investment, legal or tax advice. This publication may contain forward looking statements which reflect our best judgment based on factors currently known but involves significant risks and uncertainties. Actual results will differ from those anticipated in forward looking statements as the result of changes in underlying assumptions including, but not limited to systemic, macro and company-specific risks.