Mullaney on the Markets | Assessing the Second-Half Threats
While inflation worries slowed the cyclical and financial sectors in June, the Value benchmarks maintain a comfortable lead over their Growth counterparts, year to date, in what has been a record-breaking year so far for U.S. equities.
By Michael Mullaney | Director of Global Markets Research
Published July 2021
The stock market, as measured by the S&P 500, was able to generate a return of +2.33% during June, its fifth consecutive monthly gain. The advance occurred despite conflicting messages from Federal Reserve members on the topics of bond-purchase tapering and potential rate hikes, partisan bickering over the most recent version of a government infrastructure package and isolated spikes in COVID cases linked to variants of the virus. During the month, the index was able to hit eight record highs, bringing the year-to-date tally of “record-breaking” trading sessions to 34. For the quarter, the benchmark gained +8.55%, also for a fifth consecutive quarterly gain, each of which exceeded 5% — a feat that has been accomplished only twice since 1945. For the year, the index is now up +15.25%.
Investor optimism continues to be fueled by the relative success of the U.S. vaccination efforts, business re-openings and strength in consumer spending, which has begun to shift from goods to services.
Inflation Threat Stymies Cyclicals
Even the hint of the Federal Reserve acting to curb inflation (and correspondingly growth) had a significant impact on returns for the month. Technology — the “growthiest” of the eleven sectors that comprise the S&P 500 and the sector with the greatest sensitivity to interest-rate movements — took the pole position with a return of +6.95% for the month. This surge occurred as the yield on the 10-year Treasury fell from 1.60% to 1.47%, making the tech sector’s longer-dated cash flows more valuable. It was also the first time since August 2020 that Technology led all sectors. A continued imbalance between limited supply and increasing demand lifted Energy to the second-best performing sector with a gain of +4.60%, as oil prices “spurted” by over 11% during the month.
With a looming Fed threat, cyclical stocks gave ground, with Materials incurring a loss of -5.30%. Up to June, cyclical stocks had been among the market leaders. Financials also fell, dropping by -2.96%, stymied by the surprise drop in interest rates during the month that pressured both bank and insurance company stocks.
For the quarter, Real Estate was the leading sector with a return of +13.09%, fueled by “reopening strength.” Technology stocks followed closely behind with an +11.56% gain, while Utilities was the only sector to end up “in the red” for the quarter with a loss of -0.37%.
On a year-to-date basis, meanwhile, Energy took top honors with a gain of +45.61%. The performance marked the sector’s best first half on record, as the price of oil jumped by over 50% on average. Utilities once again lagged, posting a relatively paltry return of +2.47%.
While the absolute returns generated in June and the quarter would suggest an unadulterated “risk-on” environment, some underlying return details would suggest otherwise. For example, while lower-quality companies in the S&P 1500 Index (those rated “B” or lower by Standard & Poor’s) did beat higher quality companies by over 4%, the stocks in the highest beta quintile (i.e., “the riskiest”) of the S&P 500 lagged the lowest beta quintile by over 1%. Also, large-cap stocks (Russell 1000) beat small-cap stocks (Russell 2000) by 57 basis points and the equal-weighted S&P 500 lagged the cap-weighted S&P by nearly 1%, largely due to the five largest stocks in the S&P 500 contributing some 63% of the index return for the month.
For the quarter, these trends largely remained in place. However, on a year-to-date basis, small-cap stocks continue to maintain a lead over large-caps, while the equal-weighted S&P is outpacing the cap-weighted version of the index.
The rotation into Value-based strategies stalled in June as the returns across the Russell 1000 Value, the Russell Mid-Cap Value, and the Russell 2000 Value indices lagged their growth counterparts by an average of -6.89% across the three capitalization ranges, a return deficit not seen since March 2020. Year-to-date, however, the three Russell Value benchmarks maintain a compelling lead over the three Russell Growth benchmarks, by a total exceeding 10% on average.
Developed market international stocks, as measured by the MSCI EAFE Index, lagged the returns generated in the U.S. markets during June, both in local-currency terms and particularly in U.S. dollar terms. In fact, the DXY Dollar Index gained nearly 3% versus a basket of six major foreign currencies. For the month, EAFE gained +1.40% in local currency terms but lost -1.10% in $USD terms.
Likewise, emerging market stocks (the MSCI EM Stock Index) gained +0.87% in local currency terms but just +0.21% in $USD terms, as the MSCI EM Currency Index dropped nearly 1% versus the dollar during the month.
For the first half of the year, EAFE has gained +13.11% in local currency terms and +9.16% in $USD terms, while EM comes in at +8.08% and +7.58%, respectively. The underperformance compared to developed markets, in part, reflects the lag in reopening and vaccination progress versus that of the United States.
Assessing the Near-Term Risks
The U.S. stock market continues to enjoy a positive backdrop. The combination of a +7.8% Q2 GDP forecast from the Atlanta Federal Reserve’s GDPNow model, a consensus estimate of 63%+ year-over-year S&P 500 earnings growth for Q2, and some of the most lax financial conditions in history could continue to provide a tailwind. Global geopolitical risk aside, three primary risks loom over the stock market in the near- to intermediate-term time horizons.
First, the renewed push-back on President Biden’s infrastructure bill puts into question the likelihood of Senate passage and whether the “tag along” remnants of President Biden’s “American Family Plan” social-spending bill can get through Congress via the reconciliation process. Notably, objections emerged not just from Republicans, but from moderate Democrats as well.
Second, the prospect of delayed re-openings and/or renewed lockdowns due to surging cases of the Delta variant of the coronavirus — estimated to be twice as contagious as the original version— is becoming more pronounced. The Delta variant is now found in 85 countries, and is surging in places like the U.K., Israel, and Australia. Meanwhile, the Lambda variant, which was first detected in Peru, is now spreading throughout India. Given the effectiveness of the vaccines, the impact will likely depend on the proportion of fully vaccinated individuals in a given geography (who have received the recommended two doses of the Pfizer or Moderna vaccines).
Finally, whether inflation is transient or becoming structural and, more importantly, the Fed’s reaction to the outcome represents another potential uncertainty. Fed Chair Jerome Powell has stated on numerous occasions that the Fed will be patient in addressing an increase in inflation. However, the recent proclamation of St. Louis Fed President James Bullard that the Fed may act to thwart inflation much sooner than currently anticipated, resulted in a bond market reaction that was diametrically opposite to the 2013 “taper tantrum” during the Ben Bernanke era. Recall that at the time, Bernanke’s comments led to a jump in interest rates and a steepening of the yield curve. This time around, Bullard’s comments led to a drop in interest rates and a flatter yield curve. The reaction suggests that the bond market may be beginning to discount the possibility of a Fed policy error (i.e., taking the “punch bowl” away due to higher inflation, which is a lagging economic indicator, when the U.S. economy may have already peaked).
Time will tell how each potential scenario may pan out.
Boston Partners Global Investors, Inc. (“Boston Partners”) is an investment adviser registered with the SEC under the Investment Advisers Act of 1940. Registration does not imply a certain level of skill or training. The views expressed in this commentary reflect those of the author as of the date of this commentary. Any such views are subject to change at any time based on market and other conditions and Boston Partners disclaims any responsibility to update such views. Past performance is not an indication of future results. Discussions of securities, market returns, and trends are not intended to be a forecast of future events or returns.
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