Capital Markets Playbook Q3 2021

Download Now

Equity Returns

• US economic growth has been robust so far in 2021.
  • US economic growth, as measured by real GDP, increased by more than 6% in the first quarter.
  • Second quarter GDP, which has not been published yet, may exceed 8.5% (year over year).
• While the economy will continue to show strength throughout the rest of 2021, it is reasonable to assume that growth will begin to decelerate in the months ahead.
  • By the end of 2022, economic growth in the US is expected to remain slightly above its long-term trend of 2%.
• Takeaway
  • A deceleration of economic growth should not be a reason for alarm, it is a byproduct of extremely strong growth that is tough to replicate.
     

• The US economy has likely shifted into the mid-cycle phase, as a broadening expansion accompanied the economy’s reopening. China’s recovery is further along than any other major economy. 
• Major economies are on differing trajectories, with a number of developing countries inhibited by their more limited vaccination and reopening progress. 
• The global cycle’s momentum is widening, with staggered reopenings likely leading to ongoing improvement.
   

• The “Delta” variant is beginning to concern market participants as case counts accelerate in the US.
  • In the first two weeks of July 2021, case counts rose by more than 50%.
• Despite the acceleration in COVID-19 infections, however, case counts remain far below levels seen in January 2021.
• It is likely that COVID-19 case counts will continue to rise in the weeks ahead. 
  • With more than 50% of the population vaccinated, however, case counts in the US are unlikely to reach levels seen at the beginning of the year.
• Takeaways:
  • A widespread shutdown of economic activity, such as the one experienced in the spring of 2020, is remote.
  • Accelerating case counts, however, could create additional supply chain disruptions over the short term.
     

• Reasons for price inflation:
  • “Base Effects”: Recent inflation readings incorporate depressed price levels from economic shutdown in spring 2020.
  • Strong demand for goods as a result of monetary and fiscal stimulus.
  • Short supply due to labor and production shortages that resulted from shutdowns and government policy.
• Prices for goods, which tend to be more volatile than services, have increased substantially over the past year.
  • Durable goods prices (automobiles, appliances, etc.) have increased by more than 5% over the past year.
  • Non-durable goods inflation (clothing, household products, etc.) have increased by more than 4% over the past year.
• Prices for services have increased over the past year as well, but not to the same extent as prices for goods.
• In the months ahead, goods inflation is likely to soften while services inflation is likely to accelerate.
   

• The Treasury yield curve has steepened since the beginning of the year, which would suggest that investors anticipate higher growth and inflation in the years ahead.
  • Despite the steepening curve, however, Treasury yields have fallen in recent weeks, even as high inflation measures have been published.
• Treasury markets are currently pricing in moderate inflation over the next 5-10 years.
  • 5-year inflation breakeven: 2.5%
  • 10-year inflation breakeven: 2.4%
     

• The Fed uses its monetary policies to achieve its dual mandate of:
  • Full employment
  • Price stability
• Monetary policy is likely to remain very accommodative until unemployment reaches 4% and long-term inflation trends near 2%.
  • Over the short term, the Fed’s target for inflation will be closer to 2.5% to make up for low inflation that occurred since the financial crisis.
• Takeaways:
  • The Fed may begin to unwind its quantitative easing program as inflation ticks higher and unemployment improves.
  • The Fed is unlikely to increase its policy rate until inflation and unemployment levels reach the Fed’s target.

• To reduce inflationary pressures in the economy, the Fed will begin to tighten its monetary policy.
• The first step the Fed will take to tighten monetary policy will be to “unwind” its quantitative easing program.
  • The Fed may discuss its plans during the Jackson Hole Conference in August 2021.
  • If current trends in unemployment and inflation continue, it is likely that bond purchases begin to slow in late 2021 or early 2022.
• The second step in tightening monetary policy will be for the Fed to raise its short-term policy rate.
  • The Fed continues to suggest that rate hikes will not take place until 2024.
  • Market participants are beginning to price in rate hikes in 2023.
     

• Global equity valuations ticked modestly lower during Q2 amid the strong earnings rebound, but their trailing  price-to-earnings (P/E) ratios remained elevated relative to their historical averages. 
• US valuations are particularly rich, even when incorporating the next 12-month earnings projections. 
• Forward-looking P/E ratios for developed- and emerging-market valuations are expected to fall below their long-term historical averages.
   

• Cyclically adjusted P/E (CAPE) ratios for non-US equities remained below US valuations, indicating an attractive long-term backdrop for non-US stocks. 
• The US dollar was relatively steady during Q2, and it remains somewhat expensive against most major currencies, providing a positive valuation backdrop for non-US assets and currencies.
   

• While value stocks have outperformed YTD, large cap growth – especially more momentum names – saw a resurgence in the second quarter. 
  • Valuations remain high for mega-cap stocks and growth stocks.
  • Value tends to perform well during periods of strong GDP growth and rising interest rates, both of which are expected over the next couple of years.
• US Large Cap Value looks particularly attractive compared to US Large Cap Growth.
• From a fundamental valuation perspective, US Small Cap stocks look attractive compared to US Large Cap stocks.
• Takeaway:
  • As the US economic recovery continues, expect Value to outperform Growth, and Small Cap to outperform Large Cap.
     

• Yields for longer date investment grade fixed income assets decreased after their run-up in the first quarter.
  • A steeper yield curve was not unexpected, but the pace of the steepening in the first quarter caught many investors off guard.
  • In the second quarter, the yield curve has flattened as the spreads between the 2Y-10Y and 10Y-30Y have fallen from 2021 highs.
• Short dated yields are likely to stick close to current levels until the Fed adjusts its monetary policy to become less accommodative.
• While longer dated yields are expected to continue to increase as economic recovery takes hold, it is likely that the pace of increase is gradual until the Fed signals an adjustment in its monetary policy.
• Takeaways:
  • Shorter duration fixed income is likely to continue to outperform longer duration fixed income as economic recovery gains momentum