By Liz Ann Sonders, Jeffrey Kleintop, Kathy Jones, Charles Schwab
Could the economy slow faster than expected? Some investors have begun to worry that the spread of the COVID-19 delta variant and the drying up of fiscal and monetary stimulus could put the brakes on economic growth.
Although the growth rate may slow, U.S. economic growth remains high on level terms, and in our view that is likely to continue. However, this year’s swings between cyclicals and defensives, value and growth, and international and U.S. stocks exemplify the importance of holding a diversified portfolio to help reduce overall portfolio volatility.
U.S. stocks and economy: Growth versus growth rate
Amid the rapid spread of the COVID-19 delta variant and a significant easing in both monetary and fiscal stimulus, investors have begun to worry about a faster-than-expected economic slowdown. As we have pointed out before, the second quarter likely will mark the peak for the growth rate in several key metrics — most notably, earnings and gross domestic product (GDP) — but that doesn’t mean peak growth in level terms.
Some fears should be quelled as supply constraints ease across several industries. An increase in prices has put upward pressure on overall inflation metrics, but many areas (such as used-car and commodity prices) have cooled, signaling a possible light at the end of the tunnel in terms of pricing stress.
Growth rates peaking in the near term doesn’t suggest that the economic backdrop will sour quickly. Demand remains solid. The new-orders components within the Institute for Supply Management (ISM)’s manufacturing and services indices are still very elevated and comfortably above 50 (the level that separates expansion from contraction).
The employment components contracted in June, which bears watching. However, the weakness is likely tied to several factors affecting the labor market, including some workers’ virus-related fears of returning to the workplace and their lack of child care. Thus, the employment situation should improve if demand remains strong — but if it were to worsen, that would raise a red flag for the economy.
Given the resurfacing of some economic anxiety, investors have piled back into defensive areas of the market. Importantly, the defensive plays over the past year were not the classic sectors like Utilities or Consumer Staples. Instead, the COVID-19 era “defensives” were Information Technology, Consumer Discretionary, and Communication Services.
The Utilities and Consumer Staples sectors remain the worst performers since last November (when the market shifted toward cyclical- and value-oriented areas). Even since mid-May, when investors started to take more of a risk-off posture, they remain in negative territory.
Despite growth-oriented sectors recently retaking the reins, certain value factors continue to outperform certain growth factors. Using high free cash flow yield as a proxy for value and high five-year estimated earnings growth as a proxy for growth, value is outperforming growth considerably year-to-date. That contrasts with the outperformance of the S&P 500 Growth Index relative to the S&P 500 Value Index.
The stark disparity underscores the notion that a strategy emphasizing the factor(s) of value (as opposed to value-labeled indices) has continued to work well this year — even in traditional growth areas like Information Technology and Communication Services.
Given that unique mix, we still favor a hybrid and disciplined approach to factors. Additionally, shifts in leadership among sectors remain swift and large; and with economic momentum likely slowing from here, we continue to encourage diversification among sectors and periodic rebalancing.
Global stocks and economy: Delta hedging
Concerns of a resurgence of the coronavirus have been building over the past month and are being reflected in markets’ performance. While the global economy and corporate earnings look strong — even prompting the Federal Reserve to “think about thinking about” tapering economic stimulus in the U.S. — the spread of the delta COVID-19 variant and its potential to cause an economic slowdown has quickly become the biggest issue facing investors.
Since early June, cyclical stocks have lagged defensives, reversing their leadership since the beginning of 2021. Leading on the downside have been travel, retail, and leisure stocks, industries that could suffer the most from a delayed economic reopening.
Should the highly transmissible delta variant continue to spread, global health experts are warning that indoor mask mandates and other public health measures may make a return this fall. Authorities in Australia, South Africa, and Asia have recently reintroduced measures to curb viral spread. France is warning its citizens against vacationing in Spain and Portugal. Japan just declared a state of emergency in Tokyo and banned spectators at the Olympics.
In the near term, the news may get worse. The fall and winter months may increase the spread of the delta variant, mirroring a typical seasonal virus pattern. The World Health Organization (WHO) has urged caution on re-openings, raising risks to growth. But longer term, vaccines are proving effective against the more severe effects of the delta variant. In the U.K., despite a rise in delta variant cases, we have not seen a comparable rise in deaths. This pattern has been attributed to high vaccination rates in the U.K. With fewer hospitalizations and deaths, renewed lockdowns may not be necessary.
According to Israel’s Health Ministry, using real-world data, the Pfizer vaccine was 93% effective at preventing severe illness during an outbreak of the delta variant. The vaccine rollouts show no sign of slowing in parts of Asia and are making steady progress in Europe, though they have tapered in the United States and U.K. The outbreaks may encourage more people to get the vaccines.
With potential resistance to any renewed restrictions, influenced by both politics and lockdown fatigue, and supported by the effectiveness of vaccines against the delta variant, economic growth may remain solid. So, investors with different time horizons have been battling it out in the markets. While cyclical stocks have slid on these near-term concerns, those with a longer-term view may have an edge.
This year’s swings between cyclicals and defensives, value and growth, and international U.S. stocks exemplify the importance of holding a diversified portfolio to help reduce overall portfolio volatility.
Fixed income: Slower but not weak
Treasury yields have nosedived in the past month, falling to the lowest level since February. With the economy growing at the fastest pace in decades, inflation up sharply, job growth soaring, and the Federal Reserve talking about pulling back from its bond buying program, the steep drop in yields has defied conventional wisdom. Why are bond yields falling if the economy is strong?
It looks to us like the market moves reflect the view that the peaks in growth and inflation in this cycle have passed and the prospect of tighter policy by the Fed would dampen the outlook for the economy. While we agree with that assessment longer term, we believe yields are now too low relative to the economic outlook and are likely to rebound later this year.
The rate of change in the economic indicators has cooled, although overall levels of activity are still strong. Retail sales, consumer sentiment, and housing activity have declined from high levels, while commodity prices have fallen, and the dollar has firmed up — all signs suggesting the factors pushing up inflation are set to ease. Inflation expectations have been declining. The 5yr/5yr forward breakeven rate, a measure of inflation expectations, peaked in early May at about 2.4% and has since fallen back toward 2%.
A slight shift in the Federal Reserve’s policy stance at its June meeting also contributed to the drop in yields. The committee’s median estimates for rates indicated that there might be two rate hikes in 2023, earlier than previously anticipated. In addition, various members of the Fed have been outspoken about wanting to reduce the pace of bond purchases sooner rather than later and move toward rate hikes as early as this year.
It may seem counterintuitive, but in the past, bond yields have fallen when the Fed has ended quantitative easing (QE). After the initial “taper tantrum” in 2013 which sent bond yields higher, they retreated when the actual process began. While tapering — or ending bond purchases — increases the supply that needs to be absorbed by the market, it also signals a step toward tighter policy, which can trigger slower growth and low inflation.
The Treasury bond market is very sensitive to these signals from the Fed, and responded to the prospect of “less easy” policy by sending yields lower. This tendency appears to have been reinforced by the experience of the global financial crisis. The market absorbed the increased supply without a spike in yields.
Overall, we believe the market has gotten overextended once again. Ten-year Treasury yields at current levels appear too low relative to the economic outlook. The pace of economic growth and inflation are likely to ease in the second half of the year, but are starting from very high levels and will likely stay above the trends seen in the past decade.
Moreover, real yields (those adjusted for inflation) are steeply negative and are unlikely to be sustained if the economy continues to make progress. We expect real yields to move up due to a combination of easing inflation expectations and rising nominal yields.
Near term, we expect 10-year Treasury yields to move in a range of about 1.2% to 1.5%, but see the potential for a move up to 1.75% to 2% later in the year.
Lawton Retirement Plan Consultants, LLC (LRPC) Monday Morning Minute is crafted to provide decision-makers with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.
Lawton Retirement Plan Consultants, LLC (LRPC) is a Milwaukee, Wisconsin-based independent, objective Registered Investment Adviser (RIA) providing investment advisory, fiduciary compliance, employee education, provider management and plan design services to employer retirement plan sponsors. The firm specializes in sustainable investment strategies for retirement plans that incorporate Socially Responsible Investment (SRI) factors and Environmental, Social and Governance (ESG) elements. LRPC currently has contracts in place to provide consulting services on more than a half billion dollars in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or firstname.lastname@example.org or visit the firm’s website at https://www.lawtonrpc.com. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.
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