In January, Chairman Bill Johnston and I delivered a 2021 outlook seminar via live stream from a studio in Grand Rapids. Six months later, the world is a different place as an increasingly vaccinated population rediscovers a sense of normalcy. It is too early to call this a post-Covid era, but the narrative is now less about daily case counts and more about sustained economic growth. Below, we offer our thoughts on the current state of the economy and markets and perspective on what the rest of the year may hold.
Back to Business (Cycle)
As we move into the second half of 2021, the ongoing vaccine campaign is suppressing the virus. New case confirmations and related deaths have both declined to levels not seen since the early days of the pandemic. Risks remain (variants, etc.), but as society returns to normalcy, we return to our traditional business cycle framework.
The economy is now one year into a new expansion, which began in July 2020 by our estimation. Interest rates are low, the labor market is strengthening, and consumer sentiment is significantly improved. We expect accommodative policy measures will support the recovery. We are monitoring risks such as high asset valuations and inflation metrics that could necessitate a change in policy. Inflation metrics are likely to rise in coming months due to easy 2020 comparisons and amid supply chain disruptions and heightened demand. We believe the increase will be transitory and expect the Fed to prioritize full employment as long as possible. As a result, we view the risks of a near-term recession as low.
The pandemic wiped out nearly 22 million American jobs in a matter of weeks, causing unemployment to spike to 14.7% in April of last year. Entering 2021, the labor market had regained about 12 million of those jobs with unemployment recovered to 6.8%. Another three million jobs were created year-to-date and unemployment has improved another percentage point to 5.8% – a pandemic-era low.
While the ongoing vaccine campaign and easing business restrictions offer labor market tailwinds, it appears that some combination of skill gaps, childcare obligations, lingering virus concerns, and enhanced unemployment benefits are limiting a return to work. We expect these dynamics to take center stage in the second half of 2021 as schools reopen, expanded benefits expire, and virus concerns ease. The stage is set for a continued labor market recovery.
In April 2020, real retail sales declined more than 20% in what was arguably the worst month (economically) during the pandemic. On an absolute basis, spending declined to levels not seen since 2012 but rebounded to fresh highs by June. Savings rates that initially soared amid boundless uncertainty, fiscal stimulus, and a lack of spending opportunities, fueled record levels of retail spending into year-end. In 2021, business reopenings, increased hiring, and additional stimulus checks have supported improvements in consumer confidence and continued robust levels of spending.
Looking forward, we would expect continued strong household spending for the remainder of the year. Consumers may begin to shift spending towards entertainment and travel as pandemic fears dissipate while elevated savings supported by fiscal stimulus should continue to underpin demand.
US Stocks Charting New Territory
After plummeting 35% in March 2020, domestic stocks have marched steadily higher with total returns exceeding 90% from the bottom. It only took six months for the S&P 500 to recapture its pre-pandemic high and with a year-to-date return of nearly 15%, the index now stands more than 26% higher than it did in February of 2020.
There are a number of reasons why stocks have performed so well, not the least of which has been improving earnings growth expectations. In 2020, investors wondered how many years it might take for the S&P 500 to recapture peak earnings levels notched in 2019. As it happens, 2021 is on course to do just that. Starting the year, consensus expectations for 2021 earnings growth were about 23% on an easy compare from 2020. Six months later and analysts have raised expectations to earnings growth of 35%. This is a common early cycle phenomenon – stocks are growing into increasingly strong earnings expectations.
Yields Range Bound
Entering 2021, optimism on the vaccine front led to risk-on sentiment in credit markets and rising interest rates. During the first quarter US ten year treasury yields climbed 83 basis points, to a high of 1.74%, and maintained a range of 1.43% to 1.70% in the three months that followed. As a result, bonds (as measured by the Barclays Intermediate Government/Credit Index) declined 1.9% in the first quarter and remain 1.1% lower year-to-date.
In June, the FOMC voted unanimously to maintain the federal funds rate at 0-0.25% and to make no changes to its quantitative easing program but updated forward projections to include two rate hikes in 2023. The economy has improved more quickly than the Fed was expecting and projections of economic growth have improved, including a 7.0% real growth projection for 2021. Chair Powell highlighted the Fed’s expectation that recent drivers of inflation will be temporary as factors that have been suppressing supply abate in the coming months. In the second half of the year, we expect ‘tapering’ to be a significant theme. Chair Powell characterized June as the ‘talking about talking about’ meeting and pledged additional communication and advanced notice before announcing a plan for reducing asset purchases at a future meeting.
Looking Forward – Capital Market Assumptions
As for the market experience going forward, we share our updated capital market assumptions below. These forecasts represent our expectations for average annualized returns for each asset class over the next ten years. Over the next decade, there will be years where returns exceed our expectations and years where returns trail our expectations. We believe short-term market-timing strategies are unlikely to improve long-term outcomes.
We continue to recommend most of our clients hold a full weight to global equities in accordance with their individualized risk profile and we remain marginally more constructive on international equities. Concurrently, we are less constructive on the outlook in fixed income markets and believe a modest underweight in favor of an allocation to diversifying strategies (alternative assets) remains prudent.
Despite an ever-changing landscape, our disciplined approach and long-term orientation serve us well as we endeavor to create comprehensive investment solutions that help our clients reach their financial goals. Investment decisions are made in alignment with our documented investment philosophy and always with the intention of serving our clients’ best interests. On behalf of the entire team, thank you for allowing us to serve on your behalf and good luck in the second half of the year.