Altair Insight: Racing Ahead (2Q21) – Quarterly Market Review
A year of transition has brought much to be thankful for as we approach summer’s midway point. While a third wave of COVID-19 is cause for heightened concern in some areas, vaccines on the whole have blunted the pandemic, the world has opened back up, and joyful vacations and family reunions have replaced the fear and quarantines of a year ago.
Scarcely a day passed for years after the global financial crisis without someone referring to the new normal. This summer we are much happier with the original and once-again-current version: Normal. That is what life finally feels like again for many, although we recognize that COVID-19 still poses a serious threat in many areas, with the highly contagious Delta variant raging and prompting new precautions in certain U.S. cities and lockdowns abroad.
Noah Kroese Illustration for Altair Advisers
Along with this return toward normalcy comes another word that defines the current economic situation and stands as a highlight of 2021: Boom. After shrinking by 3.5% last year, the global economy is posting its strongest post-recession growth in 80 years, buoyed by vaccinations, the phase-out of pandemic restrictions and the stout support of governments and central banks. The United States is at the forefront of the revitalization, a result of consumers spending freely and the Federal Reserve and Treasury Department keeping the government’s stimulus spigots wide open.
An economy characterized by pent-up demand and an insufficient supply of goods and services leads to higher prices, and inflation is a primary area of concern. A close study of categories seeing the biggest increases persuades us for now that this inflationary trend should ease gradually over the coming months. We believe the data supports the Fed’s argument that the surge will be relatively short-lived, or transitory – the third and final word we believe sums up the outlook this quarter – even if officials have recently shifted to “temporary” as their preferred term with prices increasingly expected to remain elevated through year-end.
Like the economy, the stock market has moved ahead at a healthy clip despite periodic volatility amid concerns about inflation and the Delta variant. The U.S. bull market is 16 months old and the optimistic outlook for the economy suggests it is likely to continue, even if returns are unlikely to match the impressive gains of the past year. The potential impact of several proposed legislative actions in Washington – including massive spending on infrastructure and increases in corporate, capital gains and personal income taxes on the wealthy – remains clouded by unknown factors that will likely take months more to resolve. Given the 50-50 split in the Senate, we do not believe any drastic versions of these proposals are likely to gain approval.
We recommend our clients remain at target portfolio allocations in all three risk categories – higher, medium and lower. Within the medium-risk bucket, we are recommending new investments in direct lending, discussed below, that we believe will enhance portfolios through increased diversification and compelling yields at a reasonable level of risk.
Please read on for more of our quarterly discussion of trends that shape our thinking on the markets.
1. Global growth is recovering rapidly, paced by a humming U.S. economy that lacks only a fully revived labor market.
The world economy has heated back up more rapidly than anticipated, putting an end to the deepest global recession in more than 80 years. Yes, it has had special help – lots of it – from governments and central banks supplying trillions of dollars in emergency aid as well as from medical science in creating vaccines that weakened the COVID-19 pandemic. All the extra assistance notwithstanding, we believe this is the single biggest takeaway for investors at just past the midway point of 2021: a flourishing economy, underpinned by thriving economic data and solid corporate earnings that leave it well-positioned to continue improving into next year.
To be sure, the comeback remains fragile, with much damage left to fix and the risk that a rapidly spreading Delta variant will cause more. To single out just one area still lagging badly, the United Nations projects that the pandemic could slash as much as $2.4 trillion from the global economy this year due to the loss of international tourism. Some regions, particularly those with developing nations, are struggling to overcome low vaccination rates and get COVID-19 case numbers under control despite strong evidence of vaccines’ efficacy against Delta.
Yet more and more countries are seeing consumer and business activity approach normal levels again. The World Bank forecasts global GDP to expand 5.6% overall this year, up from 4.1% projected in January. There have been encouraging signs lately of the inoculation pace accelerating in China and in Europe, which will help.
The U.S. economy is particularly healthy, even if talk in some quarters earlier this year of another Roaring ‘20s was overdone. The S&P 500’s boom in profit growth is expected to ebb in coming quarters as earnings comparisons get tougher at the same time as the Federal Reserve scales back its stimulus and supplemental unemployment benefits have ended (by September 6th). For several reasons, however, we are optimistic about the economy and do not view these pressures as likely to derail its path.
Notably, a gauge of future U.S. economic activity – the Conference Board’s index of leading economic indicators – has topped its previous peak reached in January 2020 and keeps rising. Consumer spending has surpassed pre-pandemic levels. The service economy is expanding at strong levels, even after a slight dip in the June data. Stimulus payments already have left household finances in their sturdiest shape in decades and states’ coffers better fortified too. Another roughly trillion-dollar injection of government cash into the economy almost certainly lies ahead once an infrastructure bill makes its way through Congress.
All told, the U.S. economy is functioning smoothly and appears in good position to maintain an elevated growth pace over the next year or more. GDP growth is estimated by the Fed at 7.0% this year – the fastest pace in 37 years – which economists say would mark a full recovery. Next year’s growth is estimated at a more modest 3.3%, which after 2021 would still be the most vigorous rate of expansion since 2005.
The missing element: the labor market recovery, which still has far to go to return to normal with 6.8 million of the 22 million positions lost in the pandemic still absent as of June. We anticipate job growth to accelerate when summer ends, enhanced employment benefits expire and more people seek to return to the work force. The unemployment rate has stalled at just under 6% but should drop further in the fall and through the end of the year. We acknowledge, however, that the pandemic has resulted in many permanent job losses in the form of early retirements, increased automation and staff reductions.
The silver lining for investors is that the slower-than-expected jobs recovery has forestalled any move by the Fed to tighten ahead of schedule, giving the markets more breathing room even as the economic outlook brightens.
2. The sharp rise in inflation may already have peaked; we believe it will return to normal next year.
The long-dormant concerns of many investors that massive U.S. government stimulus would cause prices to skyrocket were rekindled this spring when inflation first rose to a 13-year high, only to be exceeded in June. News headlines reflected the tension: “Inflation worries soar” … “Inflation spooks stocks” … and “Is it time to panic about inflation?”
Our answer: Not so fast. The increase in prices was to be expected, as we said in a June commentary, given the swift recovery from COVID-19 and the fastest rebound in the economy in decades. This is likely a temporary bump resulting from an upsurge of demand from consumers and businesses as they reemerge from the pandemic, overwhelming supply chains and causing product shortages and spikes in prices.
Year-over-year percentages (5.4% for the consumer price index in June) are artificially high due to comparison with a slack period of 2020 when the coronavirus was rampant and economic activity was limited. Additionally, the surge in prices was not across the board; inflation was modest among most goods and services. A few areas tied closely to the reopening saw big jumps – used cars and trucks because of a computer chip shortage, air fares, lodging – that propelled headline inflation numbers, while other major categories such as owners’ equivalent rent, medical care services and food at home grew at more normal levels.
While inflation may well remain elevated through the end of the year, the rise should soon decelerate and it is unlikely to persist beyond early 2022. Prices should stabilize as consumers’ post-pandemic summer spending spree peters out, supply-chain bottlenecks are resolved, companies restock shelves and the emergency boost to unemployment benefits ends. The recent rise in wages may prove to have been temporary as the jobs recovery proceeds and employers no longer have to boost pay or offer bonuses in order to be fully staffed.
The latest data, while fodder for alarming headlines, did not alter our expectations that the highest inflation readings of the year will soon be in the rear-view mirror. Monthly price numbers should become more representative as they are compared to a more active economy last summer and fall. Used-car prices appear likely to drop after average wholesale prices fell by 1.3% in June, according to auto auction giant Manheim, their first decline since December. Kinks in the supply chain caused by the surge in demand should be worked out soon, allowing prices to normalize. Lumber already has fallen 40% since rising four-fold through May.
Inflation for all of 2021 could end up at an elevated 3%. However, we view a sustained price surge as unlikely.
3. How the Fed handles the inflation threat will determine markets’ direction. So far, so good.
Ever since the global financial crisis of 2007-09, the Federal Reserve has bent over backward to avoid dealing markets a nasty surprise – mostly successfully, albeit with a notable stumble or two along the way. Unlike Alan Greenspan, the long-time Fed chair famous for indecipherable statements, his successors have aimed for transparency about their thinking and even about what they are “not even thinking about thinking about,” as current Chair Jerome Powell famously said in June 2020 about raising rates.
Yet the guessing game about the next monetary policy move continues, with much riding on the outcome. How the Fed reacts to inflation in the second half will be pivotal in determining how markets perform. Will a change in economic data force the Federal Open Market Committee to act earlier and more forcefully than officials have suggested? As discussed above, we believe inflation will decelerate and enable the Fed to avoid resorting to aggressive steps to restrain it, keeping markets relatively even-keeled. However, we are watching the data and the Fed’s signals closely and our views could change quickly.
The Fed’s dual mandate of full employment and price stability puts it in a tricky situation, with the jobs market still relatively chilly but prices running hot. Any decision made to improve the outlook for either category could exacerbate the other. At the moment, there is no sign of urgency at the Fed to start reducing, or tapering, the $120 billion it has been pumping into the financial system monthly for more than a year.
The Fed has chosen employment as the key indicator for now, citing the need for “substantial further progress” in regaining lost jobs before it begins unwinding the multitrillion-dollar emergency policies it put it in place at the start of the pandemic. A meaningful worsening of the inflation picture would likely force it to act sooner. Fed officials already have indicated they are ready to act to contain inflation’s rise, including pulling forward their expected timetable for interest-rate increases from 2024 to 2023, or perhaps even late 2022. But the latest inflation data is not enough to force them to raise rates at any time in the next year-plus.
The first step when the Fed begins scaling back its ultra-accommodative policy will be to declare and initiate the start of the tapering process. When that happens, and it could be soon, it likely will result in increased market volatility including a rise in real interest rates – but not enough of a jolt in our view to derail this bull-market cycle. The Fed has shown in both its communications and its policies that it will do what is necessary, within reason, to keep stocks moving higher. Officials have pledged to avoid a repeat of the 2013 “taper tantrum” that roiled markets the last time it drew down its purchases.
Markets so far have trusted the Fed and its view that higher inflation will be temporary, meaning it would not have to stop its purchases or hike rates sooner than expected. Clear evidence of that faith came via the flattening of the Treasury yield curve in the second quarter, with the 10-year yield falling from a peak above 1.7% at the end of March to just above 1.4% at quarter’s end (and more recently to 1.2%).
Fed officials know exactly the approach they must take – and the one to avoid – as Dallas Fed President Robert Kaplan indicated recently: “We’ve got to be very sensitive to the lessons of 2013, and when we start tapering it has to be well-telegraphed and it has to be gradual.”
We are confident the Fed has learned its lessons and, by moving gradually, predictably and with sufficient advance warning, should be able to start winding down its easy-money policies without inordinate market turmoil. We do not believe this is the moment to start “fighting” the Fed.
4. Markets should continue to grind higher even though the momentum from their dramatic snapback has faded.
Investors endured the equivalent of Class 5 whitewater rapids on the market’s wild, though ultimately exhilarating, run in 2020. This year the experience has been much calmer overall, although some July turbulence amid renewed fears of the Delta variant’s spread served as a reminder that pullbacks occur fairly regularly in even the healthiest of markets.
The broad U.S. market had its best start to a year since 1998 with a 15.2% return as proxied by the iShares S&P 500 for the first six months – approaching the 18.3% gain for all of last year. History suggests that such strong starts typically bode well for the remainder of the year. International developed stocks already have surpassed their 2020 gains, buoyed by more stimulus from governments and central banks.
Much of the U.S. market’s 2021 success is owed to a big first half for long-underperforming value stocks (more cyclical names such as banks, industrials and energy companies). Along with small caps, they began the year strongly amid investor optimism about the economy’s reopening. Value was once again leapfrogged in the second quarter by growth stocks (such as technology and biotech firms), which benefited from falling interest rates, yet still delivered a solid quarter.
While growth has been what Morningstar recently described as “the teacher’s pet” for several years, value has gained in favor and sits alongside it at the front of the class. The two investing styles had almost identical gains from midyear 2020 to midyear 2021: 43.4% for the large-cap value index to 42.3% for its growth peer. We are allocated approximately equally to growth and value and see similar potential for the two areas in the year ahead as the economy powers ahead and ultimately downshifts to a more modest growth pace.
Another key development for markets this year has been the strong comeback of real estate investment trusts, which began recovering in late 2020 but still finished the year in the red. Our passive benchmark, the Vanguard REIT Index Fund, returned 24% through July 16th to lead all asset classes. The property sectors that were hard hit last year, such as retail and lodging, have benefited from the continued progress with vaccinations and the reopening. We anticipate further strength in this sector in the second half.
Whatever happened to the flashy trends from early in the year – meme stocks, SPACs (special purpose acquisition companies) and cryptocurrencies? Speculative fever has faded for now, along with market excitement, as the economy returns to familiar footing and markets stabilize. We find that a healthy trend.
5. Direct lending offers an opportunity to increase portfolio diversification in a low-interest rate environment.
Many investors are understandably ready for new opportunities now that markets and the economy have recovered from the worst of COVID-19 and portfolios are back at pre-pandemic levels. “Fat pitches” are harder than usual to spot in an environment where neither stocks nor bonds are cheap on a historical basis. That said, we are excited to soon recommend an attractive opportunity in a different part of the investment spectrum – direct lending – that has the potential to deliver solid returns while increasing portfolio diversification.
Lending to privately held businesses has become a much more common, and safer, investment in the wake of the global financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 introduced stricter rules and regulatory requirements that tightened underwriting standards and mandated that banks hold additional capital against credit. It shifted the business of lending money to small- and medium-sized companies from commercial banks to asset managers. Indeed, direct lending assets under management in the U.S. jumped by over 800% in the following decade to around $800 million in 2020.
A subset of the private debt market, direct lending is characterized by non-bank creditors making loans without an intermediary. We believe the most attractive area of this market is the so-called middle market – approximately 200,000 companies that generate between $10 million and $100 million in profits annually. These businesses typically use the money to finance leveraged buyouts, mergers and acquisitions, growth investments and recapitalizations.
Because the direct lending market is private and thus more inefficient, lenders are often able to negotiate relatively high rates of interest depending on the market environment. Today, the starting point for the average directly originated middle-market loan is around 5.5% above LIBOR – the benchmark interest rate at which major global banks lend to one another, currently around 0.1%. The yield will fluctuate based on certain risk premiums such as company size, private equity sponsorship and the lender’s position in the capital structure.
Risks do exist, notably due to illiquidity and leverage. Like most risk assets, direct lending would struggle in a protracted recession. But otherwise, the volatility and realized losses – particularly in senior loans – are relatively low. And the risk-adjusted returns they offer compare favorably to broadly syndicated loans and high yield bonds.
Altair has long been attracted to direct lending’s possibilities but we wanted to first observe how it fared as an investment during a recession. We were impressed by how well these loans performed during the COVID-19 recession, and how well the asset class overall endured was comforting.
Because of the bespoke nature of these loans, returns on direct lending are not highly correlated to those of public debt and equity markets. This characteristic makes it an excellent diversifier within portfolios as well as offering solid risk-adjusted returns.
- The U.S. and global economies are growing rapidly and we expect the recovery from the devastation caused by COVID-19 to remain robust through the second half. The biggest risk to global growth is the potential for a resurgence of the coronavirus due to a highly contagious variant that can defeat existing immunity.
- Inflation is likely to remain elevated for the rest of the year, but we do not view it as either excessive or a serious threat to economic growth. We expect the increase in prices brought about by the economy’s reopening to gradually ease, with inflation returning closer to its normal historical range of around 2% in 2022.
- The Federal Reserve may soon lay out a timetable for reducing its bond purchases but is likely to stay highly accommodative in its monetary policies for a considerable time to come. An interest-rate hike remains unlikely in 2022. We believe the Fed’s pledge to roll back its emergency support gradually and to communicate its policy intentions very clearly should help avoid a major market disruption.
- Markets should continue to benefit from economic momentum in the second half. We anticipate a more balanced stock market as the recovery proceeds, with U.S. and international stocks and value and growth stocks offering similar potential compared to the dominance of different asset classes since the pandemic began.
- We expect bond yields to be relatively restrained in the second half, although the 10-year Treasury yield may drift higher after falling to 1.2%. While the recent decline reflected concern about a potential pause in the recovery, growth remains vigorous and momentum should pick up as more jobs return and supply chains normalize to meet pent-up demand.
Quotes of the Quarter
“Lift-off (on interest rates) is well into the future. We’re very far from maximum employment.” – Jerome Powell, Federal Reserve chair
“There’s just going to be more (market) hiccups as the Fed comes to the reality that they’re going to have to start to tighten.” – Jeremy Siegel, Wharton School finance professor
“With a dangerous wave of a highly transmissible variant now making its way across the globe, the pandemic remains the fundamental risk facing the world.” – Kristalina Georgieva, International Monetary Fund managing director
Investors welcomed the return to near-normal daily life and a thriving economy by driving the stock market further into record territory in the second quarter as businesses reopened and the outlook for publicly traded companies brightened. Large caps and growth stocks led the way, taking back the market leadership at least temporarily from small caps and value stocks.
The iShares S&P 500 ETF reached the midyear mark up 15.2% for 2021 following an 8.4% return from April through June. It marked just the second time in history and the first time in 67 years that the U.S. benchmark has gained more than 5% in five consecutive quarters. Value stocks as proxied by the iShares Russell 1000 Value ETF outperformed their growth-focused peers 16.9% to 12.9% over the first six months. But the second quarter saw a return to growth dominance as the large-cap growth index gained 11.8% versus 5.0% for value, with similar turnarounds at the small, mid-cap and microcap levels. The biggest-gaining stock sectors through six months were energy (up 42.4%) and financials (24.5%), with technology companies rallying to return 13.2% and utilities bringing up the rear with a gain of 0.8%.
Small caps had more modest gains after strongly outperforming at the very beginning of the recovery in late 2020 and the first quarter of 2021. The iShares Russell 2000 ETF still registered a healthy advance of 4.0% for the quarter en route to a 17.4% gain at midyear.
Non-U.S. stocks overcame the dual challenges of a slower recovery from the pandemic and a strengthened dollar to achieve good performance in the first half. The iShares MSCI EAFE ETF, representing the most developed areas outside North America, was up 9.6% at midyear following a 5.4% increase in the second quarter. The dollar gave back some of its 2021 advance in the quarter but still ate into the returns of foreign stocks for the half-year, rising nearly 3% against a basket of other leading currencies. Before currency translation back into the U.S. greenback, the EAFE index was up 13.1% for the six months.
The emerging-markets index managed a more modest gain, boosted by strengthened performance from Brazil, Russia and India but held back by an essentially flat quarter by China’s stocks. The iShares MSCI Emerging Markets ETF added 3.9% in the quarter and was up 7.2% year-to-date as of June 30. Chinese stocks, their biggest component, were slowed by a decline in credit growth and the debt problems of developers and financial firms, with MSCI’s China index up just 1.1% through six months, its worst first-half performance in eight years. Turkey was the worst-performing market worldwide, falling 19.3% (denominated in dollars) in the first half.
The real estate investment trust (REIT) sector remained a leading comeback story for 2021. Among red-hot commercial property markets, regional malls, shopping centers, self-storage and retail all prospered with the economy’s reopening. The Vanguard REIT Index Fund rose 11.7% for a 21.4% year-to-date return. Internationally, reflecting the slower pace of the reopening and the strong dollar, the Vanguard Global ex-US Real Estate ETF added 4.5% and was up 7.3% at midyear.
Hedged and opportunistic strategies as measured by the category benchmark continued their recent trend of modest gains. The HFRX Global Index, a barometer of the average hedge-fund performance, rose 2.4% to reach the midyear mark with a year-to-date gain of 3.7% – slightly ahead of its 2020 pace.
Altair’s blended benchmark for closed-end funds had a strong quarter with an 8.0% advance driven by its 60% equity component, leaving it with a first-half return of 14.1%. The equity closed-end funds also benefited from the continued narrowing of discounts across the closed-end fund universe.
Our benchmark for securitized credit, or distressed debt, a blend of 65% mortgage-backed bonds and 35% high-yield bonds, moved into positive territory for the year with a 0.9% increase in the April-through-June period, helped by the decline in rates. The high-yield segment of the market continues to be supported by further spread compressions and is now back to pre- global financial crisis spread levels over Treasurys. The securitized credit benchmark was up 0.3% at midyear.
Bond prices saw a turnaround from a rough first quarter, when expectations for a surge in growth and inflation in the wake of the pandemic sent them lower, particularly for taxable bonds. The bond market stabilized amid more mixed data surrounding the economic recovery and was helped by the Fed’s repeated assurance that the rise in inflation should not be large or persistent. The 10-year U.S. Treasury yield halted its climb and dropped three-tenths of a percent to 1.4% on June 30th.
Taxable bonds as proxied by the Vanguard Total Bond Market ETF erased half of their first-quarter decline with a 1.9% rise from April through June that left the benchmark down 1.8% at midyear.
Altair’s municipal bond benchmark, a blend of the Market Vectors short and intermediate ETFs, climbed into positive territory for the year at 0.4% following a 0.9% advance in the second quarter. Munis benefited from declining rates as well as the reach for yield.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.