Market Commentary: 2021 Q3

Looking back to the second quarter of 2021, our outlook had an optimistic tone. We forecasted that both the economy and markets were poised to continue recovery and grow due to vaccine-led reopening and stimulus. We largely saw this across the globe as equity returns were strong and correlated with vaccine administration success. In the U.S., a world-leading vaccine administration effort resulted in record GDP growth numbers, double digit equity returns, and new all-time highs in equity markets. Internationally, vaccine administration lagged that of the U.S. and led to returns that, while strong, underperformed U.S. markets.

Although the positive return seen during the quarter was directionally anticipated, the areas of the market that drove this return were somewhat surprising. It was generally expected that the ‘reopening trade’ of cyclically oriented companies found within the value and small cap areas of the market would continue to outperform, as they did in the first quarter. In reality, large

companies and growth companies outperformed their small and value counterparts. In addition, despite strong reopening-driven economic growth and increasing inflation expectations, long term interest rates (a proxy for future growth expectations) fell modestly during the quarter. The second quarter also saw the consumer price index rise above 4% year-over-year for the first time since the great recession and increase even further to 5.4% in June on the back of consumer demand outpacing production, supply chain bottlenecks, and higher oil prices.

Where We’re Going – 2021 Q3 Outlook

In the third quarter, inflation will continue to be top of mind for consumers, stock and bond investors, and the Federal Reserve. The Fed has remained consistent in their message that recent inflation spikes are transitory, but a strong economic rebound and rising wages brought on from a surge in labor demand could test the Fed. Inflation will be factor as long as demand outpaces supply.

In the second half of 2021, we see a healthy economy with more muted U.S. economic growth compared to the first half. While we are generally optimistic on the outlook for the U.S. economy and stock market, we could see a brief period later this year of rising inflation and slowing economic growth (the reopening cannot go on forever!) that could bring some volatility. While a tail-risk of additional COVID-19 flare ups remains, current variants are not forecasted to meaningfully slow economic growth.

Internationally, economies are catching up to the U.S. in terms of vaccine administration. This is already leading to large improvements in economic data out of those countries. We expect this lagging reopening to continue and, because it is in such early stages, the reflation/reopening trade internationally may have more upside than U.S. markets. In addition to this perceived higher upside, both emerging and developed markets are at some of their cheapest levels relative to the U.S. over the last two decades. Combining these factors with our expectation of a lower dollar in the long run point toward a continued allocation to international markets.

Bond markets present a skewed risk-return profile as low interest rates present dull return opportunities while government bond issuance, stimulus, Federal Reserve actions, strong economic growth, and inflationary pressures continue to create more risk that rates will go up (and bond prices will go down). Until these pressures subside, we prefer to control risk by relinquishing some potential upside by allocating conservatively to short duration bonds that are less sensitive to changes in interest rates. In addition, in an effort to identify opportunities for return, we continue to allocate to interesting opportunities in alternative investments that are uncorrelated to both bonds and stocks.

Portfolio Management Updates

The current market environment presents a challenge with the classic 60% equity and 40% bond portfolio (AKA, a “60/40 portfolio”.) Historically, the price to earnings ratio (P/E ratio) has been used to create a crude but directional predictor of future returns on equities. Similarly, bond yields should be a good predictor of the long-term return on bonds. With the P/E ratio for the S&P 500 near the highest it has been since the dot-com bubble and bond yields still near all-time lows, future return prospects for this model allocation are subdued.  

In our bond portfolio, we believe that the ongoing and increased use of alternative investment options is wise to maximize growth on a risk-adjusted basis. We prudently maintain a core allocation to fixed income for diversification purposes but have adopted the use of alternatives to seek returns uncorrelated with equities and bonds, including introducing a new market neutral fund this quarter.

In equities, we see continued opportunities in asset classes that benefit from the cyclical recovery. Domestically, we see this opportunity in value-oriented equity, but more predominantly in SMID-cap (small and mid) equity. This opportunity that was available in U.S.

markets in the fourth quarter of 2020 through the first quarter of 2021 has just begun internationally. We are introducing two new developed market positions – one value and one small cap – into our international equity line-up to capitalize on this. To ‘fund’ these new allocations, we are reducing the size of (but not eliminating) our active overweights to US Small Cap and International equities.