Cycles of Recovery

Markey Commentary | July 9, 2021

For investors, the adage to ‘buy low, sell high’ offers an attractively simplistic formula for managing a portfolio as prices fluctuate. In reality, domestic and international stock markets rarely provide clear indications ahead of inflection points, and ‘high’ prices can often push higher for far longer than investors anticipate. As we move into the second half of 2021, there is a familiar uncertainty about whether the current growth cycle is sustainable after substantial price appreciation in the first six months of the year.

Over the past three months, global economic activity has continued to pick up strongly, particularly in countries that have successfully vaccinated large proportions of their population. As economies like the US, the UK, and much of Europe continue to open up, economic activity has surged on the back of pent-up demand and the delayed impact of huge fiscal and monetary stimulus. In the US, consumers have emerged from their home-based bubbles and are driving recovery across multiple sectors.

As of June 30, the US had fully vaccinated 48% of the population, ranking near the top of large developed countries.¹ This progress empowered consumers to emerge from hibernation and accelerate spending on restaurants and travel. The TSA reported 2.1 million air travel passengers on July 1 versus only 633k a year prior.² While that is still only 82% of pre-pandemic levels, it represents significant growth from the lows of last year.

In another measure of progress, The Economist developed the Global Normalcy Index (GNI) to measure the post-pandemic return to ‘normal’ (aka pre-pandemic) economic activity levels. In March 2020, the GNI was 35 overall, with 100 being the normal pre-pandemic level. At the end of June 2021, the worldwide GNI was 66, more than halfway back to normal. The US is ahead of that trend, with a GNI score of 72.8 as of June 30.³

While the US economy has recovered more than three quarters of the way back to pre-pandemic levels, the US stock market has already eclipsed its prior high point on the expectation of continued earnings growth. The S&P 500 stock index gained +15.3% through the first six months of the year, and the EAFE international stock index added +8.8%.

The pace of growth in both economic data and asset prices caused interest rates to tick higher in the first quarter, putting downward pressure on bond prices. As of June 30, the Barclay’s Aggregate Bond Index was down -1.6%, reversing a portion of its gains from 2020. The next steps for both interest rates and stock prices are uncertain, but the global reopening trajectory continues to underpin optimism in equity markets.

Surging consumer demand pushed corporate earnings higher, but it has also led to growing pains in the process. Supply chain issues arose throughout the first half of the year – spikes in lumber prices, shortages of microchips that impacted new car sales, and temporary shocks including a massive container ship getting stuck in the Suez Canal and halting global trade for more than a week.

The key question facing both investors and Fed officials is whether current inflation is caused by transitory forces during the re-opening process or whether it will remain as a more enduring headwind to growth. In late March, investors were fretting over runaway inflation as the 10-year Treasury yield peaked at 1.75%. Since then it has fallen steadily, closing today at 1.35%. For the Treasury market, these are notable moves, and they suggest that the core market narrative has shifted away from inflation fears to worries about a slowing pace of growth.

A further growing pain will arrive in the form of the Fed’s management and eventual reduction of current stimulus efforts. At present, the Fed is buying assets to support bond prices and keep yields low, at a massive $120 billion per month pace. Fed officials recently signaled that this program will be tapered earlier than investors had predicted as the economy recovers more quickly than forecasted. While this ‘ahead of schedule growth’ is ostensibly a positive milestone, the reduction in Fed support will likely lead to price volatility in the short term. Regarding interest rates, the Fed still doesn’t expect to raise rates until late 2023, but again the key variable for investors is whether that timeline gets moved up.

Acknowledging these natural speedbumps, we still see US stocks as a key driver of growth in our client portfolios over the coming years and would anticipate adding incrementally during a market decline just as we have been systematically trimming during the recent growth cycle.

Juxtaposed against encouraging vaccination rates in the US, many other countries have not yet achieved similar progress. Countries including Brazil (14%) and India (5%) lag in vaccination rates, and the Delta variant is driving additional waves of infection that hamper any seedlings of economic recovery. Even in a developed country like Japan, only 15% of the population has been fully vaccinated in advance of the upcoming Olympic Games. This has led to a recent state of emergency that prohibits spectators from attending (and spending money at) the games in Tokyo.⁴

This differential reopening progress has meant growth in international stocks has lagged that seen by US companies, but we have no reason to believe they will not experience a similar recovery correlated with vaccination progress. We expect some challenges in the form of inflation concerns and supply chain disruptions, but we also expect that lockdowns will be lifted internationally and consumers will drive economic activity higher as new pandemic variants abate.

We are maintaining our allocations to international stocks, both in developed and emerging markets, as their recovery cycle may prove to be a tailwind in the second half of the year while US growth slows to more normalized levels.

Making small incremental changes in portfolios was notably helpful in the past year in several sub-asset classes, including real estate and US small cap stocks. Both sectors were among the laggards in the portfolio last year with concerns about permanent ‘work from home’ trends impacting real estate valuations and smaller companies with less e-commerce clout not seeing meaningful recovery until after vaccines were announced late in the year. We added to both sectors last summer while they were down in price, and in the first half of the year they have been the largest gainers with real estate up +21.2% and small cap US stocks +23.5%. The recovery trade in international stocks may follow a different timeline, but we are confident that buying during periods of relative undervaluation will benefit portfolios over the long-term.

We manage uncertainty via a systematic process of adding to undervalued positions and trimming highly valued positions in client portfolios. This approach keeps portfolios in line with long-term allocation targets amidst the noise of short-term price oscillations. Further, it allows us to focus less on timing market events and focus more on aligning portfolio decisions with the events in our clients’ lives – whether transitioning to a well-earned retirement phase, supporting a child or aging parent, or planning a trip to celebrate emergence from the past year and the re-opening of our global and local communities.

References
¹ Tracking Coronavirus Vaccinations Around the World NY Times

² TSA checkpoint travel numbers (current year versus prior year(s)/same weekday) TSA.gov

³ The global normalcy index The Economist

⁴ Japan’s latest coronavirus state of emergency covering Tokyo, declared by the government Thursday, could cost the economy around 1 trillion yen ($9.1 billion), according to economists’ estimates. Kyodo News