Second Quarter 2021 Commentary

By Daniel McGarvey

2021 has continued to be a positive year for equity markets amidst the backdrop of a continually reopening economy. The second quarter has been considerably calmer than the first, but the S&P has registered five straight months of gains as we head into the summer awaiting more news on inflation, taxes and infrastructure spending.

Through the first half of the year, the S&P 500 returned over 15%, while the Barclays Aggregate Bond Index lost almost 2%. The unemployment rate decreased from 6.7% at the beginning of the year to 5.9% in June, and consumer net worth increased to new all-time highs of $137 trillion. At the same time, year-over-year core PCE rose to 3.4% amidst growing fears that inflation may not be as “transitory” as the Fed implied.

In June, the FOMC signaled a shift in its thinking by raising its inflation projection to 3.4% and admitting it may need to raise rates as soon as 2023. Of course, these projections could change by the time it meets again, but at this point, it seems as though there is almost no alternative to inflation given our massive debt load and unwillingness to experience any form of recession.

In a way, inflation could be an unspoken necessity in order to bring debt-to-GDP back to normal levels. As shown in the chart to the upper right, higher nominal GDP would shorten the debt payback window, but that increase in nominal growth might need to come from inflation, effectively shifting the cost of the debt onto unaware consumers.

The evidence of inflation has already been felt in the persistence of supply bottlenecks and historically low inventories, but it remains to be seen how soon those bottlenecks will peak. A majority of the brunt from shortages has been borne by increases in worker productivity as firms have had to regain production levels with fewer workers. Although output per hour growth is not abnormal during economic recoveries, there has been a marked increase over the past year, and the durability of these increases is certainly worth monitoring.

The likelihood of President Biden’s tax proposals has not become much clearer over the quarter, and these uncertainties are making it difficult for investors to position themselves for the potential impact. The corporate tax increase, for example, seemed almost inevitable a few months ago but now feels like it could go either way. The debate about how trillions of dollars of new spending and tax increases will unfold will probably not be settled for months.

The White House has signed on to a bipartisan infrastructure plan, which is a fraction of the original proposal but will have to involve at least some tax increases. The U.S. has also endorsed a global minimum tax, aligning with the OECD’s desire to tax cross-border digital services and limit multinational companies’ ability to shift profits to low-tax jurisdictions. These initiatives could especially hurt technology and health care companies, which traditionally benefit from shifting their profits.

After seeing all-time lows in 2020 and an abnormally quick rise in the first quarter of 2021, the 10 Year Treasury Rate has spent the second quarter in the 1.43-1.75% range. Rates are still historically low, but. like most investors, we see them rising through the end of the year and beyond.

Investment Allocation

The first quarter’s rotation from growth to value, large cap to small cap, and domestic to international calmed down in the second quarter. Whether these rotations are over is debatable, but inflation concerns do make a case for higher-quality names that distribute cash in the near term over companies whose terminal values are based mostly on future earnings that are now less certain.

We still tilt toward value and have a favorable outlook on financials and energy as traditional sectors continue recovering, and we also believe industrials and materials could continue to benefit from the unfolding infrastructure bill. As mentioned above, sectors like technology and health care are worth monitoring as they could be particularly vulnerable to the OECD’s cross-border tax initiatives.

inflation concerns do make a case for higher-quality names that distribute cash in the near term over companies whose terminal values are based mostly on future earnings that are now less certain.

We still tilt toward value and have a favorable outlook on financials and energy as traditional sectors continue recovering, and we also believe industrials and materials could continue to benefit from the unfolding infrastructure bill. As mentioned above, sectors like technology and health care are worth monitoring as they could be particularly vulnerable to the OECD’s cross-border tax initiatives.