Despite the significant pain the COVID-19 pandemic inflicted on our health and economy, markets have rallied aggressively. Throughout lockdowns and virus surges, investors were convinced that better days were on the horizon. Finally, those better days are here — with increased COVID-19 vaccination rates, massive fiscal stimulus programs and accommodative monetary policies bolstering the economy and earnings so far this year. Yet strangely, even as stocks extend their lofty 2020 gains, investors are growing anxious about the many challenges that still lie ahead. Markets have reached an inflection point as investors brace themselves for what could be a bumpier second half of 2021.
Progress fighting the pandemic boosts GDP
Nearly half of the US population has now received at least one vaccine dose. The Biden administration’s latest goal in the fight against the pandemic is to get 70% of the US adult population at least one vaccine dose and to fully vaccinate 160 million adults by July 4th. The Centers for Disease Control and Prevention also announced that fully vaccinated people could resume pre-pandemic activities without wearing a mask or physically distancing, except where required by local laws or regulations. More states are rolling back COVID-19 restrictions and lifting mask mandates, allowing the economy to further reopen.
At the same time, fiscal stimulus from December’s $900 billion Consolidated Appropriations Act and March’s $1.9 trillion American Rescue Plan Act continues to flow through the economy. And the Federal Reserve remains committed to keeping interest rates low and asset purchases steady until “substantial further progress” is made on its maximum employment and price stability goals.1
Not surprisingly, first quarter GDP rose 6.4%2 and earnings-per-share growth for S&P 500 companies soared by more than 49% year-over-year.3 Second quarter figures are likely to be even stronger. The Federal Reserve Bank of Atlanta’s GDPNow model estimates second quarter GDP of 10.1% and FactSet reports that analysts are expecting S&P 500 companies to grow their earnings by a staggering 59.5% in the second quarter.
Many investors have profited from this attractive backdrop for stocks, as the S&P 500 Index has closed at a record high 26 times so far in the first half of 2021.
Economic and earnings growth could peak in Q2
Both the economy and earnings will continue to signal a strong recovery from the pandemic throughout the second half of the year. However, the rate of growth for economic data and earnings will likely begin to decelerate by the third quarter. Investors are growing increasingly concerned that a peak in fundamentals may coincide with a peak in stock market prices.
In addition, an unusually long post-Global Financial Crisis economic expansion briefly disrupted by the COVID-19 pandemic, combined with the distortive effects of enormous fiscal stimulus and easy monetary policy, have created confusion regarding where we are in the economic cycle. The ongoing debate has unnerved investors and complicated their asset allocation decisions.
As if concerns about peak fundamentals and confusion about the economic cycle weren’t enough for investors to contend with, rising interest rates, building inflationary pressures, and potentially higher taxes are adding to their indigestion.
Rising inflation and interest rates present challenges
Low base effects from a year ago, supply chain bottlenecks and persistently underestimating demand during the recovery have resulted in big increases in inflation data. For example, the Bureau of Labor Statistics reported that the Consumer Price Index climbed 4.2% for the 12-months ending April 30, 2021, the largest year-over-year increase since 2008. Investors are trying to determine whether these price increases are truly temporary, as the Federal Reserve suggests, or if they are more permanent. Getting inflation right is critical for investors. Rising inflation could lead to higher interest rates. Surging interest rates and inflation would likely put downward pressure on once highflying growth stocks and fixed income investments.
Further fueling fears of rising interest rates and inflation is the extraordinary amount of government spending enacted to combat the pandemic. In the US, nearly $6 trillion has already been approved to defeat COVID-19. The Biden administration is also working on the $2.7 trillion American Jobs Plan and the $1.8 trillion American Families Plan. To offset some of this additional government spending, the Biden team has called for higher taxes on wealthy individuals and corporations. Uncertainty regarding future tax rates may also unsettle investors later this year.
Midyear strategies to consider
This complicated outlook underscores the fact that the second year of the market recovery following the pandemic’s peak is likely to be a lot more challenging than the first. Investors should expect greater bouts of market volatility throughout the second half of the year. Yet, the good news is that historically, despite the challenges, stocks typically continue to grind higher in the second year following a crisis.4 The first half of 2021 has provided a solid head start for investors. Given the still attractive backdrop for risk assets, investors should consider the following three strategies when constructing portfolios for the second half of the year:
For more on these investment strategies, read our 2021 Midyear Market Outlook.
1 Federal Reserve Chair Jerome Powell, Speech after the Federal Open Markets Committee meeting, April 28,2021.
2 Bureau of Economic Analysis, April 29, 2021.
3 FactSet, May 7, 2021.
4 “Corrective Phase Ongoing, with New Leadership This Time,” Strategas Research, May 13, 2021. Crises referred to include 1982 and 2009.
A debt investment in which an investor loans money to an entity — typically a corporate or governmental entity — that borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners of bonds are debtholders, or creditors, of the issuer.
Consumer Price Index, or CPI
A widely used measure of inflation at the consumer level that helps evaluate changes in cost of living. The CPI is composed of a basket of consumer goods and services across the economy and is calculated by the US Department of Labor by assessing price changes in the basket of goods and services and averaging them. Core CPI is the same series, but excluding food and energy prices, which are considered to be volatile enough to distort the meaning and usefulness of so-called headline CPI. The absence of food and energy, means the core series reflects long-term inflation trends more accurately.
Earnings Per Share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Financial Crisis, or Global Financial Crisis (GFC)
The economic upheaval of 2007-2009 that is generally considered the largest downturn since the Great Depression of the 1930s. The GFC was triggered largely by the sub-prime mortgage crisis that led to the collapse of systemically vital US investment banks such as Bear Stearns and Lehman Brothers. An aggravating factor was the speculative spike in energy that lifted oil prices to almost $150 a barrel in the summer of 2008, and which surely contributed to the economic slowdown.
GDP or Gross Domestic Product
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
The amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of assets.
The actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which, in turn, affects interest rates. Monetary policy is maintained through actions such as modifying the interest rate, buying or selling government bonds, and changing the amount of money banks are required to keep in the vault (bank reserves).
The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
The views expressed are the views of Michael Arone as of May 17, 2021 and are subject to change based on market and other conditions. The opinions expressed may differ from those with different investment philosophies. The information provided does not constitute investment advice and it should not be relied on as such. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon.
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