Weekly Investment Commentary: Stocks again reach records on easing Fed concerns and infrastructure hopes
Weekly market update highlights
- U.S. manufacturing activity grew at its fastest rate since 2007, as the June Markit Purchasing Managers Index hit 62.6.
- In contrast, new home sales fell to 769,000 in May, marking the third consecutive monthly decline.
- The core Personal Consumption Expenditures Price Index advanced 3.4% year-over-year, marking the largest increase since the 1990s.
- Market volatility fell after the prior week’s bounce, with the VIX declining to 15.6.
Global equities rebounded following the prior week’s volatility, with stocks showing strong gains as investors resumed their risk-on mode. The MSCI EAFE, EM, and ACWI ex-USA benchmarks each added around 1.5%, while the DJIA, S&P 500 and tech-heavy Nasdaq gained between 2.4% and 3.4%.
Economic week in review
- Equity markets hit their thirty-first record high of 2021 last week, helped by more dovish comments by Fed Chair Jerome Powell and the announcement of a tentative federal infrastructure spending deal.
- All 11 S&P 500 sectors were positive last week, as cyclicals and value-oriented names outperformed. Energy added 6.7%, with financials (5.3%) and industrials (3.1%) rounding out the biggest winners for the week. Relative laggards included utilities, real estate and consumer staples, which each added between 0.7% and 1.9%.
- The results of the Fed’s 2021 stress test revealed that all 23 U.S. banks passed, allowing the industry to begin repurchasing shares and boosting dividends, activities that had been restricted due to the pandemic.
Market drivers & risks
- Fed-based volatility disappears. All of the trading driven by perceptions of a more hawkish Fed following the June policy meeting appeared to reverse last week. Without any actual change in the Fed’s planned timing for tapering and rate hikes, investors returned to a more optimistic posture.
- Though a full-blown rotation away from growth and technology did not materialize last week, cyclical and value stocks recovered from their trouncing of the previous week. We believe this erratic week-to-week trading from week-to-week only underscores the importance of bottom-up selectivity and barbelling portfolios with both high-quality growth and cyclical allocations.
- Tentative infrastructure agreement. The White House and a bipartisan group of senators announced a tentative agreement on Thursday for a scaled-back version of an infrastructure plan worth roughly $1.2 trillion, with approximately $580 billion in new spending.
- Highlights included spending targets (railways, broadband Internet expansion, water infrastructure and public transit), as well as an agreement for no new individual taxes. Instead, the deal will be paid for by stricter IRS enforcement. Should it come to pass, we expect such a sizable stimulus to have a positive market impact, particularly for economically sensitive industries.
- Get ready for earnings. As the second quarter draws to a close, we offer a preview of the highly anticipated second quarter earnings season.
- Consensus expectations for second quarter U.S. earnings growth have risen following strong results in the first quarter and are currently north of 60%. This would mark the largest year-over-year rate since the fourth quarter of 2009.
- We think these expectations are on track and shouldn’t be much higher than 60%, given that economic growth appears to be moderating. From this point, we expect individual corporate actions, such as strategies to fill employment gaps, handle supply shortages and increase productivity will increasingly drive earnings results.
“The shifting economic and earnings environment should make bottom-up security selection critically important in the coming quarters.”
Risks to our outlook
The infrastructure agreement is an optimistic sign, but any disruptions in the legislative process could spark additional bouts of volatility.
The “delta variant” of the COVID-19 virus has caused a spike in cases and hospitalizations. Should this variant spread and prove to be more resistant to vaccines, we would likely see significant volatility in global equity markets.
Inflation concerns appear to have moderated following May’s CPI report and the recent decline in commodity prices, but market anxiety could escalate if new data show accelerating wage growth and/or unwieldy price appreciation. Related, we think labor supply constraints may slow the economy’s return to normal. With businesses finding it increasingly difficult to fill positions, we see signs of flattening mobility that could hamper economic and earnings growth.
With rate hikes still likely far in the future, a flattening yield curve could hinder industries that are more sensitive to interest rate momentum, such as financials, which benefited from sharp yield increases in the first half of 2021.
Best ideas
We see opportunities in developed non-U.S. markets, particularly in Europe, which appears relatively inexpensive and should benefit from improved vaccination rates, solid earnings growth and a more cyclically oriented economy. In the U.S., higher inflation could bolster returns for small caps, while select industrial companies should benefit from infrastructure spending. We are also bullish on emerging markets, specifically Brazil and areas such as China’s lodging and gaming sectors, which have lagged through the recovery but stand to benefit from easing travel restrictions as their vaccinated population grows.
In focus: The real estate rebound is real
The U.S. real estate sector ranked among the biggest underperformers of 2020, lagging the broader S&P 500 Index by roughly 20%, thanks to its association with the traditional, analog economy. However, certain areas of commercial real estate have evolved along with other critical pieces of the digital economy over the past decade, resulting in an uneven environment for REITs over the past 16 months.
Property sectors that support the digital economy, such as infrastructure (cell towers), data centers and industrials, traded at historic premiums to their net asset value in 2020, but have lagged other sectors in 2021, despite returning between 13% to 20%. The most COVID-sensitive property types (including lodging, regional malls and apartments), in contrast, have rebounded from their 2020 troughs and have notched returns between 20% and 55% this year as improved vaccination rates have provided increased mobility.
Looking ahead, we see a strong environment for REITs thanks to solid economic growth, historically strong balance sheets, access to liquidity and their ability to weather higher inflation. Although we expect the office sector will continue to remain under pressure as the trend toward remote work is likely here to stay, we see broad opportunities elsewhere. In particular, certain nontraditional property sectors such as manufactured homes, data centers and single family home rentals present attractive risk/reward profiles over the longer term, given increasing demand for cloud computing, e-commerce and affordable housing.
Endnotes
Sources
All market data from Bloomberg, Morningstar and FactSet
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