The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveens 2021 Midyear Outlook :
- U.S. economy: The growth rate has peaked but will remain high throughout 2021.
- Global economy: The economic recovery will spread to Europe and eventually Asia as more countries achieve herd immunity from COVID-19.
- Policy watch: Policy is becoming marginally less accommodative as the recovery takes hold.
- Fixed income: Even with rates subdued, credit-sensitive parts of the market should lead.
- Equities: The best opportunities may now lie outside the U.S.
- Asset allocation: Continue to allocate toward assets poised to benefit from economic reopening and recovery from the pandemic.
Quote of the week:
"No one goes there anymore. It’s too crowded.” – Yogi Berra
Not too fast, maybe too slow?
Annualized U.S. GDP growth for the second quarter is projected to come in at around 8%, representing peak expansion after the first quarter’s 6.4% rate.4 While an 8% headline number would be impressive, the U.S. economy has recently shown signs of decelerating — and financial markets have taken note.
The latest example of softer U.S. data to draw the attention of investors? June’s significant and unexpected drop in service-sector activity. The ISM’s non-manufacturing Purchasing Managers’ Index fell from May’s all-time of 64 to 60.1 — still comfortably above the 50 mark separating expansion from contraction, but a notable slowing.5 Employers surveyed by ISM continued to fret about supply-related issues such as higher input prices, longer delivery delays and persistent order backlogs, while business activity and hiring seemed to slow.
Based on this data, one might conclude not only that demand for services such as dining out, staying at hotels and air travel is growing faster than supply, but also that the gap between the two is widening. Folks are itching to get back to living normal lives, and they’ve saved plenty of cash to spend. It’s too soon to know whether this demand/supply mismatch will meaningfully hamper growth in the second half of the year. After all, many service businesses are still in the process of reopening.
Manufacturers seem to be in a different phase. Being able to restart production gave them a head start toward normalization, helping ease pressure on supply even in the face of robust demand. This dynamic was evident in June’s ISM manufacturing index. Although the headline number (60.6) was slightly below May’s (61.2), survey respondents reported fewer order backlogs and shorter supplier delivery times, along with greater ability to increase production and boost inventories.6
That’s a glimpse into how businesses currently view the state of the economy. What do investors think? Judging by last week’s 7 basis point drop in the 10-year U.S. Treasury yield, to 1.37%, investors may be putting “too slow” above “too fast” on their list of ongoing concerns. (The 10-year yield reflects market expectations of future economic growth. Lower yields tend to signal a slowing economy.) The underperformance of cyclical equity sectors such as energy and financials, along with the rally in the U.S. dollar — considered a safe-haven asset — in the early part of the week, added to the week’s distinct “risk off” tone.
Regarding the Federal Reserve, while a lot of the attention since its June meeting has centered on more hawkish expectations for rate hikes in 2022 and 2023, investors are now pricing in nearly three fewer cumulative hikes than they were just a few months ago. Some of the drop in yields is due to falling inflation expectations since mid-May. But real (i.e., after inflation) interest rates are declining as well. That’s normally a sign markets anticipate softer growth and more dovish monetary policy.
Is this pessimism warranted? Not in our view. Economies don’t slow down while in the midst of a sharp growth spurt unless (a) they’re at full employment and start to overheat, prompting the Fed to raise interest rates; and/or (b) financial conditions tighten significantly. (Financial conditions are measured by the direction of the U.S. dollar, narrowing or widening corporate bond spreads, the level of interest rates at different maturities and stock prices.) Right now, neither “a” nor “b” exists in the U.S. In fact, financial conditions are about as easy as they’ve ever been, and the Fed is pledging to keep rates below their neutral level until at least the middle of the decade. (Neutral in this context means a monetary policy stance that is exactly balanced between accommodate and restrictive.) Meanwhile, 850,000 workers started new jobs in June, and weekly jobless claims are falling steadily toward pre-pandemic levels.
Nuveen Midyear Outlook: Growth is peaking. What comes next?
If you’re looking to make sense of the always-shifting financial markets and economic landscape, Nuveen’s Global Investment Committee (GIC) can help. This committee brings together the most senior investors from across the firm’s platform of core and specialist capabilities, including all public and private markets.
The GIC met in early June to assess the state of the global economy, resulting in both good news and bad news. On the positive side, we came away from the discussion arguably more comfortable and confident about our outlook than we did after our December or March meetings. (You can read our latest outlook, “Growth is peaking. What’s next?” here .)
On the downside, we think investors may face rockier times ahead. That’s because much of the good news for 2021 is either behind us or has already been priced in by the markets. This includes the $1.9 trillion American Rescue Plan Act, the distribution of powerful, effective vaccines and the U.S. economy’s strong, broad-based reopening. Moreover, we believe the second quarter represents the peak of both economic and earnings growth for this cycle.
So what strategies might investors want to consider in this challenging environment?
- Pivot from assets that hedge short-term inflation risks to those that hedge longer-term inflation risks. Treasury Inflation-Protected Securities (TIPS) and gold rallied earlier this year as inflation expectations ramped up, but they’re less likely to repeat their strong performance as central banks gradually begin to phase in tighter monetary policy ahead of likely higher average inflation over the next few years. Rather than TIPS and gold, it may make sense to choose assets with healthier levels of income that are relatively insensitive to changes in inflation. Real assets like global infrastructure and real estate-related securities could play an important role in this regard.
- Be mindful that top-down asset allocation may not get any easier. Since the start of the pandemic in the first quarter of 2020, U.S. growth and value stocks have taken turns outperforming each other, sometimes for weeks or months at a time, and often with no pattern or predictability. That could continue, making tactical allocations even more challenging. And as investors’ attention turns to reducing risk in the face of COVID-19 variants and an uncertain labor market outlook, it’s still anyone’s guess as to which equity sectors are likeliest to lead from here. Looking beyond U.S. stocks, the global economy’s sequential reopening and recovery should favor European and, eventually, emerging market assets as the year wears on.Even favoring stocks over bonds, which has been a highly profitable trade in 2021, is less certain to remain a big winner. Investors may be less willing to pay a steep price for stocks, considering that much of the good news about the year’s earnings outlook has probably been priced in.
- Diversify to seek higher risk-adjusted returns. We’re not expecting a repeat of the first half’s stellar results across asset classes in the second half of the year. Therefore, investors in search of income may need to assume more risk — in credit, real assets, equities or a mix of all three — to generate a respectable yield.And even investors who are more interested in growth and total return may find that the high-flying gains of U.S. cyclical stocks will hover closer to earth as the economic cycle matures and growth cools off. That’s why we think the reopening trade outside the U.S. offers opportunities, mainly in the eurozone and, by the end of the year, emerging markets. The strength of the global economy, along with the pace of recovery and the reduction in COVID-19 restrictions in local economies still under lockdown, will be essential, in our view, to determine the sequence of economic and market bounces in the next six months.
- Remember to assess climate risks in portfolios. Record-high temperatures in large parts of the U.S. over the past two weeks are a reminder that the changing climate is already affecting how businesses operate, where people live and ultimately how investments will perform. The trouble is, we don’t yet have an accurate or reliable method for gauging how much of this risk is priced into markets. In addition to applying environmental, social and governance (ESG) factors in security selection, investors may benefit from deploying capital in discrete infrastructure projects tied to cleaner energy, or financing efforts to make businesses and properties operate more sustainably.