Wealth Matters Newsletter - July 2021

What To Watch In The Second Half

Written by: Mark P. Bernier, CFA, Senior Vice President/Wealth Management Officer

Midway through 2021, financial markets are poised to finish on a high note, continuing the trend that began in late March 2020. The Dow Jones Industrial Average, S&P 500, NASDAQ Composite, and Russell 2000 are poised to finish the first half of 2021 with double-digit returns, as of this writing. Still accommodative monetary policy, strength in consumer spending, and a growing population of fully vaccinated Americans have spurred investors to continue favoring stocks, despite recent readings on inflation. With such a strong finish to the mid-year, what might the rest of the year have in store for investors? Here are a few items we will be watching that will likely influence markets for the remainder of 2021.

Monetary Policy

The Federal Reserve has maintained an extremely accommodative monetary policy stance since the beginning of the COVID-19 pandemic economic shutdown in 2020. The Fed Funds rate has been pegged at zero since last year, and the Fed continues its course of quantitative easing (buying bonds to keep longer-term rates low), for now. Investors are awaiting signals from the Fed as to when these two accommodative policy positions will be reduced or removed. As has been covered in these newsletters several times, the Federal Reserve has two mandates, full employment and price stability, and the Fed has adopted a new policy framework that would require full employment and inflation running above its 2% target for an extended timeframe before taking policy action. Recent readings on employment indicate progress, but room for improvement. Initial jobless claims have stubbornly remained above 400,000 and over 14.8 million Americans were still drawing on regular state and special pandemic-related unemployment benefits programs. We expect to see these numbers decline as more states opt out of the extra federal benefits prior to their expiration on September 6.

FRED chart

Inflation, as measured by the Consumer Price Index (CPI), rose to levels not seen since 2008. Elevated inflation was anticipated during the second quarter, due in part to the collapse in prices during the second quarter of 2020. The Fed, and many economists, expect inflation pressures to ease during the back half of the year, as the base effects from last year’s price collapse wane. Additionally, labor shortages and supply chain bottlenecks are expected to ease, though the speed of improvement in either condition will certainly impact the pace and magnitude of easing inflation pressures.

The bond market, too, anticipates easing inflation. Though still at levels last seen in 2011, the 5-Year Breakeven Inflation Rate (or the difference between nominal yields of U.S. Treasury Securities and Treasury Inflation-Indexed Securities) has fallen from 2.72 in mid-May 2021 to 2.46 as of June 29, 2021.
Investors are nervous about a repeat of the “Taper Tantrum” experienced in 2013. At that time, the Fed was also executing a quantitative easy policy, but announced their plans to end those activities later in the year. In response, investors quickly sold longer-term bond positions, pushing the 10-Year U.S. Treasury yield from 1.6% to 3% in three months’ time. The Fed has vowed to be deliberate and transparent when communicating their anticipated policy changes this time around, in an effort to avoid the volatility experienced in 2013.

Fiscal Policy

The Biden administration is in the midst of drumming up support for the $1.2 trillion bipartisan infrastructure plan. The plan calls for a 5-year spending window, with investments in transportation projects, digital, disaster, environmental, and energy infrastructure. Importantly, from the standpoint of investors, the proposal does not incorporate changes in tax law or require the passage of a larger bill backed by Democrats. President Biden recently walked-back comments that appeared to threaten the passage of the infrastructure bill if not linked to the larger, Democrat-supported bill.

The issue of potential changes to tax law has been front-and-center for much the year. Without getting too deep in the weeds of Washington political chess, there is a chance that the reconciliation process of a bipartisan infrastructure bill could end up including some of the tax hikes that the Biden administration is seeking. Corporate income tax rates, personal income tax rates, capital gains taxes, and estate taxes are all in the cross hairs and material changes to any or all of these will likely have market repercussions.

COVID-19 Delta Variant

Over the last several weeks, the Delta Variant of the COVID-19 virus has wreaked havoc in many parts of the world, with estimates that it may become the dominant strain in the U.S. in the coming weeks. In response to this more contagious and dangerous mutation, numerous countries have imposed lockdowns and some states are reconsidering masking requirements. Any hurdles to the economic reopening caused by responses to the Delta Variant would likely pause current market trends.

Corporate Earnings

Second quarter corporate earnings releases will ramp up over the next several weeks. According to a recently published report by FactSet Research Systems, Inc., the current estimate for second quarter earnings growth for the S&P 500 is 61.9%. If these estimates come to fruition, this would mark the highest year-over-year earnings growth rate for the S&P 500 since the fourth quarter of 2009. Earnings reports can add to volatility in equity markets, especially during summer months when lower trading volumes can result in increased market volatility.

Many aspects of American life are returning to what we would consider normal. Vacations, summer camps, and family barbecues are on the agenda for many of us. It almost feels like a “reward” after the last fifteen months. Patient investors have been rewarded, too, over the last year. We remain optimistic about the markets for the remainder of the year, but remain vigilant in identifying risks that could dampen our optimism. We hope you all remain safe and healthy and are able to enjoy these early days of summer.

If you would like to review your portfolio and make sure you have the diversification you need to stay on track, connect with one of our dedicated professionals and schedule a time to talk.

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