At a glance
Global growth may be transitioning past peak acceleration, but we remain positive about the market outlook. Earnings growth should modestly improve, in line with above-average growth, while bond investors should seek incremental yield opportunities.
We maintain a glass half-full perspective for diversified portfolios as we move to the year’s second half. In short, while we acknowledge that recent corporate sales and profit growth will likely ease and macro data points may slow, global economic growth and corporate earnings will continue to grow. Inflation remains a risk and higher price readings may continue for a period of months, but we do anticipate easing price levels over time. Long term, we view deflation as a larger risk than inflation given low economic productivity trends and an aging global population. However, with low interest rates and some tension between short-term inflationary concerns, we favor traditionally riskier asset classes over fixed income investments.
We have shared a two-investment-horizon framework for clients: The first horizon represents opportunities as the global economy continues to reopen and mobility trends improve, and the second represents the investment opportunity set once reopening is complete. While this transition occurs, investors will need to absorb U.S. monetary policy (via the Federal Reserve or “Fed”) and fiscal policy (spending and taxation proposals from the Biden administration) transitions along with actions from foreign governments. The transition from horizon one to horizon two could coincide with policy changes, and markets await clarity and direction. We anticipate that economic growth will remain positive but demonstrate a slowing trend as countries emerge from the pandemic at varied rates.
The below represents thoughts from our senior investment leaders and their teams. Please do not hesitate to follow up with any questions on how these insights relate to your specific financial situation.
― Eric Freedman, Chief Investment Officer, U.S. Bank Asset Management Group
U.S. equity markets
- First-half performance was superb and broad-based. The S&P 500 ended June 30 up 14.4 percent for the year, above the long-term annual average of roughly 10.5 percent. All 11 S&P 500 sectors have delivered year-to-date gains, with eight returning 10 percent or more. Broad-based performance strength is consistent with periods of economic expansion.
- Both secular-growing and cyclical-oriented sectors are favorably positioned. Cyclically-oriented sectors (those that tend to move with the overall economy) outperformed in the first six months of 2021, led by Energy, Financials, Real Estate, Industrials, Materials and Communication Services, which is consistent with an economic recovery. Ongoing monetary and fiscal stimulus in concert with vaccination progress continues to support reopening, with cyclical sectors well-positioned to benefit in this investment environment. Meanwhile, the positive trends in digitization, artificial intelligence, machine learning, mobility and e-commerce extend well beyond COVID-19. We continue to have a favorable longer-term view of secular growth prospects in sectors such as Information Technology, Consumer Discretionary, Communication Services and Healthcare.
- Broad-market valuations are within a “zone of okay” ― elevated yet short of dot-com era extremes. As we look into 2021’s second half, the global economy continues to recover as the world heals from the COVID-19 pandemic. However, comparable year-over-year sales and earnings become more challenging as we traverse the second half, implying a slower earnings growth rate and, presumably, more subdued equity returns.
- Inflation and tax rate changes are among potential disrupters to our glass half-full second half outlook. Through our analysis of early-2021 company earnings reports, an increasing number of companies signaled higher labor, freight and commodity prices spurred by pent-up demand due to COVID-19, along with port congestion and a shortage of semiconductor chips, ships, cargo containers and workers. While not yet at alarming levels, inflationary pressures are potentially problematic for equity prices. Should inflation prove to be persistent, we have historically seen investors demand higher interest rates to compensate for higher costs. Additionally, potential corporate tax policy changes may have disparate impacts on companies and industries.
- While second quarter performance was positive and broad-based, foreign developed equities retain catch-up potential as the global economy continues to recover from COVID-19. Muted inflation, relatively low interest rates and accommodative monetary and fiscal policies across Europe and Japan provide a positive economic backdrop. Vaccination progress supports Europe’s ongoing recovery, while sectors sensitive to the economic cycle such as Energy, Financials, Industrials and Materials comprise more than 40 percent of the MSCI EAFE Index, highlighting foreign developed equities’ potential as the global economy continues to recover.
- Foreign equities’ 2021 earnings outlook remains upwardly biased, supporting higher prices. Analysts expect accelerated vaccine progress will continue to support reopening, leading to an economic and corporate profits recovery in 2021’s second half. Since the start of the year, analysts have raised foreign developed equities’ full-year 2021 earnings growth forecasts by 18 percent, providing support for future price appreciation despite above historical average valuation measures such as the price-to-earnings ratio (the index’s price per share divided by expected earnings per share).
- Local government policies remain a key risk consideration for emerging market investors. Emerging markets continue to provide attractive investment opportunities for investors, including China’s continued economic ascent and the thematic appeal of emerging middle-class consumers’ increasing purchasing power. However, recent Chinese scrutiny into the business practices of the country’s largest publicly traded companies highlights the additional policy risks investors must navigate in emerging markets.
- Rising commodity prices are both boon and bane for emerging markets. Rising energy and metals prices benefit commodity-producing countries such as Brazil, Russia and South Africa, increasing the value of their raw materials exports. However, rising prices represent a “tax” on higher-growth commodity-importing countries such as China, India, South Korea and Taiwan, highlighting emerging markets’ diverse characteristics.
- Treasury bond yields fell from their March highs and remain very low by historical comparisons. The Fed is unlikely to lift interest rates for some time but has opened the door to potentially trimming asset purchases later this year if employment and inflation data run hot. Increasing debate at the Fed around timing of rate increases keeps its policy rate near zero for an extended time. The Fed retains an option to expand Treasury purchases if rapidly rising bond yields threaten the recovery. Rising growth and inflation expectations may push longer-term bond yields higher, but rates are unlikely to return near historical averages in the near term. Treasury bonds provide important portfolio diversification, but low and rising yields indicate better return opportunities exist elsewhere.
- Corporate bonds are fully valued, and riskier high yield bonds should outperform if the recovery continues. Investment-grade and lower-quality bond yields remain near all-time lows due to strong credit fundamentals. Alternate sources of yield offer better value, such as corporate loans and mortgage bonds not backed by the government (non-agency). Loans are good substitutes for corporate bonds, considering similar borrowers, less extended valuations and floating-rate exposure. Non-agency mortgages offer a compelling source of yield and limited risk exposure to rising interest rates. They also sport strong fundamentals driven by rising home prices, which serve as loan collateral, homeowners with strong balance sheets and high savings and improving payment histories.
- Municipal bonds provide a valuable source of non-taxable income, though yields are low versus history. Rapidly improving sales and income tax revenue, significant fiscal stimulus directed at state and local governments and rampant investor demand for tax-advantaged income continues supporting municipal bond credit quality and prices. We continue recommending allocations to high yield municipal bonds, though valuations are becoming elevated. We also emphasize credit selection, considering the degree of idiosyncratic risks inherent in the high yield municipal market.
- Excess capacity exists in retail properties, as well as office and multi-family properties in the urban core. It will be hard for landlords to increase rents in these property types. Forward revenue and earnings for these properties are likely to disappoint.
- An economic expansion should be a favorable backdrop for commodities and commodity producers. However, we believe the window of opportunity could be shrinking for these assets. We are taking a more defensive stance on commodities.
- Crude oil prices accelerated higher in the second quarter as major producers held to production cuts. For now, it appears the large oil producers will keep supply balanced with potential demand. This could allow crude oil prices to rise further.
Hedge fund strategies
- After a long hiatus, Europe and, to a lesser extent, Asia are generating interest among hedge fund managers seeking investment opportunities in companies with lower valuations and strong growth compared to U.S. counterparts. Moreover, these regions do not have the same fiscal policy uncertainty, such as potential tax rate changes and their impact on U.S. corporate earnings.
- Rotation into more cyclical sectors will likely continue as hedge funds reposition their portfolios to capture the growth in companies sensitive to the economic cycle and modest increases in inflation. Managers are allocating capital into companies within the Materials, Energy and Industrial sectors; the unknown is whether current inflationary pressures are transitory or persistent, and this outcome will determine how long managers stay invested in these cyclical sectors.
- Technology and Healthcare companies remain key economic drivers based on innovations that permeate all aspects of most businesses and services. Uncertainty regarding inflation’s persistence and the Fed’s potential reaction has led to a greater focus on valuation as investors reassess the fortunes of companies that show promise but have little to no earnings. Hedge funds managers remain committed to these two sectors for the long-term based on the continual innovations that spawn new companies that change how we live and companies that can generate profits during the process.
- Several factors are behind companies’ high valuation at the early stage of their development cycle. First, technology-enabled and software businesses demonstrated resilience during the pandemic-related shutdowns. Second, these businesses provided growth in an otherwise growth-constrained environment. Finally, persistent low interest rates caused investors to seek higher returns elsewhere.
- The performance gap between the top quartile private equity manager and the median private equity manager continues to widen. This gap has widened from 4 percent in 1999 to about 10 percent in 2019. Wide dispersion in managers’ performance means being highly selective in picking the appropriate investment is ever more important.
- Growth through operational initiatives, continued digitization of industries and healthcare innovation should continue. These remain our consistent themes for investing in private markets. The Financial Services sector is benefiting from the capital investments made over the last decade and is also ripe with investment opportunities.
- We continue to focus our research efforts on smaller companies with revenues ranging from $5 million to $3 billion annually. Large-company buyouts are showing strong signs of re-emergence for the first time since the flurry of large deals executed prior to the global financial crisis in 2008-2009; however, we believe investment managers have a much greater edge to add value and grow smaller businesses through a variety of strategic and operational initiatives.
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