Economic news: 3Q 2021 investment outlook

Market news

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

Global economy

Quick take: The COVID-19 global pandemic caused a synchronized global recession, but differing regional reactions led to a multi-phased recovery that should eventually converge into a unified expansionary cycle. Variations in growth likely reflect regional and demographic differences.

Our view: The world entered a multi-speed economic recovery as the number of COVID-19 vaccinations grows and economies reduce social distancing measures. Near-term product shortages are lifting prices, but we believe these pressures are likely to ease late this year. Government policy remains the key risk to the recovery, especially if global central banks tighten credit policies.

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    • The surge in U.S. growth and inflation reflects the recovery from pandemic shutdowns and economic reopening. We anticipate the pace of both will moderate by year-end as the economy migrates into its steady state of post-pandemic economic growth and companies resolve near-term shortages.
    • Foreign economies are experiencing disparate recoveries, with COVID-19 vaccination rates lagging the United States in most cases. China, among the first into recession and then recovery, continues with COVID-19 limitations, which caps prospective growth. Europe and Japan are just now emerging from recession and tentatively reopening as vacation rates increase. Policy differences are a key swing factor to economic recovery.

U.S. equity markets

Quick take: Policy, pandemic and economic reopening progress have spurred domestic equities generally higher in 2021. The Federal Reserve (Fed) hinted in mid-June that interest rate hikes could come earlier than analysts previously projected, which has stoked investors’ concerns over equity valuation (stock prices relative to companies’ expected earnings).

Our view: We maintain our “glass half-full” orientation for U.S. equities. Rising revenue and earnings, generally restrained inflation, relatively low interest rates, ongoing monetary and fiscal stimulus policies and COVID-19 medical progress support our outlook for rising U.S. equities in 2021’s second half.

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    • 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.

Foreign markets

Quick take: After lagging both domestic and emerging market peers in 2020, foreign developed (largely continental European and Japanese) equities delivered broad performance gains for investors in 2021’s second quarter, reflecting the region’s catch-up potential in a global recovery from the COVID-19 pandemic. Emerging market equities’ 2021 performance gains have been more muted compared to U.S. and foreign developed alternatives as investors digest virus case growth (particularly in India), Chinese policymakers’ increased capital markets oversight and Fed interest rate expectations.

Our view: While we maintain a strategic bias toward U.S. equities over time, accelerating European vaccination progress is leading to relaxing activity restrictions and consumers’ increased mobility and confidence, highlighting foreign developed equities’ potential in 2021’s second half. Emerging market equities’ risk and reward outlook appear reasonably balanced through year-end, with policy and virus risks counteracting thematic growth opportunities.

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    • 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.

Bond markets

Quick take: Long-term Treasury yields, which move in the opposite direction of bond prices, fell while short-term yields rose on accelerated expectations around Fed rate hikes. Treasury yield changes combined with falling incremental yield on corporate and municipal bonds contributed to a dual tailwind supporting bond prices in the second quarter. High yield municipal debt performed the best, with limited supply and the ongoing search for yield driving prices higher.

Our view: We continue to see opportunities in riskier bonds with higher current income, with a focus on niche sectors like non-agency mortgage-backed securities bank loans and some additional high yield bonds. Traditionally safe bonds like Treasuries and agency mortgage-backed securities are less attractive due to their low absolute yields and risk of rising yields/falling prices if economic conditions continue normalizing.

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    • 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.

Real assets

Quick take: Real Estate was one of the top-performing asset classes in the second quarter, benefitting from the continued reopening of the U.S. economy. More defensive strategies like Utilities lagged the broader market. We believe many real estate investment trust sectors are priced to perfection, with upside moderating to average economic growth.

Our view: Gross domestic product (GDP) and inflation growth rates are expected to decelerate in 2021’s second half and into 2022. With that economic backdrop, we are becoming more concerned with the window of opportunity for Real Estate and commodities.

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    • 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

Quick take: Hedge fund managers are actively repositioning portfolios to capture anticipated growth in recovery-oriented companies across the United States and Europe. Although managers are investing more overseas than in the recent past, they remain committed to domestic investment opportunities, particularly within the Technology and Healthcare sectors they believe will benefit from the continual push in research and development and innovation.

Our view: Inflation uncertainty and speculation on the Fed’s reaction may lead to more pronounced market volatility in 2021’s second half. Sectors, industries and individual companies react differently during transitory or persistent inflationary periods, and hedge funds are able to react quickly to capture dislocations that may occur.

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    • 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.

Private markets

Quick take: Public market actors have supported high private market valuations. Corporate buyers are paying up for strategic assets capable of delivering top-line growth, allowing incumbent businesses to expand into emerging areas of the economy. We expect more large-company buyouts supported by cheap and plentiful credit and equally large pools of private equity capital looking for investments.

Our view: Public market equity performance recently has been catching up to private equity performance. We view recent strong public markets’ performance relative to private markets within a normal cycle of a public markets catch-up followed by a return to historical relationships when private market investing once again provides additional return opportunities.

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    • 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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This commentary was prepared March 2021 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.

U.S. Bank, and representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation. Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE).

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies. There are distinct risks associated with Special Purpose Acquisition Companies (SPACS) and they may not be appropriate for all investors. It is important for investors to understand the specific features of any SPAC under consideration and carefully consider the associated risks in light of individual goals, risk tolerance, investment horizon and net worth.

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