Balancing opportunities and risks in today’s market

Market news | September 1

Capital markets can be difficult to read at times as you try to determine how best to position your investment portfolio. The current environment seems to represent one of those times. Since March 2020, the S&P 500, a benchmark for larger capitalization or “large cap” U.S. stocks, has more than doubled in value. At the same time, interest rates on U.S. Treasury bonds, which move in the opposite direction of bond prices, have persistently remained near historic lows. It’s been a rewarding time for investors, but what about expectations going forward, and should investors consider adjusting the mix of assets in their portfolios?

The direction of the economy clearly impacts market expectations. The dominant story on that front continues to be the ongoing impact of the COVID-19 pandemic. Geopolitical events are another factor that have the potential to drive the markets, at least in the short term. On top of that, legislative initiatives that could result in major new government spending programs and a range of new taxes are also on the table.

“While these are all potential issues that could come into play,” says Eric Freedman, chief investment officer at U.S. Bank., “we think investors will want to closely watch four additional variables that may determine where the market goes from here.”

The key issues Freedman sees as having the biggest impact on the direction of stocks and other parts of the investment markets through the remainder of 2021 and into early 2022 are:

  1. Inflation, which emerged as an ongoing concern this year.
  2. Federal Reserve (Fed) policy, little changed recently but possibly due for some adjustments based on economic developments.
  3. Consumer spending and how the pace of economic expansion from this point affects consumer sentiment in the U.S. and around the globe.
  4. Business capital spending, particularly in reaction to consumer attitudes.

Here is a closer look at each of these issues.

Inflation – will the resurgence persist?

Inflation, a measure of changes in the cost-of-living, has been almost a non-factor for most of the past three decades. In July, the key measure of inflation, the Consumer Price Index (CPI) for All Urban Consumers, increased 5.4 percent over the previous 12-month period.1 The last time inflation reached levels that high was for a brief time in 2008.

“Even though we expect inflationary trends to dissipate, inflation has remained elevated for longer than markets anticipated,” says Freedman. “The key question now is whether CPI readings will prove to be higher and stickier than markets expect?”

Price changes reflect the relationship between supply and demand. While demand may have been supported in part by government stimulus checks in response to the economic fallout from COVID-19, Freedman believes current elevated CPI levels have more to do with supply issues. This occurred in various parts of the economy, such as with lumber and housing inventory. He believes, in many cases, issues with the supply chain are likely to be resolved.

“Ultimately, what usually drives the inflation rate higher is if growth rates in the economy are accelerated for an extended period of time,” according to Freedman. He points out that longer-term economic trends are likely to result in slower growth than we’ve seen so far this year. “Demographic trends show an aging population and productivity is likely to decline,” says Freedman. These factors will likely keep growth rates more subdued, and inflation is likely to follow a similar pattern.

Read more about inflation and its recent impact on investors.

Federal Reserve policy – is tapering upon us?

To this point, Federal Reserve chairman Jerome Powell has been clear in repeating that the Fed has no intention of raising the short-term interest rate it sets – the Fed Funds rate2 – prior to 2023. Once again, inflation trends could be a factor. The Fed historically has used the strategy of raising interest rates to temper inflation.

Before doing that, however, the Fed’s first step may be to taper back its program of acting as a significant buyer in the bond market. Since early 2020, the Fed has been buying $120 billion per month in Treasury bonds and mortgage-backed securities. This added liquidity to these markets, propping up bond prices and keeping mortgage rates in check to support the housing market. Indications have emerged that the Fed plans to begin tapering this strategy, though no action may come until late in 2021.

If this occurs, says Freedman, it will impact the bond market. “If you have a buyer who is a source of demand for bonds, and then that buyer is diminished, the market has to adjust.” This might result in interest rates in the broader bond market rising at least modestly once the Fed acts, or prior to that as the market anticipates a tapering strategy. That said, how markets react to potential tapering of bond purchases by the Fed is an open question.

Consumer spending – how long will confidence prevail?

Economic growth has been strong in the U.S. After a deep but relatively short-lived recession in the first half of 2020, the U.S. economy exhibited a strong recovery. Growth in the first half of 2021 as measured by Gross Domestic Product is impressive – a 6.4 percent annualized rate in the first quarter and a 6.5 percent rate in the second quarter.3 Consumer spending activity, as is typically the case, has been critical in fueling the recovery.

Growth may level off in the months to come. Freedman notes that from a consumer standpoint, “we’re starting to see a shift away from purchasing goods and more toward spending on services. That could mean people going to events, renewing gym memberships and traveling more.” Freedman will be watching whether consumer spending stalls out. “Will a tremendous renaissance of consumer spending activity suddenly not materialize globally due to the resurgence of COVID activity?” If that occurs, it could dampen investor enthusiasm for stocks.

Business spending – how does it hold up?

Business investment through capital expenditures tends to rise when ownership is confident that the global economy will sustain continued growth. Consumer attitudes play a big part in this. “Business spending is likely to shadow consumer spending,” says Freedman. This is another factor to monitor as a measure of how the global economy is performing and, as a result, what expectations should be for stock performance.

A new development for the global economy is the state of the business environment in China, the second largest economy in the world. Its leadership has recently tightened up regulations and exerted more control over specific industries and companies. Freedman notes that if the trend continues, it could have implications for business development in China and the ability of global companies to generate revenue from its burgeoning marketplace of consumers and businesses.

Learn more about China's impact on capital markets.

Implications for your portfolio

As investors carefully watch these four key economic factors that could point to the prospective direction of the economy, Freedman offers this overarching guidance for consideration:

  • Stocks should continue to be a prominent part of the portfolio mix, particularly large-cap domestic stocks. “We remain believers in a ‘half glass-full’ forward view, one that says the economy will perform well enough to benefit stocks and real assets over fixed income investments,” says Freedman. He believes the U.S. market is best positioned based on a more favorable economic outlook and the fact that some countries – like China – are undergoing regulatory changes. While stock valuations are somewhat elevated, Freedman is confident that the most likely scenario is that earnings growth can meet expectations created by the recent strong run-up in stock prices.
  • Bond holdings should be pared back and adjusted. Bonds have enjoyed a 37-year run of solid total return and income and provided valuable diversification benefits for portfolios to help offset periods of stock market volatility. Freedman expects the bond market to face a more challenging environment over the next 5-7 years. “We believe the best opportunities for this segment of the market will be found in non-agency mortgage bonds, reinsurance, bank loans and municipal bonds.” If inflationary pressures persist or even elevate, parts of the bond market could be vulnerable.
  • Real asset exposure can be an important way to round out a portfolio. This includes publicly-traded real estate (such as REITs), private real estate, infrastructure investments, and potentially some commodities. “All of these categories should perform well if inflation remains elevated for a period of time,” says Freedman.

This is a good time to review your portfolio with your U.S. Bank wealth professional. Consider whether it makes sense to rebalance your asset mix. Given the significant rally in stocks, you’ll want to be certain that your current portfolio properly reflects your investment objectives and your risk tolerance level.

 

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. The value of large-capitalization stocks will rise and fall in response to the activities of the company that issued them, general market conditions and/or economic conditions.

Investments 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 fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. 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).

Diversification and asset allocation do not guarantee returns or protect against losses.

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