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Oarsman Outlook: July 2021

July 14, 2021

All major investment categories recorded solidly positive results during the second calendar quarter. Domestic equity benchmarks gained between 5% and 9%, with large-company stocks outperforming small-caps. Non-U.S. markets rose 4% to 6%, with developed markets narrowly beating the emerging-market category (the latter held back by weakness among Chinese stocks). Real-estate securities were some of the strongest performers, though timber-related issues lagged. Commodity prices were broadly higher, even as many finished well off mid-period highs: oil jumped 24%, though gold ended with a gain of just 3%. Following their early-year surge, bond yields slipped: the 10-year Treasury fell to 1.44% from 1.75% at the end of March; credit spreads continued to narrow, resulting in positive returns from nearly all types of fixed-income investments.

Clear-cut industry/sector trends were difficult to discern: among U.S. large-company stocks, only Energy and Technology issues outperformed broadly; all other sectors lagged or approximately matched the benchmarks. In the large-cap universe, 'growth' names bested their 'value' counterparts by better than two-to-one (a sharp reversal of the early-year pattern), while among small-caps, value prevailed, but with a more modest edge.


Exceptional progress combatting the COVID pandemic in the U.S., accelerating economic growth, surging company profits and falling bond yields proved a heady combination during the April-June period. U.S. stock prices – as represented by the S&P 500 Index – rose more than 5% for a fifth-consecutive quarter, bringing the fifteen-month gain to more than 90%.

The U.S. public-health situation improved dramatically. A rapid and successful vaccination rollout saw infection, hospitalization and death rates plummet throughout the period; by late June, seven-day averages of all three metrics had fallen more than 90% compared to January peaks. Meanwhile, revised CDC guidance allowed the gradual lifting of most remaining economic/social-distancing restrictions. Globally, however, the spread of the highly infectious Delta virus variant combined with uneven rates of vaccine uptake produced markedly less encouraging trends.

The U.S. economy accelerated from a strong base, as most of the country fully reopened for business and consumers began to spend savings accumulated over the past year. Having expanded at a robust +6.4% annual rate in the first three months of the year, gross domestic product likely grew by around +10% in the second quarter, goosed by the $1.9-trillion American Rescue Plan passed in March. After a disappointing April gain of just 266,000, net job growth accelerated to 583,000 and 850,000 in May and June; in a further sign of economic confidence, workers also voluntarily left their jobs at historically high rates. Analysts from Wall Street to Main Street to the federal government called for the economy to expand by more than 6% on the year – likely the strongest calendar-year reading since 1984.

Overseas, the European and Japanese economies continued to struggle with recurring surges of COVID infection. After shrinking in the first quarter, both likely expanded modestly in the April-June period; full-year growth will probably measure about half the pace of the U.S. The Chinese economy, essentially recovered from its COVID downturn by the end of last year, began to show signs of slowing in response to deliberate tightening of credit conditions; buoyed by reopening export markets, full-year growth is still likely to come in comfortably above the official target of around 6%. Other emerging markets were hamstrung by surging virus variants and lagging vaccination efforts; rising inflation and a stronger U.S. currency prompted several developing-market central banks to raise interest rates during the period, further damping activity.

Rapidly re-accelerating economic activity resulted in surging commodity prices and widespread supply-chain and labor-market disruptions, fueling growing concerns about inflation. Recent metrics were attention-grabbing: the headline U.S. consumer price index and its less volatile core component showed year-over-year gains in May of +5.0% and +3.8% – the highest readings since mid-2008 and mid-1992, respectively. Residential real estate was another eye-popper: the nationwide Case-Shiller home-price index notched year-over-year gains above +10% throughout the period; the latest reading (+14.6%, for April) was the highest in the survey's 34-year history, eclipsing even the largest gains of the 2005-2006 housing bubble.

In the surprise of the quarter – given accelerating growth and burgeoning price pressures – bond yields fell substantially and closed at period lows. A number of growth-sensitive industrial commodity prices – e.g., copper, steel, lumber – also rolled over during May and finished well off recent highs. Gold declined more than 7% during June; Bitcoin fell more than 40% from its mid-April peak. Meanwhile, the future rate of inflation implied by the pricing of inflation-protected Treasury notes eased from its mid-period peak – though it remained well above the level that prevailed before the onset of the pandemic. Finally, following an eventful Federal Reserve Open-Market Committee (FOMC) meeting (see below), the Treasury yield curve flattened as short rates spiked while longer-term yields pulled back. The most straight-forward (not to say only) interpretation of these moves is an anticipation of slowing growth and moderating inflation.

The mid-June FOMC policy-setting meeting was much anticipated and didn't disappoint, embodying several important changes. The Fed's pandemic-crisis policy could heretofore be summarized as: 1) not even 'thinking about thinking about' raising rates, 2) willing to tolerate a sizable inflation 'overshoot' above the 2% target, and 3) clearly favoring the labor-market component of its dual mandate to seek both full employment and price stability. A growing chorus within the investment/financial community has for much of 2021 decried this policy as dangerously complacent. The June FOMC meeting and attendant communications were widely interpreted as an acknowledgment of that concern (even if policymakers continued to believe it is misplaced or overblown). The Fed seemed intent to reassure investors it had not 'taken its eye off the (inflation) ball'; policymakers would soon be not merely thinking about, but actually planning to tighten policy – via 'tapering' their asset-purchase program ('quantitative easing') – perhaps as early as yearend. Moreover, in conjunction with boosting their forecasts for both growth and inflation, a majority of the committee indicated they expected Fed-controlled short-term interest rates to begin to rise during 2023 – about a year sooner than previously.

Within global equity markets, the first half of the period saw a continuation of trends dating to late 2020: investments geared to accelerating economic activity – value stocks, basic-industry and commodity-related stocks, financials, emerging-market equities – were among the strongest performers, while growth-oriented stocks, including the U.S. mega-cap technology/media complex, lagged. The pattern reversed convincingly beginning in early May, however, and the second half of the quarter saw the tech/media-heavy NASDAQ and growth-oriented benchmarks soundly beating the Dow Jones Industrials and value-leaning indices (see graph below). The abrupt value-to-growth leadership reversal coincided with a notable narrowing of the market's fifteen-month-old advance: as the S&P 500 notched new highs at quarter-end, fewer than half its constituent stocks were trading above their 50-day moving price averages; research provider Bespoke Investment reported this phenomenon last occurred near the end of the NASDAQ/Dot-Com bubble in late 1999.

Profits reported by the companies in the S&P 500 index during the period (mostly covering the January-March quarter) came in 53% above 2020's depressed figure; against an even more dismal April-June comparison, Wall Street analysts expect an improvement of almost 90% this quarter! The current calendar-year estimate represents a year-over-year gain of almost 50% and an improvement of nearly 20% versus 2019. The relentless upward march of earnings estimates has been a key underpinning of the remarkable stock-market performance of the past fifteen months.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

  1. Dividend Income (for three months this is the annual yield divided by four)
  2. +/- Change in Earnings per Share* (average for S&P 500 companies)
  3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +8.6% S&P 500 total return?

Second Quarter (April-June) 2021
Dividend Income+0.3%+8.6%
+ Change in Earnings+10.0%
+ Change in Valuation-1.7%
= Total Return+8.6%

Our read: Another blow-out change in earnings (recall that this is essentially a quarter-over-quarter figure, so it represents an annualized growth rate on the order of +45%) allowed valuation to improve marginally despite a strong market gain.


After a heady fifteen-month run fueled by improving news flow and decreasing uncertainty, the investment environment of late 2021 seems likely to be appreciably murkier. Beginning early last Fall, investors became increasingly confident that: 1) the prospect of highly-effective vaccine rollouts promised a steady ebbing of pandemic worries, 2) massive fiscal support and lifting pandemic restrictions would propel economic growth and corporate profitability across a widening geographic footprint, and 3) the world's central bankers – following the lead of the Federal Reserve – were committed to a multi-year period of ultra-accommodative monetary conditions. All three of these market underpinnings are now being undermined to varying degrees.

On the pandemic front, the rapid overseas spread of the Delta virus variant in recent weeks is surely not welcome news. Existing vaccines seem effective against the variant, particularly in protecting against hospitalization and death. But the Delta variant appears to be several times as infectious as the original strain, allowing it to spread even among populations with high levels of immunity (e.g., the U.K., Israel). With uneven (and slowing) rates of vaccination uptake in the U.S., the spread of the Delta variant here seems inevitable (it's been reported already to account for some 25% of new infections). This developing threat has the potential to impede the astonishingly salutary trajectory of the past five or six months, further delaying a full return to 'normal.'

Though 2021 looks set to be a banner year for economic and corporate-profit gains, we sense a growing realization that it represents the high-water mark for the current, compressed economic cycle. A late-June Financial Times survey of economists indicated that, though most expect strong global growth ahead, their uncertainties were skewed to the downside – that is, more were worried about a growth disappointment than an upside surprise. Headlines of near-record growth and profits make such concerns seem incongruous, but several factors support this unease. We have surely passed both the point of maximum policy support and the most frenetic phase of economic reopening (at least in the U.S. and China; Europe and Japan are important laggards here). After emergency-relief spending amounting to more than 10% of U.S. GDP in both 2020 and 2021, the comparable figure for 2022 is likely to be around 2%; meanwhile, negotiations on an infrastructure-spending package have steadily diluted its likely near-term impact. As always, from a financial-market perspective, it's vital to look ahead and to focus on what's happening at the margin: at present there seems little doubt that, even though growth should remain above average in 2022, the world's two largest economies (that is, the U.S. and China) will both be slowing as this year turns to next.

Monetary policy, too, may in coming months become less supportive of financial markets – or, at minimum, less supportive than investors had lately been expecting. Despite its recent hawkish pivot, the Fed remains keenly focused on returning the labor market to full health. With total employment still some 10 million below the level implied by pre-pandemic trends, more than a year of employment gains like those of May/June will be needed to erase the deficit. But the monthly job figures have been notably volatile. Moreover, questions remain regarding the number of workers who have left the labor force for good. So the recovery could be considerably longer or shorter. As for inflation, 'base effects' (year-over-year comparisons with pandemic-depressed data) and the many bottlenecks, shortages, and labor-market frictions associated with the highly unusual and clearly temporary circumstances of rapid economic reopening probably account for a large part of recent price rises. However, even unusual, temporary factors could lead to broadening wage and price increases that become increasingly concerning (especially in light of structural trends some observers think are reversing the powerful dis-inflationary tide of the past three decades). But we think it is too early to make that call.

Accordingly, incoming data will be key (when aren't they?): accelerating job gains and/or worsening inflation (or inflation expectations) could result in a surprisingly aggressive Fed; conversely, a slowing or choppy job market and/or easing inflation pressures could allow the Fed to steer a course closer to what investors were eyeing early in the year. For the moment, we are marginally reassured that financial-market reactions have not so far matched the near-hysteria conveyed in some headlines (which has itself moderated somewhat since the June Fed meeting) as well as by the tentative 'cooling' implied by recent data.

Tentative shifts in both economic statistics and asset-price trends that began in May probably signal the end of the 'early cycle' investment-market phase where nearly all 'risk assets' rally in unison. We have likely entered a period where less unambiguous incoming data fuel a more nuanced, back-and-forth debate regarding the prospects for growth, profits and inflation beyond the next couple of quarters. This more fluid – and possibly more volatile – environment should favor a balanced investment approach featuring both economy-sensitive and consistent-growth asset categories, while holding cash and near-cash reserves to fund opportunistic purchases. Meanwhile, the lagging nature of pandemic recoveries in Europe, Japan and many emerging-market economies – combined with still-high valuations among U.S. equities – suggests a continued portfolio tilt toward overseas investments.

Please let any of the Oarsman team know how we can be helpful in the weeks ahead. We hope you are having a great summer!