Mid-Year Outlook: Not Out of the Woods Yet

Investors have had good reason to celebrate this year, but is it truly time to let our guards down?  Thanks to practical policy guidance, more than half of the US population has received at least one COVID-19 vaccine in 2021.  Add to this the boost from a $1.9 trillion fiscal stimulus package introduced in March, and the US economy today is on pace for its most robust recovery in nearly 40 years.

So, how have the financial markets taken these improvements?  Well, risk assets have responded to the positive health and economic developments by posting solid gains in the first and second quarters. Looking ahead, however, the market and economic outlook appear less promising. A resurgent COVID variant, accelerating inflation, and a notable lack of bipartisan support for additional fiscal stimulus pose challenges to economic and market momentum in the second half of the year.

Mid-year Review

Now, before discussing likely challenges to the markets and economy in the latter half of the year, let’s take a moment to recall how we got here.

Stabilizing Economic Growth

It can be argued that ongoing fiscal and monetary stimulus and easing COVID restrictions led to improving business and consumer sentiment in the first half of 2021.  According to government data, the US economy posted a 6.4% gain during the first three months of the year.  And by some estimates, the US economic growth is expected to have come in around 8.7% in the second quarter.

For many households, the extra $1,400 per person stimulus checks, coupled with easing social distancing restrictions, likely contributed to this year’s spending boom. For example, the latest retail sales data showed that spending at restaurants outpaced pre-COVID levels, rising to a record $67 billion in May.

It’s also worth noting that in 2020, approximately 114 million people lost their jobs due to social distancing efforts and the economic downturn.  Today, however, labor market conditions are on an upswing.  For example, the US unemployment rate as of June was 5.9%, which remains elevated but nevertheless improved from 14.8% last April.  Unemployment claims have also fallen back to levels not seen since early 2020 as some businesses have quickly reopened.

Now, one downside to this year’s economic boom has been rising inflation.  And as we recently wrote about in last month’s report, a key reason for higher inflation today is ongoing supply chain disruptions.  To be sure, global logistics bottlenecks have had lingering effects on the price of goods used in end-consumer products and manufacturing inputs alike.  Add in trillions of dollars in fiscal and monetary stimulus, and a key concern for markets and households is whether inflation will truly be transitory. 

We’ll discuss this point about inflation more in a moment.  But, for now, we can say with some confidence that the recent economic improvements have underpinned positive investor sentiment even as the nearly 16-month market rally shows signs of exhaustion.

Solid Market Performance

In terms of market performance during the first half of the year, the US remained one of the best-performing markets, led higher by small-cap stocks.  For instance, the Russell 2000 Index was up over 17% during the first six months of 2021 as cyclicals rallied in anticipation of the US economic recovery.  A 14% gain in the S&P 500 Index followed this positive performance along with a 12% move higher in the tech-heavy Nasdaq 100 Index. 

Internationally, emerging markets lost momentum during the first half as COVID concerns in Asia and uncertainties surrounding China weighed on overall performance.  Even so, the MSCI Emerging Markets Index posted a solid 6% gain during the first six months of the year.  Across the pond in Europe, while economic conditions are anticipated to improve this year, ongoing health concerns have limited equity market gains to around 10%.

And while we’re talking about risk assets, we would be remiss, not to mention the recent attention given to “meme stocks” and crypto.  These highly speculative investments made a splash last year but have seemingly lost their fizzle recently.  After peaking early in the second quarter, prices of these assets have given up much of their gains. And these highly volatile price swings are a crucial reason why we view such assets are speculative in nature.

From a fixed income perspective, the bond markets aren’t quite so convinced that the US economy is entirely on solid footing.  This point has arguably been seen in rising Treasury prices even as inflationary pressures move higher.  For example, the yield on US 10-Year Treasurys fell 50 basis points from their April peak even as core and headline inflation surprised to the upside in the first half of the year. 

At the same time, however, the low yield environment coupled with investor desire for income led to increased demand for high yield bonds, and thus driving down credit and quality spreads to levels not seen in several years. 

On the commodities side, lumber prices have also made headlines with their exponential rise and sharp selloff this year.  Even so, prices for real estate and commodities are higher on balance given solid demand for housing and as consumers get out and about in this post COVID world.  To this point, the NAREIT All REIT Index gained 21% during the first half of the year, while the S&P GSCI Commodity index was up 30%. 

Second Half Outlook: Not Out of the Woods Yet

Certainly, the economy and financial markets have shown solid improvements during the first half of the year. But a key question right now is, “can we let our guards down and rely on the positive developments to carry performance into the latter half of 2021?” The short answer is, possibly not. 

The reason for this caution comes from the fact that market participants, households, and business leaders alike will have many unknowns to contend with during the second half of this year.  To be sure, an ascendant COVID Delta variant, accelerating inflation, and policy uncertainties likely will dominate the market and economic narrative over the coming months.

Inflation May be a Drag to Growth

While the US economy has made significant strides this year, it’s essential to note that lingering political and healthcare concerns coupled with uncertainties surrounding inflation remain potent headwinds to market sentiment.  While we expect the US economy to expand at around 6.5% this year, this estimate reflects a deceleration from solid growth earlier in the year. 

Of these issues, rising inflation and, more specifically, how policymakers respond to it will remain top of mind for many market participants.  And it’s this uncertainty that likely will contribute to ongoing bouts of market volatility in the months ahead. As noted earlier, much of the recent inflationary pressures have come from global supply chain issues related to COVID lockdowns. 

Even so, in recent testimony to congressional leaders, Fed Chair Jay Powell indicated that if inflation does not slow down as expected, the “[Fed] will use [their] tools to guide inflation back down.” While such language has raised market expectations for a rate hike later this year, the path to that outcome remains highly uncertain and a headwind to positive market momentum in the near term.

Variant Spread a Key Risk to Sentiment

On the healthcare front, an infectious surge in the coronavirus Delta variant globally likely will give market participants reason for pause. Recent reports show that new cases are on the rise again in the US and are at their highest levels since mid-May.

Globally, less prepared economies are struggling to contain this highly contagious variant, which is putting downward pressure on economic growth projections. To this point, even countries that have seemingly overcome COVID, like Australia, have found themselves in lockdown once again.

What’s more, a relentless spread of the Delta variant might once again complicate the US economic and market outlook as children return to school in the fall. Should efforts to contain the Delta variant fall short in less prepared economies (and at home), there’s a potential for rolling global lockdowns, which could further upset global supply chains and keep prices elevated for an extended period.

Stay on Track to Financial Independence

So, what does this outlook mean for your financial independence journey?  Well, while the economy and markets are indeed on the upswing, it’s essential to note that we’re not out of the woods yet.  From a financial markets perspective, positive price action in risk assets this year has primarily been driven by an economic recovery narrative.

Lately, this narrative is coming under pressure as higher than expected inflation and the potential for another economic slowdown are bringing into question whether the Fed will raise interest rates sooner rather than later.  The concern behind this approach is that policymakers may try to address inflationary concerns at a time when the economy is slowing, potentially reducing market liquidity and subsequently putting the markets on the back foot.

While Biden’s infrastructure plan may offer another fiscal thrust to the economy, the latest iterations of the package may not provide the same impulse that the dual effects of monetary and fiscal stimulus provided early last year.  From this perspective, positive market sentiment could begin to wane.  Indeed, ongoing healthcare concerns, inflation worries, and policy uncertainties may all contribute to higher levels of market volatility in the months ahead.

So, what can you do to ensure that your plans for financial independence stay on the right track? Well, at this crossroads between still buoyant market sentiment and economic uncertainty, we recommend evaluating your risk management process and giving your attention to two key points of consideration.

Reposition Your Investments for Risk

First, whether you’re still building wealth or relying on it to fund your post-employment years, now might be a good time to rebalance your investment portfolio.  Sharpen your pencil and position your portfolio to take advantage of potential sales in pro-cyclical investments like emerging markets, small caps, and value stocks if you’re in the wealth accumulation phase of your financial independence journey.

For those of you dependent on your wealth to remain financially independent, now may be the time to raise enough cash to meet living expenses in anticipation of a market pullback. This approach might involve taking some of your winning positions off the table, adding to cash to cover near-term lifestyle expenses, and reducing the need to sell at inopportune times if you’re already dependent on retirement income.

Now is also a good time to evaluate trimming unnecessary risky positions in your portfolio and focusing on more high-quality, tax-efficient investments.  At the same time, you’ll want to be sure that your portfolio is closely aligned with your long-term asset allocation objectives. Why?  Well, when market volatility does pick up, you’ll want to ensure that your retirement nest egg has a fighting chance to quickly recover from a period of heightened market volatility.

Check Your Assumptions

Finally, it’s hard not to ignore the rising cost of living. Whether inflation is truly transitory or not is yet to be seen.  Either way, inflation rates may be unlikely to return to pre-pandemic levels once global supply chain issues are resolved.  To this point, if you haven’t already evaluated the inflation assumptions in your financial plan recently, now may be an opportune time to recheck them.  The reason being is that higher than anticipated inflation over the long term could result in your spending more than expected in retirement and lead to cutting your financial independence plans short.

That’s why it’s essential to periodically review assumptions used in your retirement plan, evaluate whether those assumptions are generous considering the changing economic environment, and make necessary adjustments today to ensure that your financial independence journey is on track for the long term.