The second quarter of 2021 continued to produce strong returns for domestic equities, with the S&P 500 Index registering an 8.55% gain to end the quarter at yet another all-time high. The increased vaccination rate, continued federal stimulus programs, easy monetary policy, and robust earnings growth all served as catalysts for domestic equities’ positive quarterly performance. The rally in the equity market did hit a speed bump mid-way through the quarter before resuming, as a weaker-than-expected jobs number and a higher-than-expected inflation reading temporarily increased market volatility. In response to this, investors began to rotate back into the less economically sensitive technology sector. At quarter’s end, technology and real estate were the best-performing sectors, while laggards included consumer staples and utilities. On a market capitalization basis, large-cap equities outperformed their small-cap counterparts and growth names outperformed value.
Internationally, both developed and emerging market regions finished the second quarter higher, though both underperformed domestic equities, as an acceleration in vaccine rollouts coupled with a decline in COVID-19 cases aided market sentiment and furthered reopening efforts. Developed economies, as defined by the MSCI EAFE Index, rose 5.35% on the quarter, supported by a strong performance from European markets. Europe’s vaccination rate, which had lagged over prior quarters, is now roughly in-line with the U.K. and the U.S. Additionally, economic data out of Europe has been relatively strong, with leading economic indicators such as the purchasing managers’ index (PMI) reaching multi-year highs during the quarter. Emerging market equities, as defined by the MSCI Emerging Market Index, registered a 5.08% return during the second quarter, slightly underperforming their developed market counterparts. This slight underperformance came as higher-than-expected inflation readings from the U.S. caused China’s government to reduce support for its economy. Overall currency strength in Brazil helped it become the best-performing emerging market during the quarter, while Peru and Chile came in among the weakest.
Turning to the fixed income market, inflation and the subsequent response by the Federal Reserve became the main focal points driving fixed income assets. During the quarter, annualized inflation rates rose to multi-decade highs, prompting concern amongst investors that elevated inflation rates may cause the Federal Reserve to reduce accommodative policies earlier than expected. At its meeting in June, the Federal Reserve acknowledged that tapering is now in discussion but reiterated that it believes the rise in inflation is transitory. Additionally, changes to the dot-plot projections now show two rate hikes in 2023, up from no rate hikes from the prior quarter’s plot. That said, the U.S. 10-year Treasury Note ended the quarter yielding 1.45%, down from the prior quarter’s 1.74% yield, as effective messaging by the Fed led investors to discount less inflation over the long run. Within the corporate market, investment-grade bonds outpaced their lower quality high-yield counterparts. Additionally, corporates outperformed government issues, including municipals, and long-duration bonds outperformed those with shorter duration.
Outlook – As we enter the back half of the year, U.S. economic figures and high-frequency data continue to suggest that the U.S. is in the midst of a strong and durable recovery. Current gross domestic product (GDP) readings show the U.S. economy growing at an annualized rate of 9.1% for the second quarter, followed by third quarter estimates of 8.2% annualized growth. This continual tick up in GDP would put U.S. real GDP above its prior December 2019 peak and set the economy back on track to reach its long-term trend growth rate of 2.5%.
On the high-frequency data front, restaurant dining has now returned to pre-pandemic levels, and hotel occupancy and air travel, while still down 10% and 25%, respectively, have both seen a meaningful move higher. Vaccination rates have contributed to significant improvements in these areas of the economy, with roughly 45% of U.S. adults now fully vaccinated at quarter’s end – up from prior quarter’s 20% rate. This material progress against the pandemic has helped underwrite improvements in the macroeconomic outlook and spurred equity markets’ record rally.
Moving forward, we at Condor see markets less driven by pandemic-related news and, absent an unforeseen change, we do not expect COVID-19 to be the primary concern over the coming quarters. Instead, inflationary pressures and corporate earnings growth will be top of mind. Spikes in inflation readings during the second quarter put some investors on edge, although current inflation pressures look to be a consequence of constrained supply and recovery-influenced consumer demand. We at Condor maintain our belief that current inflation trends are transitory, with inflation remaining elevated through the back half of this year before leveling back down to a range of 2% to 3% over the medium term. We look to the coming quarter for more conclusive evidence supporting this belief, although some metrics in June implied that a reversal in the inflation rate may have started to unfold. Regardless of our own personal beliefs, Jerome Powell and the Federal Reserve have signaled that they also believe that these inflation trends are transitory, meaning they are likely to keep stimulative measures in place at least through the next year.
Turning to corporate earnings, the current rally in markets is underpinned by very strong corporate earnings growth, which has continued to beat expectations over the prior quarters. For 2021, S&P 500 earnings are now expected to jump around 18% from pre-pandemic levels. This 18% rise compares to earlier estimates at the onset of the year where earnings were supposed to grow roughly 12% from pre-pandemic levels. The combination of rising earnings, strong corporate operating leverage, and record levels of cash could be supportive of a move higher in markets.
As we move into this next stage of the recovery, our hope is that some of the pandemic-related overhangs surrounding the market, and life itself, begin to dissipate. Good long-term investing is a marathon rather than a sprint, and as such we will continue to monitor developments with both COVID and broader economic and market trends and update our outlook accordingly. As always, we thank you for your trust and look forward to continuing to work together to meet your financial goals and objectives.
