Strength Begets Strength, Historically Speaking
July 2021
Given we’re now in July, it’s been a profitable first six months of the year for investors in global equities, with the S&P 500 higher by 14.4% - its second best first half return since 1998, the small-cap Russell 2000 rising 17.5%, and the Euro Stoxx 50 index rose 14.7% as European equities garnered investor capital. Historically, in calendar years in which the S&P 500 generated a 10% or greater return over the first six months of the year, strength begets strength. Based on data provided by Cornerstone Macro, since 1928, when the S&P 500 is higher by 10% or more in the first half of the year, the S&P 500 has generated a positive return in the second half 74% of the time, with an average return of 5.8%.
The 10-year Treasury yield closed at a year-to-date high of 1.74% on March 31 which coincided with President Biden proposing a $2-plus trillion infrastructure spending package. The proposal was met by resistance from moderate Democrats in the House, making its passage a longshot. Lofty expectations surrounding the size of government spending and the debt issuance required to pay for it were ratcheted lower, forcing long-term Treasury yields down. A setback on the infrastructure front was followed closely by the Delta COVID-19 variant spreading abroad, leading to a dampened outlook for global economic growth. As long-term yields peaked and began to roll over, investors flocked back into growth stocks set to benefit on a relative basis should COVID containment measures be reinstated. Growth gained ground on value during the quarter, the Russell 1000 Growth index returning 11.8% versus a 4.8% return out of the Russell 1000 Value index.
At the sector level, energy and real estate, which skew toward value, garnered inflows as inflation plays, each rallying nearly 13% in the second quarter. On the ‘growth’ side of the ledger, information technology and communication services also outperformed the S&P 500, as each jumped over 11% in the quarter. Defensive sectors such as consumer staples and utilities meaningfully lagged the S&P 500, despite the tailwind afforded them by long-term Treasury yields moving lower. Market breadth narrowed, with fewer stocks making new highs and/or outperforming the S&P 500 during the quarter, potentially a sign that the recent rally is running out of steam. Still, so long as defensive sectors such as staples, utilities, and health care lag the broader market, the S&P 500 is likely to continue its ascent.
Broadly speaking, we remain constructive on equities as evidenced by our overweight to stocks relative to bonds, though we continue to monitor investor sentiment, the Delta COVID-19 variant, higher energy prices, and potential changes to tax policy in the U.S. as potential headwinds. The American Association of Independent Investors (AAII) survey showed those bullish on stocks over the next six months fell to 40.4% on June 23 from 44.1% on June 2; however, optimism spiked to end the month at 48.6%, the highest ‘bullish’ reading since April. Coinciding with the AAII reading, the CBOE Volatility Index, or VIX, ended June with a 15-handle, below its historical average of 19, indicative of investor complacency.
The economic recovery we expected outside of the U.S. in the back-half of this year, driven by strength in Europe and a recovery in emerging markets, may be more uneven than expected as the Delta COVID-19 variant spreads, leading to a tempering of expectations surrounding a 2021 bounce back. Higher energy prices and U.S. dollar strength could weigh on emerging markets as these countries are, on balance, importers of crude oil priced in U.S. dollars. Much of the developing world has also issued U.S. dollar denominated debt, and as the dollar appreciates, funds earmarked for infrastructure and other growth projects may be redirected toward interest payments or paying down debt. On the policy front, a higher tax rate on corporations and capital gains remains top-of-mind for equity investors and movement on this front could spur volatility and repositioning.
We enter the third quarter neutral versus our strategic targets across equity sub-asset classes, as well as between exposure to both growth and value stocks. The pronounced rotation out of value and into growth during the second quarter stands as a reminder of how swiftly market leadership can change, making it a challenge for even the nimblest of asset allocators to fully capitalize on such a move. The third quarter has historically ushered in a weak seasonal stretch for stocks, and amid overbought conditions, bullish sentiment, and aggressive positioning as earnings season kicks-off, there are near-term hurdles for stocks to clear. Most importantly, when compared to bonds, there’s little debate as to where relative value lies, in our view, and with liquidity ample, equity drawdowns should remain limited.
Source: Bloomberg, Factset, AAII, Cornerstone Macro
