Global equities sustain rally amid vaccination gains and growing pains

Equity market overview and outlook for Q3 2021

Global equities were broadly positive in the second quarter, but the ride wasn’t entirely smooth. Economic growth rates largely depended on vaccination progress and governments’ ability to contain COVID-19 and its more contagious variants. Central banks were in the spotlight as inflation pressures mounted due to base effects and global supply chain shortages in the face of powerful pent-up demand. While these factors sparked volatility at times, most equity markets ended the period on steady and higher ground.

Key takeaways

• Although the U.S. economy continues to grow, the pace of expansion has begun to decelerate as the effects of stimulus and pent-up demand fade.
• It’s now clear that the global economic recovery will be sequential rather than synchronous. The baton of growth leadership is being passed from the U.S. to international economies.
• Given the cyclical tilt of their market composition, European equities should benefit from stronger growth in the region.
• We are still bullish on U.S. stocks, but higher valuations and a peak in earnings growth will require greater selectivity going forward. We see opportunities in certain industrials, reasonably priced growth stocks and small caps. Signs of increased capex and the recent U.S. infrastructure deal provide an encouraging backdrop.
• Globally, we like growth and technology names with strong connections to the digital economy, including front-office software companies that are changing how the world conducts business.
• Firms prioritizing environmental, social and governance (ESG) issues should continue to do well — especially “clean tech” and alternative energy providers at the forefront of low-carbon transformation.

Vaccination gains, supply chains and growing pains

The equity market exuberance of the first quarter carried into the second, although returns for major indexes were generally more moderate. Historic levels of fiscal and monetary stimulus persisted, providing ongoing support to individuals, businesses and financial markets. Globally, economic growth rates varied by country and region, in large part depending on the degree of progress made in vaccinating populations against COVID-19.

U.S. vaccination efforts have been among the most effective, though lagging the U.K., Israel and China. It became clear during the quarter that President Biden’s original goal of a 70% inoculation rate by the Fourth of July would be missed. Overall, as shown in Figure 1, developed nations tended to be more successful than their emerging markets (EM) counterparts in gaining an upper hand against the virus. Japan was a notable outlier, with a disappointing 24% vaccination rate. In the EM sphere, both Brazil and India suffered from surging case counts and challenging vaccine delivery logistics.

Against this backdrop, the U.S. accelerated economic reopening during the quarter and led the global growth recovery. This, in turn, enabled U.S. equities to outperform their non-U.S. peers (Figure 2), just as they had done in the first quarter. The S&P 500 Index overcame some bouts of volatility and rallied in late June, notching a series of consecutive all-time highs.

The Fed is not fed up with inflation (yet)

Hotter-than-forecasted Consumer Price Index (CPI) data and expectations of higher future inflation rates were a source of equity market volatility during the quarter, primarily due to concerns that the Federal Reserve may accelerate its timetable for tightening its ultra-dovish monetary policy. Several factors contributed to higher inflation:

Base effects. For April and May, year-over-year CPI increases hit their highest levels since 2008. These readings were distorted by comparisons to the exceptionally low (sub-1%) inflation rates that prevailed during those same months in 2020, when the economy was in the depths of the pandemic-induced recession.

Supply chain disruptions. With the economy reopening more swiftly than expected, unleashed pent-up demand overwhelmed available supply in certain sectors, fueling sharp price increases.

Commodity prices. While prices for many commodities either stabilized or declined following the first quarter’s broad-based rise, oil prices continued to climb as crude inventories shrank and demand surged. West Texas Intermediate oil jumped 23%, from $59 to $74 per barrel, reaching levels in June not seen since 2018.

Wage pressures. Despite record levels of open positions, net monthly payrolls underwhelmed in April and May, as large numbers of unemployed Americans remained on the sidelines. Many employers, unable to staff up as the economy boomed, sought to entice potential workers with higher pay. This contributed to fears that stronger wage growth would put upward pressure on the overall inflation rate.

The Federal Reserve maintained that higher inflation was being driven by transitory forces that would recede as the economy moved closer to normalization. The markets greeted this mantra with varying degrees of skepticism and hope. For most of the quarter, the Fed also stuck to its guns regarding its expected time frame for transitioning to tighter monetary policy.

That commitment, however, seemed more tenuous at its June meeting. Although the Fed pledged to remain accommodative, it upgraded its inflation forecasts (Figure 3), with Chair Jerome Powell acknowledging “the possibility that inflation could turn out to be higher and more persistent than we anticipate.” Moreover, the Fed’s closely watched dot plot showed most members expect the Fed to raise rates in 2023. A majority believe there will be at least two hikes that year, and a sizable minority suggest rate increases could begin as early as 2022. These views represented significant shifts forward in the anticipated timing of rate lift-off versus the Fed’s last set of forecasts in March.

Markets, interpreting the meeting in the most hawkish light, threw a mini-tantrum. But the volatility was short-lived, as the Fed quickly sought to clarify its intentions and reiterated that its timeline for tapering its quantitative easing asset purchases (early 2022) and raising rates (early 2023) remained intact.

Second quarter trends and highlights

Earnings growth rebound was key

In the U.S., momentum from the economy’s reopening and blockbuster corporate earnings results (Figure 4) helped counter concerns that hotter inflation would cause the Fed to pivot from its ultra-accommodative policy stance. S&P 500 earnings grew 52% year-over-year during the quarter, more than twice the rate of growth initially estimated. On a sector basis, consumer discretionary, financials and materials recorded the largest earnings increases.

Substance over style

After trailing value by a wide margin in the prior two quarters, growth outperformed in the latest period. But chasing the value vs. growth dynamic required a willingness to be whipsawed, as cyclical/ value and technology/growth shares constantly traded market leadership. Value still led growth year-to-date through June, but the margin has narrowed considerably.

This erratic showing demonstrates why betting on one style based on the magnitude or duration of past outperformance is not a sound strategy. Style performance drivers tend to be period-specific, hard to predict and unlikely to be repeated. For these reasons, we focus on selectivity, bottom-up research and a balanced approach to growth and cyclical allocations.

Dollar bucks trend, but for how long?

The U.S. dollar has trended significantly lower against other currencies since the COVID-19 outbreak in early 2020. But following another leg downward in April and May, the dollar reversed course and strengthened 2.5% in June. This countertrend, while notable, has been driven by short-term technical factors rather than a change in economic fundamentals. We consider it a bear market rally and believe the longer-term trend of dollar weakness remains intact, which should support non-U.S. equities.

Outlook and best investment ideas

Annualized U.S. GDP growth for the second quarter is projected at around 8%, representing peak expansion after the first quarter’s 6.4% rate. While an 8% headline number would be impressive, the economy has already begun to show some signs of decelerating as the pace of vaccinations plateaus and the effects of stimulus and pent-up demand fade.

Meanwhile, other parts of the world are still ramping up vaccine distribution and economic reopenings, providing greater potential upside in growth. Figure 6 shows projected eurozone and emerging markets GDP growth for 2022 exceeding that of the U.S. This shift in economic momentum reflects the sequential, rather than synchronized, nature of the global recovery. This is a key to our near- to medium-term outlook and equity market preferences.

Non-U.S. equities

• Developed non-U.S. markets offer opportunity, particularly in Europe, where valuations are more attractive relative to the U.S. and stocks should benefit from improved vaccination rates, solid earnings growth and a more cyclically oriented economy. Figure 7 shows the higher cyclical composition of non-U.S. equity market indexes versus the S&P 500.
• Select emerging markets also look compelling. Specifically, Brazil offers opportunities tied to growth in the global digital economy, including innovative fintech and e-commerce names. In China, where 70% of the population is expected to be vaccinated by the end of this year, the easing of economic and travel restrictions should benefit Chinese gaming and lodging industries.

Earnings growth has peaked, but opportunities remain

In the U.S., consensus estimates call for second quarter earnings growth of 60% to 65%. This would be the largest year-over-year increase since the quarters immediately following the global financial crisis and likely represents peak earnings growth for this cycle. That doesn’t mean investors should be preparing for an imminent end to the current economic recovery. The effect of the rising tide of the economy lifting all boats is likely to wane, and the theme of peak growth has spurred some recent volatility in equity markets. But we expect economic progress to continue, especially considering the eventual impacts of filling 9 million U.S. job openings and the sequential global recovery that is still in its early stages.

U.S. equities

• We still like U.S. stocks, but the combination of higher valuations, the passing of the global growth baton to Europe and peak earnings growth mean greater selectivity will be required going forward. Certain industrials, reasonably priced growth stocks and small caps are all areas of potential interest. Signs of increased capital spending and the recent U.S. infrastructure deal also provide an encouraging backdrop.
• Dividend growers could remain attractive if inflation and rates stay orderly. We also see a supportive environment for REITs, thanks to still-solid economic growth, historically strong balance sheets, access to liquidity and their ability to weather higher inflation.

Global opportunities

• We favor growth and technology names with strong connections to the digital economy, including front-office software companies that are changing how the world conducts business. • Both U.S. and non-U.S. firms that prioritize environmental, social and governance (ESG) considerations should continue to do well. These companies include those at the forefront of low-carbon transformation, whether through direct improvements in more challenged industries or “clean tech” components and alternatives.

Risks to our outlook

• Economic forecasting remains a challenge, and with decelerating growth taking center stage, we suspect equity markets may react poorly to economic data that falls short of consensus expectations.
• We are keeping an eye on the spread of the COVID-19 delta variant, as any sign of diminishing vaccine effectiveness would likely rattle global equity markets.
• With Fed rate hikes still a ways off, a flattening yield curve could hinder industries that are more sensitive to interest rate momentum, such as financials, which benefited from sharp yield increases earlier in 2021.
• The U.S. infrastructure agreement is an optimistic sign, but any disruptions in the legislative process could spark additional bouts of volatility.
• Inflation readings continue to come in ahead of expectations, warranting closer scrutiny. Market anxiety could escalate if new data shows accelerating wage growth and/or renewed spikes in consumer prices.