Quarterly Review: Markets Looking Beyond COVID-19

SUMMARY

• Equity markets had a strong quarter led by the US with no clear style dominating.
• We expect taxes and inflation to dominate the headlines this summer.
• Security selection is increasingly important as we choose which ‘recovery’ and ‘growth’ sectors to own, hence our ‘barbell approach’.

Anyone who has used a GPS for navigational assistance knows there is rarely only one way to reach our destination. There are usually multiple routes, and each has trade-offs. Some may involve tolls, sometimes there is a scenic route, and detours often pop-up unexpectedly. Using the GPS analogy seems fitting when thinking about the twists and turns experienced during the second quarter of 2021 as we continue on the path to normalcy. Paved with employment trends that are trending positively, consumer and corporate confidence returning to pre-pandemic levels, and a ‘V-shaped’ recovery for corporate earnings, the foundation appears solid. However, detours caused by inflation fears and threats of higher taxes acted as speed bumps along the way.

The strong returns for both the quarter and the trailing twelve months (TTM) illustrate to us that investors continue to look beyond COVID-19, expecting a continued recovery in earnings. Early in the quarter, recovery momentum in Europe boosted performance for developed international equities, but that relative momentum faded due to rising COVID-19 cases resulting in the S&P 500 (US Large-Cap) turning in the strongest performance in the quarter at nearly 8.6%. Ironically, despite a negative return over the trailing twelve-month period, gold increased to over 4% during the second quarter reflecting heightened inflation worries. US Small and Mid-cap equities retained the lead as the strongest performing asset class over the trailing twelve months rising 57.3%.

The table below shows the performance of asset classes on the left and US equity sectors on the right. Returns for both the second quarter and the past 12 months (TTM) are shown. The table is anchored by US Large-Cap equities, which are shaded, and allows for easier comparison to see higher and lower relative performance by each asset class and sector.

While the best performing sectors over the trailing twelve-month period are those most sensitive to the economic recovery, the returns for the second quarter tell a different story in our opinion. Our GPS analogy about different routes is well-illustrated as the top three performing sectors during the second quarter are each associated with a different theme – inflation, growth, and value. Inflation concerns resulted in the Real Estate sector turning in the best performance, rising to over 13%. The Information Technology sector is the bellwether for growth and was the second-best performing sector during the quarter as investors responded to positive earnings guidance. This sector had the highest number of companies issuing positive earnings and revenue guidance of all eleven S&P 500 sectors during the second quarter. Finally, the value-oriented Energy sector also rose over 11% during the quarter as it continued to benefit from higher oil prices. Oil prices rose to two-year highs in June due to the growing strength in demand.

We believe the uneven nature of the recovery makes the case for diversification and increases the importance of selection as we navigate through the remainder of 2021.

Our current domestic equity selection is characterized by what we refer to as a ‘barbell’ approach, which gives us exposure to both growth and value-oriented equities. Our strategies currently hold a mix of industries that continue to benefit from the work-from-home environment as well as those that stand to benefit from the high levels of government stimulus. We prefer industries such as software, data warehousing, financials, and medical devices within our US equity portion of the portfolios. Our outlook for international stocks remains mixed in the near-term as we watch the increase in COVID-19 cases that could hinder economic recovery in Europe and Japan. COVID-19 containment issues have also caused us to adjust our emerging markets exposure lower. We remain underweight fixed income in our balanced strategies and hold US Treasuries as an equity shock absorber.

Process over Prediction:

For much of the past year, market momentum has been tied to one theme: COVID-19 recovery. Now investor attention is subject to multiple detours in the form of headlines creating concern over issues such as higher inflation or higher taxes. At RiverFront, we remain focused on our process rather than the headlines. We are constructive as we look out through the remainder of the year due to our belief that the fundamental underpinnings for a sustainable economic recovery are in place. However, as we noted in the June 14, 2021, edition of the Weekly View (Three Tactical Rules: Flying with the ‘Fasten Seatbelt’ Sign On), we believe markets could face headwinds this summer. Chief among them may be a downturn in investor sentiment as earnings or economic data disappointments serve to dampen investor enthusiasm in the near-term.