Q2 Market Commentary – July 8, 2021
U.S. home prices have gone through the roof (pun intended). Every week we are hearing of more clients who have either sold their houses within days for prices they hadn’t dared to imagine previously, or who had to pay hundreds of thousands of dollars above the listed price just to beat other bidders on the home of their choice.
Price wars for homes are not only occurring in boom cities like Seattle and San Francisco. The S&P Case-Shiller national single-family home price index is up about 15% over the past year through April 2021.
Very little of this increase is showing up in the official inflation (CPI) numbers yet. The cost of housing is classified as “Shelter” in the CPI data and was up only 2.1% on a year-over-year basis in the April CPI measure. This is important because Shelter is more than 30% of the weight of the entire CPI measure, suggesting that a significant part of the CPI numbers might be lagging a bit behind reality.
There are several factors that create a delay in housing costs showing up in the inflation data, but a big one is that CPI is based on average rents and average estimated rent value of existing homes, and rents only adjust very slowly.
Inflation has arrived (4.9% for the past twelve months as of May), and while we don’t subscribe to the hyperinflation hyperbole, we do think the era of very low inflation (less than 2%) is unlikely to be revisited any time soon.
Overall, the markets have some concern about inflation, but are more focused at the moment about passage of the infrastructure bill that we commented on last quarter, and how long the torrid pace of economic recovery following the pandemic is sustainable.
Below, we take a look back at the second quarter, which was a quarter of positive continued momentum, and another good quarter for client portfolios.
U.S. Stocks have been buoyed by strong corporate earnings growth and steadily increasing earnings estimates. From March 31st to June 30th, analysts tracked by Factset increased projected 2021 earnings for companies in the S&P 500 by 7.3% (this was the largest increase in earnings estimates over the course of one quarter in Factset history). Stock market investors responded, and the S&P 500 gained 8.6% for the quarter (and 15.3% so far this year).
Small cap stocks trailed large cap stocks this quarter after surging ahead in the first quarter. The Russell 2000 index of small company stocks had total returns of only 4.3% in the second quarter but remain ahead of larger stocks with a 17.5% total return year to date. Growth stocks outperformed value stocks for the quarter, although value indices are still mostly ahead for the year to date.
International stock returns trailed US stock returns for the second quarter, with the MSCI EAFE International index total returning 5.2% (8.8% for the year to date), and the MSCI Emerging Market index returning 5.1% (7.5% year to date).
Interest rates stopped rising in the second quarter, and even started to fall back a bit. The 10-year Treasury rate hit its high for the year at 1.74% at the end of the first quarter but declined to 1.45% by the end of the second quarter, and has continued to fall a bit more in the early days of July. It appears the bond market still considers recent inflation to be transitory, although there is much debate about what is causing the recent rate decline.
Bond returns fell slightly this quarter despite the small drop in rates (bond prices tend to move inversely to rates). The aggregate bond index had negative returns of -1.6%. Other bond categories held in our portfolios did better, as inflation-protected bonds rose 1.7%, and short-term bonds were closer to even, returning -0.3%.
The price of oil has continued rising from the extreme lows of 2020. A barrel of oil (WTI) rose from $61 to $73 this quarter, rising sharply toward quarter end amid a deadlock among OPEC nations. Discussions about boosting crude oil output from the low levels agreed upon during the pandemic to levels more suited to the current economy are being stalled by the UAE, which is seeking a greater share of output.
The price of gold bounced back a bit in the second quarter, rising 4.3% after falling over 10% in the first quarter. Gold had been negatively impacted by rising interest rates and the improving economy. It still remains a good hedge against unexpected inflation or potential negative news on the economic recovery.
In the opening to this commentary, we noted that inflation had arrived and is likely to stay with us for some time. Our inflation-protected bond holdings have outperformed other bonds this year, providing a positive return even while the overall Bloomberg Aggregate Bond Index has declined in value.
Still, we believe a diversified mix of bonds is important, just as we believe in the power of diversification among stocks. Different types of bonds will outperform in different environments, and as a whole their lack of correlation with stocks helps reduce the volatility of the overall portfolio.
There are a number of things we’ll be keeping a close eye on in the coming quarter, most of all new legislation that will impact retirement and estate planning. We expect there may be more to report on that in the third quarter, so keep an eye on your email for any updates from us.