- Economic data continues to improve as the economy reopens and vaccinations increase but business are still having trouble filling open positions helping to drive wages higher.
- Earnings growth is expected to increase at its fastest pace since 2009 while inflation concerns amongst companies are becoming more prevalent.
- Interest rate uncertainty could cause increased volatility later in the year if the Federal Reserve needs to pivot from its easy monetary stance.
- U.S. Equity closed-end fund discounts are averaging their lowest discounts in the last five years.
It is hard to believe we are already halfway through 2021. This year has felt different from others in the sense that the news has seemed to focus on almost everything but the market. Between the volatility in cryptocurrencies, the rise of non-fungible tokens, meme stocks, SPACs, and housing booms it seems like the tried-and-true stock market has become somewhat boring. As “boring” as it may be, the market has certainly reflected the recovery in the underlying economy.
First quarter real GDP grew 6.4% at a seasonally adjusted rate. Manufacturing PMI has been in expansionary territory for 13 months in a row while the services PMI has increased for 12 months in row indicating improving business activity. The U.S. added 850,000 jobs in June which is the largest gain since August of 2020. For the 2nd quarter, the estimated earnings growth rate for the S&P 500 is 61.9%. This would mark the highest year-over year earnings growth rate reported since the 4th quarter of 2009 which was 108.9%. Interestingly, inflation is not just a concern for investors. According to FactSet, 197 S&P 500 companies highlighted “inflation” during their earnings calls for the first quarter, this is an increase of 138 companies from last year. This is the highest overall number of S&P 500 companies citing “inflation” on earnings calls and the largest year-over-year increase since 20101.
The Federal Reserve held their most recent meeting on June 17th where they maintained their accommodative stance leaving the federal funds rate and asset purchases unchanged. They remain focused on their dual mandate of maximum employment and stable prices but acknowledged that inflation has risen but believe that to be mostly transitory. The big news surrounded the dot plot, which shows each members projections for the federal funds rate at different points in the future.
Seven of the eighteen members projected a rate hike in 2022, up from four in March, while thirteen saw at least one hike by the end of 2023, an increase from seven.
The PCE Price Index, the Federal Reserve’s preferred measure of inflation, increased 3.4% excluding food and energy on an annual basis. The Federal Reserve Board’s latest projection for 2021 PCE stands at 3.4% before declining to 2.1% for 2022 and 2.2% in 2023. They also project 7% growth in real GDP for 2021 which was an increase from 6.5% back in March.
Consumer confidence also continues to rise. The Conference Board’s Consumer Confidence Index rose 7.3 points to 127.3 and stands at its highest levels since March of 2020. The Present Situation Index which is based on consumers’ assessment of current business and labor market conditions, rose from 148.7 to 157.7. Finally, the Expectations Index, based on consumers’ short-term outlook for income, business, and labor market conditions, improved to 107.0, up from 100.9 last month2. These strong readings are suggestive of sustained economic growth.
Within our investment objectives our equity has performed well year-to-date. Closed-end fund discounts have narrowed substantially helping performance. From a historical perspective, average discounts for closed-end funds are averaging their lowest levels over the last five years. The chart below compares the current average discount of U.S. Equity closed-end funds versus their average, average high, and average low discounts over the years.
We continue to believe that purchasing skilled managers at attractive discounts provides investors with additional benefits above other standard investments. As the discounts have narrowed however, we have been shifting assets from closed-end funds to exchange traded funds as opportunities arise. The exchange traded funds have performed in line with expectations. Exchange traded funds offer broad, low-cost diversification and market like performance in times that closed-end fund dynamics look unattractive. Option writing broadly has detracted from performance as the market returns remained strong for the first half of the year. When applicable we use options to tailor risk for different investment objectives. The risk-reduction from option writing is largely a function of the amount of premium collected. One of the factors that affects option premiums is volatility. Higher volatility leads to higher option premiums and vice versa. Interestingly, volatility is also the only factor that is not known beforehand and therefore must be implied. For example, when I sell a 3-month option, I know exactly what the strike price is, how much time is left to maturity, and what the 3-month interest is. What I do not know (amongst many other things) is how volatile the market will be over the next three months. The market tends to overestimate this risk which translates into higher option prices. This difference between realized and implied volatility fluctuates over time but is frequently positive and over the past year remained above average3. Collecting this additional premium helps to offset forgone gains in strong rising markets while still providing an effective way to reduce risk.
Our structured investments have been more conservatively positioned as the market has continued its resilient run. This portion of investors’ portfolios serves as the ballast against market volatility, providing downside protection and enhanced returns in exchange for capped upside. Our laddered approach to the structured investments allows us to reinvest proceeds of maturing notes at higher prices with new downside buffers and more upside. We continue to find this buffered approach attractive compared to fixed income in a time where 10-year treasuries are yielding 1.49% which translates into a -2.31% yield after factoring in inflation. Moving out the risk spectrum within fixed income into investment grade corporates and even further into U.S. high yield only increases the yield to 2.05% and 3.78% respectively before factoring in inflation. With yields and spreads at historic lows the risk remains to the downside. For example, a 1% increase in interest rates would result in total returns of -7.3%, -6.7%, and -0.1% for U.S. 10-year treasuries, investment grade corporates, and high yields respectively due to the inverse relationship between bond yields and prices. The general market seems to agree with this approach as there has been an influx of buffered or defined outcome exchange traded funds that have come to market over the past year. These ETFs provide us a greater opportunity to invest and diversify across structured investment allocations.
As always, it is important to remember the reason why you are investing. In the short-term there will always be reasons not to invest or what seems like missed opportunities. Your investment objective should be based on your long-term needs and goals. As financial advisors it is our job to remind you of that and guide you along the way. We value and appreciate the trust you place in us and look forward to serving you and your families for years to come.
1 – FactSet Earnings Insight
2 – The Conference Board Consumer Confidence Survey®
3 – Natixis Gateway Fund Q1 Quarterly Portfolio Commentary