Markets connecting the dots on transitory inflation
U.S. equity markets advanced for the fifth consecutive month as the S&P 500® had its second best start to the year in 20 years, up 8.6% in the second quarter. While performance appeared resilient, market leadership saw a material reversal from the first quarter, with large-cap growth outperforming value by nearly 700 basis points (bps) for the quarter.
Both small-cap and mid-cap stocks lagged large-caps for the quarter; but, small- and mid-caps were led by value stocks, while large-cap was led by growth. However, context matters: The “meme stocks,”defined as stocks which see dramatic price increases based on social media hype rather than a company’s performance, were a material impact for smaller-capitalization value stocks. Therefore while the Russell 2000® Value Index outperformed its growth counterpart for the quarter by approximately 60 bps, more than 25% of the return was from one stock: AMC Entertainment Holdings. In our view, smaller-capitalization value stocks remain vulnerable to a post-COVID-19 world of low interest rates and a consumer that may not revert to pre-pandemic spending in nondigital platforms.
The COVID-19 delta variant, which is believed to have originated in India, has been reported in 77 countries, and the Centers for Disease Control and Prevention estimates it accounts for more than 20% of all cases in the United States. Of particular concern is the rising number of delta variant cases in the United Kingdom given the country’s recent success in reducing cases through social distancing restrictions and vaccinations. Vaccination levels in the United Kingdom and the United States are similar at 50% and 47%, respectively. While we believe COVID-19 is impacting markets, we caution that the recent rise in global cases has been a primary catalyst for growth stock outperformance, as that rotation has been underway since March.
Economic data in the month continued to show an accelerating expansion in the business cycle, with both retail sales and industrial production growth rates near record levels. Survey data including the Chicago Fed National Activity Index and the Market News International Chicago Business Barometer™ came in below expectations; however, their respective rolling averages continue to trend upward. Those reports, combined with monthly payroll reports that either came in below expectations (May), or showed additional declines in the labor force (June), suggest the accelerating expansion phase of the business cycle may be shorter than consensus anticipates.
We believe investors have begun to accept the Federal Reserve’s (Fed’s) “transitory” stance on inflation which its members have uniformly reiterated. In addition to further discussions about tapering its quantitative easing program, the Federal Open Market Committee (FOMC) updated its Summary of Economic Projections, which includes the “dot plot” projections of the federal funds rate. FOMC participants collectively moved forward their expectations for increases in the federal funds rate, implying two rate hikes in 2023 compared to expectations for only one at the last meeting (Chart 1). This modestly hawkish surprise has likely contributed to the softening of inflation expectations as evidenced by Treasury inflation-protected securities breakevens falling since their peak in mid-May.
The PNC Economics team expects the Fed to signal a plan for tapering in a few months and most likely will gradually reduce its quantitative easing asset purchases starting in early 2022 and ending those purchases by the end of 2022. The team expects the first increase in the federal funds rate to come in mid-2023, at a time when it is expected that the economy will return to full employment and inflation readings will be consistently above 2%. The FOMC has repeatedly stated it aims to achieve inflation moderately above 2% for some time so that long-term inflation expectations remain well anchored at 2%. In our view, inflation readings in the near term will be skewed higher by the base effects of economic restrictions in 2020 and should fade later in the year as comparison levels rise meaningfully.
Shift in the FOMC Dot Plot As of 6/30/2021 (Chart 1)
Source: Bloomberg L.P.
Another possible contributor toward the easing of inflation expectations may be the struggles related to passing infrastructure stimulus. Since the American Jobs Plan was proposed in late March, its initial price tag of $2.25 trillion has been revised considerably lower to approximately $1 trillion at the end of June. We think investors are factoring in the challenge of passing meaningful fiscal stimulus with the Senate effectively split 50-50 and parties in the House of Representatives in disagreement over different parts of the package. Early spending estimates that included renewable and clean energy programs may be significantly reduced as part of the negotiations. In our view, investors may have overestimated the amount of deficit spending Congress could deliver, thus driving expectations of sustained high inflation in recent months. As the global economy reopens and stimulus proposals are cut back, we believe inflation concerns will be transitory.
Equity markets continue to be somewhat dismissive of corporate tax increases as 2022 consensus earnings estimates for the S&P 500 rose in June to $212, the highest level since the pandemic. The increase in the earnings-per-share (EPS) estimate may be impacted by rising 2021 expectations, as the growth rate for 2022 of just 11% is at the lowest level since estimates began. In our view, should ongoing fiscal stimulus discussions involve raising corporate tax rates, it would be a material headwind for 2022 earnings estimates. At a forward price-to-earnings (P/E) of nearly 22 times (x) for the S&P 500, we believe equity valuations are fairly rich. In addition, we do not anticipate any increase to corporate tax rates.
After breaking below major technical support in May, long-term Treasury rates reacted positively to the FOMC dot-plot adjustments. The 10-year Treasury, for example, ended the month at 1.47%, near the lowest level since March, and the yield curve spread (the difference between the 2-year and 10-year Treasury yields) flattened to 122 bps, the lowest level since February. We believe this indicates a market that is skeptical of both sustained high inflation and pent-up demand leading to a years-long cyclical market boom.
Corporate credit rates are falling along with Treasury rates. While the headlines focus on below investment grade yields, which are at all-time lows, the spread in investment grade credit is just 5 bps from its 2005 all-time low of 75 bps. We believe the ongoing quest for yield in fixed income is causing investors to increase risk exposure for incremental sources of income, driving down yields and spreads in corporate credit. While credit spreads should be declining in an accelerating expansion phase of the business cycle, we think fixed income valuations are more stretched than equities.
Developed International Markets
Developed markets once again facing COVID-19 headwinds
Despite a strong start, developed international equities ultimately underperformed their domestic counterparts during June, with the MSCI World ex USA Index down 1.1% after four consecutive monthly gains. Losses were broad-based — the vast majority of countries and sectors moved lower on the month in reaction to renewed COVID-19 concerns and a slowdown in 2021 earnings revisions. As such, the index closed the month below its 50-day moving average for the first time since January.
In yet another headwind to Europe’s economic reopening, weekly COVID-19 cases rose for the first time in 10 weeks, prompting new international travel warnings from Europe’s World Health Organization officials regarding the new delta variant. To make matters worse, less than one-third of E.U. citizens are fully vaccinated, and the United Kingdom has already delayed its reopening plans by yet another month. This could explain why the MSCI UK Index lagged the overall developed international index for the month, as we believe COVID-19 is a primary market driver.
Renewed COVID-19 concerns are one reason we believe recent traditional economic readings such as the increase in consumer confidence to -3.3 and the IHS Markit Eurozone Manufacturing PMI® to 63.4, the highest reading on record, should be examined in context. For starters, both of those reports were performed before COVID-19 cases worsened in the latter half of the month. Second, data such as Eurozone retail sales and industrial production are still below their respective pre-pandemic levels. In yet another reopening false start, a number of higher frequency data points, such as OpenTable seated diners and traffic mobility, have already started to stall out. This suggests to us that developed international economies still face a variety of hurdles to a more meaningful recovery (Chart 2).
Higher Frequency Indicators Reflect Yet Another Reopening Fakeout As of 6/30/2021 (Chart 2)
Source: Bloomberg L.P.
Not surprisingly, developed international equity valuations remain well below those of domestic equities. The forward P/E of the MSCI World ex USA Index ticked down 0.1 point lower over the month to 16.3x, and its ratio with the forward P/E of the S&P 500 remained 0.77, 11.5% lower than the 10-year average. Looking at valuations from an earnings perspective, the S&P 500 and MSCI World ex USA Index are expected to deliver comparable EPS growth for 2022 despite estimated 2021 growth of 63.3% and 40.8%, respectively. Therefore, while developed international market valuations may appear relatively attractive at first glance, the earnings growth backdrop and the broader macro backdrop are still in favor of U.S. equities.
A variety of headlines recently announced a U.K. “ban” on the world’s largest cryptocurrency (crypto) exchange, Binance. While some may be surprised crypto markets did not sell off on such news, it was in large part due to inaccuracies in reporting. The regulatory announcement was specific to Binance Markets Limited, not the parent company as many initial headlines suggested. As crypto markets are relatively new and represent potential disruption to numerous industries, we think the level of FUD (fear, uncertainty, and doubt) can be a challenge for investors looking to invest in these new technologies.
Equity market gains overshadowed by crypto market weakness
Emerging market (EM) equities are having their third best start to the year of the past decade, supported by rising commodity prices and a global economic recovery. Performance was driven by a concentrated number of countries and sectors that do well in periods of rising prices, an environment in which EM equities add value, creating a strong fundamental outlook for the asset class.
Economic data across the asset class was largely positive, as most countries are seeing COVID-19 cases fade. However, one common theme was that most EM countries have yet to see consumer price index (CPI) data return to pre-pandemic levels. That is in sharp contrast with the United States, where CPI is at the highest level since 2008. In our view, the global inflation imbalance is one of the primary reasons we believe inflation will be transitory in nature. EM countries did not deliver the same magnitude of fiscal stimulus as the United States; thus, as those programs expire and the global economy reopens, price levels in the United States should normalize.
China had notably weaker-than-expected data for the month, with both retail sales and industrial production growth not only coming in below consensus estimates, but decelerating from May on a year-over-year basis. In spite of ongoing evidence of slowing economic data in China, equity performance continued its path higher due to growth stock leaders in the Consumer Discretionary and Information Technology sectors.
Both Indonesia and South Africa lagged the rest of the EM index considerably. At the sector level, the two countries are quite different; Indonesia is relatively overweight Financials, whereas South Africa has significantly more exposure to Consumer Discretionary. So why did both countries see their equities lag? In our view, the primary reason was a spike in COVID-19 cases, with both countries seeing the number of daily cases reach all-time highs in June. It is a stark reminder that COVID-19 is still a meaningful market driver and cannot be dismissed until the pandemic is contained.
We think a primary reason the crypto bitcoin is struggling to recapture higher price levels is the material decline in its hash rate (technical term for the level of mining activity, Chart 3). We believe this lends to the probability that Chinese regulators are enforcing restrictions on bitcoin mining not seen in prior years. This matters because bitcoin’s network effect — which in our view is how crypto networks derive value in the first place — will remain under pressure as miners relocate to other countries or simply do not return to crypto markets. It is widely believed that the majority of bitcoin mining occurs in China; thus, while the hash rate decline is a near-term headwind, the expectation is that bitcoin mining could diversify into other countries and thus end up a long-term tailwind for the strength of the network.
Significant Decline in Bitcoin Hash Rate as Miners Go Offline As of 6/30/2021 (Chart 3)
On the last day of the month, the Chinese ride sharing company, DiDi Global Inc., debuted on the New York Stock Exchange with the second largest initial public offering for a Chinese firm ever, second only to Alibaba Group Holding Ltd. in 2014. Similar to the recent scrutiny of Alibaba and other Chinese technology companies by both Chinese and U.S. regulators, investors were surprised when Chinese regulators removed DiDi from Chinese app stores citing security risks. While this is an issue we will monitor, it is a reminder of the ongoing tensions between the United States and China that act as an ongoing headwind between the two global economic superpowers.
TEXT VERSION OF CHARTS
Chart 1: Shift in the FOMC Dot Plot As of 6/30/2021 (view image of chart 1)
Graphic showing the Federal Open Market Committee (FOMC) Dot Projections for meeting dates 6/16/2021 and 3/17/2021. The chart depicts the expectations of the members of the FOMC as to when the federal fund rates will be increased. The chart displays the change in projections between the two meeting; members are now expecting two rate hikes in 2023. At their last meeting, members expected only one rate hike in 2023.
Left axis shows the Implied Federal Funds Target Rate (percent) and bottom axis the projection year end for years 2021 through 2023 and for the longer term.
Chart 2: Higher Frequency Indicators Reflect Yet Another Reopening Fakeout As of 6/30/2021 (view image of chart 2)
Chart 3: Significant Decline in Bitcoin Hash Rate as Miners Go Offline As of 6/30/2021 (view image of chart 3)
|Date||Hashes per Second||Thousands of Dollars|