Overall Risk-Taking Score
We monitor the backdrop for investing in risk assets across three primary pillars: economic conditions, asset prices, and technical considerations such as investor sentiment. On balance, we still believe that conditions are favorable for accepting investment risk, but above average asset class valuations and the potential for above-trend inflation should give pause.
For example, economic conditions are very favorable with the labor market improving (and continued room for hiring) and corporate earnings are trending higher. In addition, household balance sheets are healthy, partially thanks to the unprecedented level of support from the federal government and Federal Reserve in the form of direct payments to households, enhanced unemployment benefits, and very low borrowing costs. The above-average rise in prices, particularly related to energy and housing, and accounts of significant supply gaps for manufacturing and construction materials are the one primary concern for the economy today.
This favorable economic and technical backdrop is no secret and is being fully reflected in the price of many assets today. For example, the S&P 500 index has touched multiple all-time highs this year and has already returned 13% through May after returning 18% in 2020. The backdrop is favorable, but asset prices leave little room for error and potentially put investors in a precarious position if economic conditions were to unexpectedly change like they did in early 2020.
EconomyUS stock market indices, such as the S&P 500, touched new all-time highs in April as economic, household, and business data all continued to imply that the recovery from the COVID-19 economic recession remains on track and stable. As of this writing, nearly 50% of US adults have received at least one vaccine dose, which has helped to support a robust reopening of economic activity this spring. Economists and stock analysts have consistently underestimated the strength of the recovery in the labor market and corporate earnings, so the better-than-expected data in 2021 has helped to drive the stock market higher.
Percentage of Adults that Have Received At Least One Vaccine Dose
The labor market has continued its recovery, though the total number of employed Americans is still below pre-pandemic levels (see chart below). In early June, the US Bureau of Labor Statistics released their monthly assessment of labor market conditions. 559,000 jobs were added to the economy, which was generally in-line with the consensus estimate of economists of 675,000 (source: Bloomberg).
The economy remains more than 8 million jobs short of pre-pandemic levels, which allows significant room for labor market gains before capacity runs out, which has typically been a challenging point in economic cycles as wage inflation may begin to pressure company profitability on average. In May, leisure and hospitality jobs rose by 292,000 following similar gains during the previous two months as a sign that consumers are anxious to resume in-person activities like dining and travel.
Total Non-Farm US Payrolls (millions)
Above average inflation, which has not been a significant concern for most investors in more than a decade is now discussed regularly in the financial media and on corporate earnings calls. While companies and households have witnessed meaningful increases in the costs of labor, materials, and energy over the last year, we do not anticipate runaway inflation that would cause a collapse in corporate earnings and economic activity anytime soon (like the environment witnessed in the 1970s, as highlighted in the first chart below). However, much of the increase in the price investors have been willing to pay for current and future corporate earnings over the last year may be predicated on a very low interest rate and inflation environment. So, while we do not anticipate a hyper-inflation environment, even a return to normal levels of interest rates and inflation may result in a pricing of risk assets. The second chart below highlights the potentially precarious position of the S&P 500 index, which is trading at nearly 30x its most recent year of earnings. But, as we will see in the next section, corporate earnings have continued to recover at a robust pace and outperform expectations, which also provides support / justification for above-average index prices.
The Interaction Between Inflation and the S&P 500 Index
Corporate EarningsIn the first quarter of 2021, 86% of S&P 500 companies outperformed the consensus earnings expectations of Wall Street analysts. The year-over-year growth in earnings was 52%, which was significantly higher than the 24% growth expectation as of March 31st. Additionally, companies and analysts have been upwardly revising their forecasts for calendar year 2021 and 2022. The chart below highlights the future consensus expectation for calendar year 2021 earnings (bottom line) and 2022 earnings (top line) over the past year. For example, as of May 2020, analysts had been expecting, on average, that S&P 500 earnings would be approximately $165 for 2021, and as of May 2021 those forecasts have been revised up to nearly $190. In other words, expectations for 2021 earnings are now 15% higher than a year ago, which has helped to drive the index higher. The same is true for 2022 expectations, which also nearly 15% higher than a year ago.
ValuationThe unprecedented level of fiscal and monetary support in response to the COVID-19 pandemic and recession coupled with the successful vaccination campaign has led to a robust economic recovery in 2021 and above-average asset prices. The chart below highlights the blended earnings and coupon yield of a traditional “60/40” stock and bond portfolio, which is at its lowest level in four decades. These levels do feel precarious and leave less room for error should the economy experience an unexpected reversal of its growth and recovery. Foreign equities may also offer a relative value opportunity compared to the US-based S&P 500 index (second chart below).
Guide to the Markets – U.S. Data are as of May 31, 2021.
Given current conditions, we advocate that investors:
- Trim exposure to risk assets such as equity and credit back to target weights after rallies.
- Position toward higher quality companies with less-cyclical revenue and earnings.
- Add strategies that may be less sensitive to above-average inflation or even profit from it.
- Add alternative strategies that are less correlated to traditional stock and bond markets.
- Favor actively managed funds as these tend to add the most value inflection points in the market relative to their index-based counterparts.
Asset Class Returns
|Full Year 2020
|MSCI All-Country World
|US Large Cap Equity
|US Small Cap Equity
|Foreign Developed Equity
|Emerging Market Equity
|MSCI Emerging Markets
|US High Yield Fixed Income
|ICE BofAML High Yield Bond
|US Fixed Income
|Barclays Aggregate Bond
|ICE BofAML 3 Mo Deposit
|Source: Morningstar (total returns shown gross of fees)
As of May 31, 2021
Prices & Interest Rates
|May 31, 2021
|Dow Jones Industrial Avg.
|Crude Oil (US WTI)
|2 Year Treasury
|10 Year Treasury
|30 Year Treasury
|Source: Bloomberg, US Treasury (total returns shown gross of fees)
As of May 31, 2021
Past performance may not be representative of future results. All investments are subject to loss. Forecasts regarding the market or economy are subject to a wide range of possible outcomes. The views presented in this market update may prove to be inaccurate for a variety of factors. These views are as of the date listed above and are subject to change based on changes in fundamental economic or market-related data. Please contact your Financial Advisor in order to complete an updated risk assessment to ensure that your investment allocation is appropriate.