In many ways, the first half of 2021 has played out as largely expected. Here’s a quick list of forecasts made at the beginning of the year that I think are largely running their course:
- Rising vaccination rates were expected to give way to loosened and eventually removed economic restrictions;
- The economy was expected to surge on the heels of returning demand and a spending boom;
- The “reopening trade” was expected to favor companies that suffered most during lockdowns but could benefit most from re-engaged consumers;
- Surging demand would generate strong growth rates along with inflationary pressures.
The first six months have gone fairly close to script, in my view, which tees up a few key factors to watch in the second half. Here are three factors that investors should keep an eye on.
Factor #1: Will Inflation be “Transitory”?
The consumer price index jumped 5.4% in June – its quickest increase in 13 years – and has been trending firmly higher. Globally, inflation measures in 49 countries have also been tracking higher.1
The inflation debate continues to center around whether these price pressures will be transitory or more nefarious and long-term. In Q2 earnings calls and reports – both of which we monitor closely here at Zacks Investment Management – we noticed a majority of CEOs referencing inflation. Here are a couple of examples that stood out:
From the massive consumer packaged goods company, Conagra: “We expect the negative impact of the cost inflation to hit our financials before the beneficial impact of our responsive actions, including our pricing.”
From PepsiCo: “We’re seeing inflation in our business across many of our raw ingredients and some of our inputs in labor and freight and everything else.”
Early on, it appeared price pressures were largely being driven by energy, reopening categories like restaurants and travel/hospitality, and big-ticket categories like used cars and housing. But we’re seeing inflationary pressures in much broader categories this summer, and many producers are indicating continued firmness in commodities and other input costs. Continued supply chain bottlenecks aren’t helping.
For investors, inflation will be a key metric to watch in the second half, but there are a few things to start thinking about now. For one, history tells us that stocks do better during flat or disinflationary regimes, versus periods of higher inflation. This does not mean stocks should be avoided if inflation is expected – rather, it means investors should be more selective during inflationary periods. A pivot to value could be a play – data dating back to 1927 indicates that value stocks have tended to outperform growth during periods of moderate to high inflation.
If inflation does indeed prove sticky, we’d generally want to favor companies with strong pricing power, i.e., firms that can pass along rising costs to consumers without losing market share.
Factor #2: Will Leadership Continue to Shift Between Cyclicals (Value) and Growth?
We have seen quite a bit of style rotation year-to-date so far, namely as capital moved between cyclical (value) stocks and secular growth stocks. From the beginning of the year through the middle of May, value outperformed—the Russell 1000 Value index rose +15% compared to just +2% for the Russell 1000 Growth index. From mid-May to the end of the second quarter, however, U.S. Treasury bonds have rallied alongside growth stocks (+12%), while value stocks have lagged (+2%).
There are some logical explanations for the rotation year-to-date. When vaccines were announced to be effective in November, economically sensitive cyclical stocks started to outperform as investors anticipated the economic reopening. Some of the most beat-down stocks during the pandemic started to rally strongly.
But the rapid surge in demand gave way to what is largely considered peak growth in Q2, which has caused investors – in my view – to rotate into growth names expected to perform better as the U.S.’s pace of growth moderates. Concerns over rising inflation have also nudged capital back to secular growth names.
The key question from here is whether this rotation continues or if the value will start to lead again. In my view, economic growth has likely peaked, but I think will it continue at a faster pace than many expect. In other words, cyclicals likely have some room to run, but quality growth names should also do well in an expanding economy. I expect leadership to shift quite a bit, which favors a broadly diversified approach to equity investing.
Factor #3: Are Interest Rates Poised to Move Higher?
Interest rates in the U.S. – as measured by the 10-year and 30-year U.S. Treasury bond yield – moved higher in the second half of 2020 and throughout Q1 2021. However, as you can see in the chart, yields have slipped back over the last quarter:
Source: Federal Reserve Bank of St. Louis2
There could be a few reasons for this fluctuation in rates. Yields may have pushed higher in anticipation of higher inflation and economic growth, and we may have seen some retracing as investors started to shift expectations to moderating economic growth and inflation that may indeed be transitory.
Going forward, I’d expect better-than-expected economic growth and an eventual reduction in the Fed’s bond purchases to put upward pressure on rates, both of which I could see playing out by the end of the year.
Bottom Line for Investors
I think worries over sticky inflation, peaking economic growth, and rising interest rates are together contributing to a wall of worry over the durability of the economic expansion – and by extension, the bull market. But in my view, the worries may inspire investors to start moderating expectations for sustained economic growth and profitability, and falling expectations could give way to positive surprises. And stocks tend to love positive surprises.