Despite a myriad of challenges, risk assets across the capital markets head into August with healthy 2021 gains. Notably, in July, the National Bureau of Economic Research “officially” announced that the pandemic-induced U.S. recession lasted only two months, from February 2020 to April 2020, which places it as the sharpest, yet also the shortest in modern history. More importantly, U.S. economic output, as measured by GDP, just surpassed its pre-pandemic peak.
Our macro team expects the Delta variant flare up to modestly reduce economic growth in the third quarter. However, the expansion should continue to chug along at a healthy clip. Consumers are in good shape as evidenced by excess savings, low debt service ratios, and a recovering job market. Likewise, corporations are bolstered by record profits and cash levels; additional spending will also be needed to rebuild depleted inventories.
While the virus remains a risk, one silver lining, so far, is we are seeing a decoupling between surging new COVID-19 cases and hospitalization and death rates, which have remained contained, a sign that vaccinations are making a difference relative to last year.
This decoupling along with another blowout earnings season are among the primary reasons markets have held up well. Periodic setbacks should be expected as we move into the seasonally-weaker August to September period and given that markets have gone the second longest period of the past decade without so much as a 5% pullback. However, our constructive 12-month outlook is supported by an economy that remains on solid footing, corporate earnings power that remains underappreciated, and attractive relative valuations.
Indeed, strong momentum tends to be a positive: following past six-month winning streaks, such as what just occurred, the S&P 500 has been higher 12 months later 18 out of 21 times, with an average gain of 12%. Further, more than 50% of stocks in the S&P 500 now have a dividend yield above the 10-year U.S. Treasury yield.
From a positioning standpoint, we maintain our long-standing U.S. bias. We further downgraded our outlook for emerging markets (EM) after moving them to less attractive in May given ongoing concerns about the crackdown of industries by the Chinese government as well as underwhelming profit trends. This has broader implications given China accounts for 35% of the EM index.
We maintain a value bias, but slightly downgraded our outlook in late July given weakening relative price trends and near-term uncertainties around the Delta variant.
Also, our sector strategy overweights have shifted over recent months from a concentration of economically-sensitive segments of the market to a balance between cyclicality (energy and financials) and other areas including communications services (growth) and real estate (containing growth and value characteristics).
On the fixed income side, the pullback in the 10-year U.S. Treasury yield is inconsistent with our still upbeat economic outlook and expectation for inflation to stay above pre-pandemic levels. Thus, our fixed income group recommends investors keep bond duration slightly short. High quality bonds remain an important portfolio ballast, but we remain overweight high yield and leveraged loans, which should remain well supported by the economic recovery and the search for yield.
Keith Lerner, CFA, CMT
Chief Market Strategist
Truist Advisory Services, Inc.
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