Over the second quarter, equities rose as vaccination campaigns continued to accelerate in most developed economies, especially in Europe, which is now catching up with the UK and the US. Emerging economies continued to lag on the vaccination front but cases remain very low in China and seem to have peaked in India. 10-year Treasury yields dropped by 30 bps, falling to 1.45%, with the decline helping growth stocks to outperform value stocks.
Governments in most developed markets continued to ease Covid-related mobility restrictions and activity levels picked up. Economic data over the last three months has generally been very strong, especially in the US, which posted an annualised growth rate of 6.4% in the first quarter. Although the eurozone economy contracted by 0.6% in the first quarter, leading economic indicators, such as purchasing managers’ index (PMI) business surveys, have reached multi-year highs in many regions. These indicators point to a strong economic rebound having taken place in Europe in the second quarter. We believe global growth will remain strong in the second half of the year.
However, the reopening of economies and the quick rebound in activity that has followed has fuelled inflation in some countries. In May, the US consumer price index increased by 5.0% year on year, although some of the underlying details suggest that there are temporary factors at play, such as the rise in used car prices. While the Federal Reserve continues to see this inflation increase as transitory, it has become slightly more hawkish, acknowledging that tapering is being discussed. The median Federal Open Mark Committee participant also now expects two rate hikes sometime in 2023, up from no rate hikes just three months ago.
Whether or not inflation is transitory is one of the biggest questions for investors right now and we look at this in more detail in our recent article, “Monetary and Fiscal Coordination and the Inflation Risks”.
Exhibit 1: Asset class and style returns
At a regional level, the S&P 500 delivered the best return (+8.5%) last quarter, thanks to the rebound of growth stocks, strong first-quarter earnings growth (47% y/y), and the prospect of more fiscal stimulus as Joe Biden reached a bipartisan deal to boost infrastructure spending by USD 600 billion. European stocks followed closely (+7.1%), supported by the reopening of regional economies and strong global goods demand.
While the spread of the delta variant is a potential concern, as it could slow the full reopening of economies, the increasing number of cases has so far not led to significantly higher hospital admissions in the UK. This suggests that the vaccines work well against the variant and UK equities were still able to deliver 5.6% over the quarter.
In contrast, the slow vaccination campaign weighed on the relative performance of the Japanese equity market last quarter. Meanwhile, policy tightening and regulatory concerns have weighed on China’s relative performance and on Asian indices as a whole.
Exhibit 2: World stock market returns
Within fixed income markets, investors searched for yield and inflation hedges against a backdrop of low sovereign bond yields and higher inflation, turning to spread products such as emerging market debt, US investment grade credit, and US and European high yield, as well as inflation-linked bonds.
Exhibit 3: Fixed income sector returns
In terms of duration, the US outperformed last quarter as investors appeared to prefer relatively higher Treasury yields to still deeply negative real European core sovereign bond yields. In addition, the issuance of EUR 20 billion of 10-year bonds to fund the European Union’s NextGenerationEU recovery package probably also helped to push European core yields slightly higher.
Exhibit 4: Fixed income government bond returns
In conclusion, as discussed in our Mid-Year Investment Outlook, “Still Up, But Bumpier”, we think the outlook for near-term global growth remains strong. As the bounce from pent-up consumer spending fades, we expect government and business spending to pick up the baton. While the second half of the year could be bumpier for financial markets, we still expect equity markets to continue their upward path.
Inflation worries are likely to contribute to market jitters, but it will take a lot of bad news to shift the central banks towards a more rapid withdrawal of easy money. Value stocks have still outperformed growth stocks so far this year and we believe the rotation into value has room to run if we’re right that bond yields rise from here. We also believe that the recent underperformance of Asia and China, due to worries over policy tightening and vaccine progress, is temporary and that the structural case for Asia remains intact.
Finally, as we expect more volatility in coming months, not only for equity markets but also for fixed income markets, we believe that an allocation to alternatives could help increase portfolio resilience.
Exhibit 5: Index returns for June 2021