July 1, 2021
The equity markets rose strongly in the second quarter of 2021, as the S&P 500 was up +8.55%, US small caps +4.51%, US mid-caps +3.64%, international developed +5.04% and emerging markets +5.73%1.
We think the primary driver of the equity market upside has been the continued recovery of the economy from the prior downturn caused by the pandemic. Indeed, daily new COVID cases in the US have fallen from over 305,000 on 1/8/21 to an average of approximately 15,000 per day over the past few weeks2.
Cases may rise from current levels due to the increasing prevalence of the delta variant3. However, we are hopeful that vaccines may help contain a potential rise in cases; Moderna shared early indications on 6/29/21 that its vaccine may be effective against the delta variant3.
Despite the economic recovery, the 10-year Treasury yield fell from 1.74% to 1.47% during the quarter1. We believe this was due in part to the Federal Reserve’s (Fed’s) statement on 6/16/21, which we interpret as a moderate change to the Fed’s views on inflation3.
While the Fed continued to characterize the current inflation pressures as “transitory,” they increased their 2021 inflation estimate by a full percentage point to 3.4% and now indicate that they may increase short-term interest rates as soon as 2023, compared to March 2021 when they indicated that they did not expect to raise short-term interest rates until 2024 at the earliest3.
It seems investors have purchased long-term Treasury bonds, pushing the bond prices up and the yields down, based on the belief that the Fed is now paying closer attention to inflation. If the Fed were to proactively raise short-term interest rates to counteract inflation, that could justify higher Treasury bond prices as inflation would have a smaller negative impact on the economic value of fixed income payments.
However, we expect the 10-year Treasury yield to resume its upward trajectory from the 0.51% yield recorded in August of 2020; inflation may continue to come in higher than the Fed expects due to the strength of the economic recovery1.
External sources: Bloomberg data1, Worldometer2, CNBC.com3.
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