2nd Quarter Update - 2021 Economic Outlook

A Long-term Look At The Year 2021 - Mid-Year Update
Every year-end since our founding, our team conducts an in-depth analysis of the U.S. economy and financial markets to develop an Annual Economic Outlook. This forecast serves as a blueprint for our investments throughout the year. During this episode, we review our 2021 forecast and discuss mid-year updates.

About The Speakers

Moustapha Mounah, CFA
Research Analyst

Trent D. Dysert, CFA
Associate Director of Research, Assistant Vice President, Portfolio Manager
Investment Committee Member

Neil Craft
Client Relationship Manager

Neil Craft: Hello and welcome to the James Market Clarity podcast. I'm your host Neil Craft, and today on episode 10, we have Trent Dysert and Moustapha Mounah with us to provide you a mid-year update to our annual economic outlook. Gentlemen, how are you today?
Trent Dysert: Doing well, Neil excited. Excited to be here.
Moustapha Mounah: Doing great.
Neil Craft: Good. Excellent. Well, I'm very excited to have you both here today, you know, as this is our first panel approach to the show and I think our listeners are in for a real treat. Mo, I'll start with you. If you don't mind, let's go ahead and provide our listeners with just a brief recap of the second quarter. What happened in the stock and bond markets?
Moustapha Mounah: Well, in the second quarter, we saw the broad stock market index like the Russell 3000 rising over 8% and reaching an all-time high on June 30th, almost the end of the quarter. We saw a lot of stocks of the Russell 1,000 outpacing the smaller stocks of the 2000 by over 4%.
This is a reversal from what happened in the first quarter, where small cap actually outperformed large cap. From a style and size perspective, we saw large growth gaining more than twice as much as small cap value, and that was also a change from the first quarter. In the bond wards, looking at the broad bond market indices, all of them rebounded during the second quarter as rates declined. The 10 year went from 1.7 all the way down to 1.3. The U.S. Aggregate Bond Index 2% total return basis after losing 3.4% in the first quarter. Again, that's a change from what happened the first quarter. Overall, it was a good quarter for both stocks and bonds.
Neil Craft: Okay. Well, I appreciate that Mo. Trent, it seems as though the inflation debate as it is, is it transitory? Is it here to stay? It really reached a crescendo last quarter. What research do we have and where do we see this inflation debate heading for the remainder of this year?
Trent Dysert: Yes. The debate with inflation has certainly heated up. On one side you have Fed Chairman, Powell and Treasury Secretary, Yellen who are arguing inflation is only temporary and is driven by the base effects, short term supply demand, imbalances, and negative domestic output gap. Then on the other side of the debate, you have the surge in consumer spending, rising commodity prices, trillions in government aid, decoupling from China, and the rise of de-globalization, are all arguments for the permanent spike in inflation. I think a few things to keep in mind and things to watch out for in the future, are the amount of the unemployed workers and the rise in wage growth.
Neil Craft: Okay. Well, we appreciate that. Especially things that we can look at into the future. Trent, I'm gonna stay with you here for a minute as we shift on to the Federal Reserve. Now the Fed has been really supportive during the pandemic and throughout the recovery. We're just now starting to hear some rumblings about pulling back or tapering their current bond purchases, which, I remember back in 2013, when the smallest couple of words from the Fed share, set the stock market into a frenzy. Can you share your thoughts on that nuance there, and how balanced portfolios could be effected?
Trent Dysert: Well, you're right Neil, the Fed has been very supportive throughout the pandemic. They pump trillions of dollars into the system. Their balance sheet has expanded well above levels last seen during the financial crisis in 2008. The rumblings you mentioned can be traced back to revisions in the dot plot, which is essentially the Fed official’s rate expectations in the future.
The dot plot now hints at a potential increase in interest rates in 2022. This kind of jolted the market recently, as those expectations got pulled forward, compared to just a few months ago, with what they were saying. For listeners, the concern is whether the Fed can time this taper correctly. If they pull back too early, it could stall the economic recovery. If they're too late to the game, and wrong on inflation, they could also lose confidence among investors as inflation runs rampant.
Neil Craft: Would you say that the timing is ultimately the key?
Trent Dysert: Yes, I would say that that's going to be very important.
Neil Craft: Okay. Gotcha. Mo, I’m going to pass it back to you for our next topic. We've seen value definitely have a great first half of the year, and in cyclical names, have done pretty well also. Do we anticipate those trends to continue into the second half?
Moustapha Mounah: Well, are you right Neil. Thanks to rapid vaccine development and distribution, coupled with the reopening of the economy, the small cap value of cyclical trade have done very well over the past six and nine months. But to answer your question, we need to look at where we are in the business cycle. A typical business cycle has four distinct phases; early, mid, late, recession. Value oriented plays and cyclical names historically performed well in the early part of the economic cycle. The COVID-19 recession though, is unique in a sense that it caused a complete shutdown of the economy and rapid reopening. It's likely that some of the economic sectors are already transitioning into mid cycle state, while other are still in the early phase. We believe the strong economic performance would continue in the second half of the year. Albeit at more modeled pace is probably going to be growing at 7%, the rest of the year instead of 13% in the second quarter. But the supporting tailwind to the economy are provided again by the pent up consumer demand, friendly fiscal monetary policy, a favorable credit condition, and we have a potential infrastructure deal that may come to fruition, hopefully by the end of the year. The general reopening of the economy is a plus to the cyclical trade. But we need to note that as Trent mention, the growing Fed chatter about tapering is likely to be a headwind for the value cyclical trade, and a tailwind to the large established growth stocks.
So in sum, we believe that during inflation rallies, investors should lower exposure and maintain a tilt to cyclical and economically sensitive stocks, while also having significant weight into the secular growth area, as we transition it to meet the part of the economic cycle where those do well.
Neil Craft: Thanks Mo, definitely lots of moving parts there. Are there any risks that we can identify that could potentially alter, or affect our outlook for the year?
Moustapha Mounah: Certainly, we here at James are watching five risks that we think are major. First of all, we have inflation. We believe that current high inflation is transitory and the base effect will fade, the bottleneck in the supply chain should ease by the end of the year, and we should see much more manageable CPI (Consumer Price Index) next year. However, there is always a risk that inflation is more permanent, and that definitely could impact markets and the economy and overall, impact the style of investing that everyone is favoring at the moment.
The second is that we're watching valuation. Valuations are at that extreme level, not seen since the dotcom bubble. Looking at the cyclically adjusted price to earnings, it's standing at 38.
Third, we're watching the sentiment, which is historically very, very bullish. Looking at margin debt fund flows into leveraged ETFs, if you look at the small speculator position in the S&P 500 future markets, that's also highlighting extreme bullishness, and usually that's a contrarian view that you need to be cautious of going forward. But, we need to note that the sentiment and valuation indicators are historically not great sell timing tools. But they can accelerate any sell off.
The fourth we're watching as Trent already mentioned is the timing or the Fed taper too early, you could stall the economic recovery too late. You could lose confidence among investors, and finally watching the U.S. dollar, which is very in a bearish trend; but we think a hawkish Fed bodes well for U.S. interest rates going higher, and these too are attracting more foreign inflows, which could push the dollar higher. This is bearish for U.S. equity, especially large cap stocks, because they drive 35% of their revenue from outside the U.S. so stronger data usually hurt the currency exchange of their foreign sales.
Neil Craft: Well, thank you Mo. Trent back to you as kind of, we tie all this together today, would you mind summarizing and sharing our conclusions for the outlook?
Trent Dysert: Sure. No problem. Overall, with the tug of war between the permanent and transitory inflation camps and the Fed's policy response to economic recovery, we expect some increased volatility here in the third quarter. However, we expect the economy to continue its expansion. With the potential for a bipartisan infrastructure bill coming down the pipeline, we think this will bode well for the economy.
Neil Craft: Okay. Now, given those conclusions, what's our message to the investors and the listeners out there today?
Trent Dysert: Yeah. We believe the secular bull market should remain intact.
It's important to be very selective though by looking for stocks that, you know, with good relative value, quality characteristics, but as Moustapha mentioned, don't neglect those that exposure to the growth areas as the recovery transitions into more of a mid-cycle.
For fixed income, we'd encourage investors to keep the portfolio duration low. We kind of say, you know, more below maybe a benchmark level, with the potential risk of a taper tantrum here in the maybe second half of 2021. Short-term corporates, senior bank loans, floating rate securities; they should do well, and we think those can be beneficial as it should provide slightly higher income than treasury securities.
Neil Craft: Excellent. Trent, Mo thank you so much for being here today. We really appreciate it, and I know our listeners do as well.
Trent Dysert: Of course. No problem. Thanks for having me.
Moustapha Mounah: You're welcome.
Neil Craft: If you have any questions about our updated annual Economic Outlook or our podcast, please visit us at www.jamesinvestment.com for more information.
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Russell 1000 Index: The Russell 1000® Index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000® represents approximately 92% of the U.S. market.
Russell 2000® Index: measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
Russell 3000 Index: The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market.
Consumer Price Index (CPI): Measures the average change in prices over time that consumers pay for a basket of goods and services.
Dot-com bubble: was a stock market bubble caused by excessive speculation of Internet-related companies in the late 1990s.
S&P 500 Index: S&P (Standard & Poor’s) 500 Index: a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
The Bloomberg Barclays U.S. Aggregate Bond Index: a broad base, market capitalization-weighted bond market index representing intermediate term investment grade bonds traded in the United States.
Price/Earnings P/E: is a ratio for valuing a company that measures its current share price relative to its per-share earnings.


Typical Allocation Range

Equity: 40% - 70%
Fixed Income: 30% - 60%
Cash: 1% - 15%

Small, mid, and large cap stocks
Benchmark: 25% Russell 1000® Index , 25% Russell 2000® Index and 50% Bloomberg Barclays Aggregate U.S. Intermediate Government/Credit Bond Index

The Balanced strategy has a target range of 40% - 70% in equities, with a mix of small, mid, and large capitalization stocks. We weight the stock exposure toward the most advantageous market capitalizations based on our research.

Sector analysis in an important part of our portfolio management process. Changes in sector weightings are made based on our analysis.

We believe that having the maximum flexibility to follow our research is the key to adding value to our clients' accounts.