At a glance
A positive environment for the economy and markets for the rest of 2021 remains our base case. Investors still have risks to face, including changing monetary policy, inflation and the continuing global coronavirus pandemic.
As we begin the year’s final quarter, we retain a positive outlook for diversified portfolios and economic growth. Despite a solid total return environment for many asset classes, especially traditionally riskier ones, the year’s final stanza will present some challenges to a generally placid investment backdrop. We are in a transitional time period, with the world adjusting to a persistent pandemic, potential changes to central bank policy that has been mostly pro-growth and markets digesting dogged inflationary pressures.
In the segments that follow, our investment leaders share their perspective across asset classes and geographies as we work to synthesize what may impact markets and your portfolio. As always, we appreciate your trust and welcome any questions you may have. Our best wishes for a safe and healthy end of the year to you and yours.
― Eric Freedman, Chief Investment Officer, U.S. Bank
- Broad-based sector performance reflects economic recovery and expansion. The S&P 500 ended the third quarter up 14.7 percent for the year, above the historical longer-term annual average of roughly 10.5 percent. All 11 S&P 500 sectors have generated positive returns, with nine rising 9 percent or more. The defensive-oriented Consumer Staples (up 2.6 percent) and Utilities (up 1.7 percent) sectors are lagging behind secular and cyclical growth sectors, which is customary during periods of economic recovery and expansion. Positive broad-based sector performance is typically indicative of a market that is poised to grind higher.
- Earnings are trending toward record levels. Rising earnings are providing valuation support and the basis for U.S. stocks to trend higher. Analysts have revised consensus earnings estimates for S&P 500 companies in 2021 to more than $200 per share, up from approximately $165 at the start of the year, according to Bloomberg, FactSet Research Systems and S&P Global.
- Below-extreme valuations support our glass half-full outlook. The S&P 500 ended the third quarter trading at roughly 21 times consensus 2021 earnings of $201, below the dot-com era extremes of nearly 30 times in 2000 and below pre-pandemic 2019 levels of roughly 28 times. According to Bloomberg and the U.S. Bureau of Labor Statistics, based on data extending back to the 1950s, price-earnings multiples typically don’t become compressed, resulting in lower equity prices, until periods of sustained inflation exceeding
- Equities remain an alternative for income-oriented investors. The relative attractiveness of dividend-paying equities over select fixed income alternatives remains favorable, helping support equity prices. At present, 42 percent of S&P 500 companies offer dividends yielding above the 10-year Treasury yield of 1.5 percent.
- We continue to monitor risks for their potential to weigh on equity valuation and prices. Investors’ list of worries includes the impact of COVID variants on the pace of economic and earnings growth, inflationary trends that may prove to be sustained versus transitory, monetary and fiscal policy changes, and geopolitical events. The release of third quarter earnings results, along with companies’ forward guidance, are among immediate catalysts that we expect to impact equity prices into year-end.
- Foreign developed equities retain catch-up return potential relative to domestic alternatives. Due to relatively high exposure to economically sensitive sectors (Energy, Financials, Industrials and Materials), foreign developed equity performance is sensitive to investors’ future economic growth and inflation expectations. Foreign equities finally eclipsed the previous all-time high set all the way back in October 2007, suggesting investors have not yet fully priced in the region’s recovery potential if vaccination progress continues and the global economy continues to recover and reopen.
- Vaccination progress is driving economic reopening and equity performance in foreign developed markets. Authorities have administered at least one vaccine dose to 73 percent of France’s total population and 65 percent of Germany’s, and the recent Delta variant surge appears to have crested in Japan. Cyclical sectors have delivered double-digit year-to-date performance gains, as has the Consumer Discretionary sector, which reflects relaxed activity restrictions and consumers’ increased mobility and confidence.
- Diversified investors need to consider rule of law when allocating assets across the globe. In the United States, regulatory and other policy changes that impact capital markets are infrequent and often relatively well telegraphed. Over the past year, China’s regulatory authorities have asserted greater control over key industries, highlighting the additional rule of law risks that investors in emerging market equities must navigate and the additional policy uncertainty, or risk premium, they price across emerging markets.
- China’s policy outcomes remain a key factor for emerging equities’ fortunes as we conclude 2021 and look toward 2022. Despite emerging markets’ heterogenous country makeup, spanning Asia, Latin America, Africa, Europe and the Middle East, Chinese-domiciled companies comprise the largest proportion of emerging markets’ country exposure, and China’s largest publicly traded companies are consumer-oriented e-commerce, mobile gaming and social media enterprises at the center of regulators’ recent scrutiny.
- Limited income from low Treasury yields and gradual reductions in Federal Reserve asset purchases dampen our Treasury return outlook. The Fed is unlikely to raise interest rates until mid-2022 at the earliest, but it will likely begin trimming asset purchases later this year. We expect longer-term bond yields to rise modestly, but rates are unlikely to return to historical averages in the near term. Treasuries and other high-quality fixed income options like investment-grade corporate and municipal bonds provide important portfolio diversification, but we see opportunities to hold larger-than-normal allocations in riskier (but well-diversified) higher yielding bonds for additional income but not necessarily price gains.
- The ongoing economic recovery should lead to riskier high yield bonds outperforming, despite fully valued investment-grade corporate bonds. Investment-grade and lower-quality bond yields remain near all-time lows due to strong credit fundamentals and low default expectations. Alternate sources of yield offer better value, such as corporate loans and mortgage bonds not backed by the government (non-agency). Loans are good substitutes for corporate bonds, considering similar borrowers, reasonable valuations and less sensitivity to Treasury yields. Non-agency mortgages offer a compelling source of yield and limited risk exposure to rising interest rates. They also sport strong fundamentals driven by rising home prices, which serve as loan collateral, homeowners with strong balance sheets and high savings and improving payment histories.
- Municipal bonds provide a valuable source of non-taxable income, though yields are low versus history. Credit fundamentals have strengthened from tax revenues that rapidly improved, already recording a new high of first quarter state and local tax collections. Strong investor demand for tax-advantaged income relative to limited municipal bond issuance supports municipal bond prices. We continue to recommend somewhat higher-than-normal allocations to high yield municipal bonds for highly taxed investors, though the focus remains on capturing income rather than anticipating price gains. We also emphasize credit selection, considering the degree of idiosyncratic risks inherent in the high yield municipal market.
- The economic backdrop should be supportive for property prices, though excess capacity continues to exist in retail and office properties. Landlords may struggle to raise rents across many commercial property markets. Additionally, the secular growth Real Estate properties ― cell towers, data centers and industrials ― appear priced to perfection. If interest rates rise too far, incomes relative to property prices could become dislodged from their historic low levels and move higher, hurting investor returns.
- An economic expansion should be a favorable backdrop for commodities and commodity producers. Tight supplies reflect limitations on oil exporting countries’ output and improved cash flow stewardship among U.S. shale oil producers. Ongoing global economic recovery should continue to modestly lift prices despite planned output expansion from oil exporting countries.
- Hedge funds have favored companies expected to benefit from economic reopening. They also rotated away from those companies at times to strategically pursue quality and value opportunities. Healthcare, Energy and Materials are notable sectors that have been targeted and fallen out of favor this year.
- Increased regulatory rhetoric and lack of edge in gauging future policy outcomes has made hedge funds especially reluctant to invest in China. Hedge fund strategies have reduced their holdings in a variety of the country’s sectors and neighboring countries, and also selectively added to short positions — investments that stand to gain if asset prices fall.
- Our themes around digitization and healthcare innovation remain intact. Secular trends and healthcare and technology advancements continue to support a strong pipeline of private companies creating or reshaping markets ripe for transformation.
- The Financial sector presents attractive private equity opportunities. Consolidation within the industry, digital transformation and technological innovation is creating efficiencies, expanding markets and introducing new product offerings — all conducive to private equity investing.
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