Q2 Stock Market Recap [2021]

In this Q2 recap: U.S. economic growth strong as reopening widens. Europe’s recovery picks up steam; Stocks reach new record highs, face new interest rate and inflation landscape.

The second quarter began by building on the first-quarter’s gains, with stretches of sideways trading and incremental increases that led to multiple record highs over the course of the three months. Encouraging economic data, a strong corporate earnings season, and the broadening of the nation’s economic reopening was juxtaposed by heightening inflation fears, a short-lived spike in bond yields, and a simmering anxiety over potential changes in Fed monetary policy.

With 99% of the companies in the S&P 500 index reporting, 86% reported a positive earnings surprise, with an average earnings growth rate of 61.0%, the highest since the fourth quarter of 2009.¹

Solid corporate earnings, however, did not drive the overall market materially higher, as inflation weighed on investor sentiment. Many investors were troubled for much of the second quarter by an acceleration in the rate of inflation, worried that the Federal Reserve could begin tapering some of its easy-money policies sooner than expected. Some investors were particularly anxious about the prospect of the Fed being wrong about the transitory nature of the pick-up in inflation, which could require the Fed to slam the monetary brakes harder at a future date, potentially sparking a recession and affecting stock valuations.

Stocks stumbled following a Fed announcement that interest rate hikes could begin in 2023—sooner than it had anticipated—and that it had raised its inflation expectation, though it remained steadfast in its position that above-target inflation would be transitory.

The quarter closed out on a strong note, as investors welcomed the announcement of an apparent agreement on a $1 trillion infrastructure spending bill and news that banks had passed Fed stress tests. The news was enough to send stocks to new all-time highs in the final trading days of June.

The US Economy

The U.S. economy continued its remarkable recovery in the second quarter, aided by a substantial pick-up in the pace of COVID-19 vaccinations nationwide, an increase in economic reopenings at state and local levels, and by government stimulus spending.

Though second-quarter economic growth won’t be known until July’s release of the Q2 GDP (Gross Domestic Product) report, the economy looks to be building on its first-quarter gains.

According to the Federal Reserve Bank of Atlanta, which tracks economic data in real time, their model is pointing toward a 8.3% real rate of GDP growth in the second quarter.²

Economic data released during the quarter suggest that the Federal Reserve Bank of Atlanta’s estimate looks realistic. Manufacturing activity, as measured by the ISM (Institute for Supply Management) Manufacturing PMI (Purchasing Managers Index), rose in May, marking the 12th consecutive monthly increase. The central challenge for U.S. manufacturers has been meeting high-consumer demand, as the combination of increased consumer spending and supply chain bottlenecks have created temporary shortages. Meanwhile, the ISM Services PMI reached an all-time high in May, rising for the twelfth straight month, as well.^3,4

Consumer confidence is high, with June’s reading reaching its highest level since the onset of the pandemic in March 2020, according to the Conference Board’s Consumer Confidence Index.⁵

This elevated level of consumer confidence is backed by some $2 trillion in personal savings that Americans may be looking to spend as the summer unfolds and vaccination rates increase further.⁶

The labor market recovery, which has lagged other parts of the economy, such as consumer spending and manufacturing, saw meaningful improvement in the second quarter. The weekly initial jobless claims fell below 400,000 for the first time since the pandemic began, while job openings reached 9.3 million, the highest number ever recorded by the Department of Labor’s Job Openings and Labor Turnover Survey (JOLTS).^7,8

The Federal Reserve’s revised outlook on economic growth grew a bit more optimistic. In its June publication of members’ economic projections, the median view was that GDP growth would come in at 7%, a half percentage point higher than its March projection. Accompanying this higher economic growth revision was also a change in members’ inflation expectations. The median inflation expectation for 2021 jumped to 3.4%, up from its 2.4% March estimate. Its view on the unemployment rate was unchanged, projecting the unemployment rate to end the year at 4.5%.⁹

Looking Back, Looking Forward

Investors have enjoyed strong gains so far this year as stocks have responded well to rising vaccination rates, economic reopening, fiscal stimulus, and an accommodative monetary policy.

If the market is to build on these gains over the next quarter and through the year-end, it may depend on how several important questions are answered over the coming months.

Second-quarter GDP growth is expected to come in very strong, perhaps the strongest in decades, leaving investors to wonder if this represents peak growth. In other words, how much will the economy continue to expand absent further fiscal stimulus and with the prospect of Fed tapering? There is a case for above-trendline economic expansion as consumers spend their accumulated savings and people begin filling open jobs once schools reopen and their comfort level with the safety of returning to work rises. Nevertheless, economic expansion appears set to slow, and that’s a potential hurdle for the market.

Then there is the matter of inflation and how “transitory” is defined. The Fed believes that the recent acceleration in inflation is transitory, but transitory is not a technical economic term. It’s a rather ambiguous term. Is “transitory” three months? Six months? Or longer? The market may have a different definition of transitory than the Fed, which could lead to future market dislocation.

For the three-month period ending May 2021, the annualized rate of inflation accelerated to 5.2%, the fastest pace since 1991. The months ahead should provide a clearer picture of whether inflation proves transitory or becomes a more sustained feature of a post-Covid economy.¹⁵

There is an additional, more overlooked, concern regarding inflation, i.e., its impact on consumer spending. While inflation may be transitory, price increases generally are sticky. Thus, it remains uncertain if increases in overall consumer prices will dampen consumer discretionary spending, which investors may be expecting to drive future economic growth.

The Fed’s easy-money policies have been a contributing factor in the market’s sharp recovery from its pandemic lows. Consequently, investors are expected to continue to focus on Fed signals about the timing and degree of its plans to taper its monthly bond purchases. (Its June meeting was silent on this issue.) Tapering is a concern, but given the excess liquidity worries of many investors, any start of Fed tapering later in the year may turn out to be a welcomed development.

Another market headwind is stretched investor sentiment. Though markets are hovering around all-time highs, market breadth has not been exceptionally strong, which suggests investor enthusiasm has moderated. A weekly survey by the American Association of Individual Investors reflected a 10% decline in bullish sentiment and a concomitant rise in bearish sentiment in the month of June. With potentially fewer positive economic surprises ahead and muted buying sentiment, the market may mark time until a new catalyst emerges.¹⁶

The economy appears in good shape, and most economists expect it to remain strong into 2022. This portends a positive second half, but investors shouldn’t lose sight that the market is currently priced above historical average.

Sources:

1. factset.com, June 4, 2021

2. atlantafed.org, July 1, 2021

3. ismworld.org, July 1, 2021

4. ismworld.org, July 1, 2021

5. conference-board.org, June 29, 2021
6. kansascityfed.org, April 29, 2021

7. dol.gov, July 1, 2021

8. cnbc.com, June 8, 2021

9. federalreserve.gov, June 16, 2021

10. oecd-ilibrary.org, July 1, 2021

11. oecd-ilibrary.org, July 1, 2021

12. oecd-ilibrary.org, July 1, 2021

13. oecd-ilibrary.org, July 1, 2021

14. msci.com, July 1, 2021

15. bloomberg.com, June 10, 2021

16. aaii.com, July 1, 2021