APW Investment Committee Q3 2021 Commentary
Q2 2021 Review
Global equity markets continued to appreciate in the second quarter of 2021 with a rotation back into the big global technology leaders out of the highest growth companies whose valuations had been stretched to extreme levels in Q1. US small caps also lagged in the quarter. The continued spread and acceleration in some parts of the world of COVID-19 along with a focus in China on potential regulatory actions put headwinds on many international financial markets.
US GDP grew at 6.4% quarter over quarter as the recovery in the US economy continued. Interestingly, the US 10 year Treasury Note interest rate fell during the quarter from 1.74% to 1.45% and the spread on the 10 year Treasury vs. the 2 year Treasury narrowed by roughly the same amount. Moves in this direction generally indicate a slowing economy contradicting the underlying statistics.
Last quarter we discussed the market’s potential concerns about inflation and therefore rising interest rates. During most of the second quarter the financial markets were absorbing the impact of rising inflation rates, but as we expected, took the news in stride. In fact, interest rates continued to fall into early Q3 and the S&P 500 made new all-time highs.
The backward slide in interest rates allowed investors (ourselves included) to stay overweight stocks in spite of elevated equity valuations - S&P 500 12 month forward earnings sit at around 22 which is quite high. Historically, a price to earnings ratio this high leads to lower than expected 5 year returns in the S&P 500. However, we believe the current dynamic can stay in place so long as the 10 year US Treasury stays below 2%.
As mentioned in a previous commentary, this environment is known as a TINA trade (There Is No Alternative). We remain overweight stocks relative to each model target. We anticipate strong US corporate earnings for the remainder of 2021, and a potential for outperformance in any international market that can overcome COVID-19 resurgence. Valuations are significantly cheaper overseas and many countries are just emerging from lockdown.
One question that consistently comes up with investors is why we maintain international exposure at all when US equity returns (specifically the S&P 500 and Nasdaq 100) have been so much better performing for so long. It is true that being diversified has been a drag on performance. A little bit of history might be helpful here.
While the S&P 500 has outperformed for over 13 years now, that has not always been the case. More importantly, we believe that it will not be the case at various points in the future. The trouble with investing is that it is never obvious when that shift will take place. The fact that valuations are so much higher in the US are not by themselves enough reason for international markets to reverse course. Changes in interest rates, currencies, inflation, technology, and other global impact items (what we have called Tier 3 information in prior commentary) are typically the drivers of these shifts, but there is rarely a clear demarcation line. In fact, “Investors world-wide have funneled more than $900 billion into U.S.-domiciled mutual and exchange traded funds, on a net basis, during the first half of the year, according to data compiled by Refinitiv Lipper. That is a record in data going back to 1992 and is more than investors have put into funds elsewhere around the world combined during the first two quarters of 2021.” [The Wall Street Journal 7/25/2021. Link to article]
If and when that trend ultimately reverses, US outperformance is also likely to wane. The question is when. Below is a chart that outlines the various periods of US outperformance and underperformance.
One item that is particularly concerning moving forward for US equities is that the systemic advantage in demographic growth we have enjoyed for almost our entire history is starting to narrow. As illustrated below, the US population growth rate during the decade between 1/1/1999 through 12/31/2009 was almost double that of the growth in the subsequent decade. Partially due to COVID-19, in 2020 the US population growth rate declined almost to zero. While population growth rates are slowing everywhere in the world, the economy of the US has always benefited from strong growth in this area. If this shifts from a tailwind to a headwind in the decade to come, it will certainly impact US equity returns relative to the rest of the world.
It is almost impossible to pick inflection points for these types of long-term trends. Demographics is one piece of a puzzle that includes underlying GDP growth, currency changes, prevailing interest rates, the regulatory environment in that geography, and other geopolitical issues. As a result, our approach is to overweight US equities in the short term, given the strength of the inflows and underlying economic growth metrics. We anticipate making adjustments as new data emerges.
Austin Private Wealth, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Austin Private Wealth, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Austin Private Wealth, LLC unless a client service agreement is in place.