The positive trends seen in the first quarter for the overall economy carried forward into second quarter of 2021. The Conference Board’s monthly Leading Economic Index (LEI) continued to trend up. This index is comprised of 10 economic components whose changes tend to precede changes in the overall economy. These components range from building permits to new manufacturing orders to stock prices.
The U-3 unemployment rate has continued to drop, albeit more slowly and still not at pre-pandemic levels. The U-3 rate is the most basic of the unemployment measures, as it only looks at people actively looking for jobs. The U-3 rate excludes part-time and discouraged workers, but it does provide a quick view of the health of the employment situation.
The Conference Board’s Employment Trends Index (ETI), which aggregates eight leading indicators of employment, continues to trend higher, a positive for the employment picture.
Additionally, both the US Jobs Openings Rate and US Quits Rate, metrics monitored by the U.S. Bureau of Labor Statistics, are at record highs. At first glance, these should be bullish for the economy. The Jobs Opening Rate suggest that the economy has many jobs that need to be filled, which should bode well for the overall rate of unemployment to continue to fall. The Quits Rate is also bullish because it means people are more confident in their ability to quit their jobs and find better employment opportunities elsewhere. The argument against these bullish trends was that the large stimulus checks issued by the U.S. government created incentives for many to stop working, which is creating the resulting large opening and quit rates. While the truth may lie somewhere in the middle, it is also true that the economy is experiencing a surge of pent-up-demand and that the work-from-home trend is allowing many to re-think where they want to live, work and play. Companies that completely oppose this trend may find themselves less able to recruit competitive employees.
Broad market indices posted very strong performance through the first half of 2021.
From a factor perspective, value remains on top, although it lost a bit of ground during the second quarter to growth, momentum and the general market indices.
The chart below shows the growth of $1 year-to-date in small value divided by (1) the growth of $1 in large-cap growth and (2) the growth of $1 large-cap momentum. The first quarter was a small value story (increasing ratio means small value outperforming the other two factors), whereas the second quarter was more of a stalemate.
As discussed in our prior post Pain in the Bond Markets, the bond market experienced a painful first quarter. In 44 years of the flagship index, the Bloomberg Barclays U.S. Aggregate Bond Index, this was the second worst start to a year ever recorded. The silver lining based on historical precedence is that forward returns tend to be positive. Not including 2021, 12 calendar years posted a negative performance in the first quarter of the year, of which 9 (75%) went on to finish with a positive return for the year. As fate would have it, the second quarter was much stronger for the bond market, suggesting a recovery may be underway.
The chart below shows the returns of various bond asset classes. Note that they are ranked from least-to-most correlated to the stock market (S&P 500 Index). This is useful as most investors view bonds as a ballast to their stock allocation, providing protection during bouts of stock market volatility.
Overall, the first half of 2021 has been very positive for stock investors and while bonds struggled, their second quarter gains are a bullish signal.
From an economic standpoint, the overall picture is solid and a continuation of higher than average growth coming out of the pandemic will continue. The direction and level of inflation remains the elephant in the room. However, as falling bond yields (rising bond prices) may be suggesting, the rate of economic growth may remain robust but will likely start to moderate and the Fed’s transitory inflation narrative may win the day. Falling yields are starting to suggest that this explosive environment for growth and prices may have seen its peak.
From a market perspective, high market valuations and milder than usual volatility year-to-date may warrant some caution. One metric of market complacency that bears watching is the spread between US corporate high yield bonds and the 10-year Treasury bond. High yield corporate bonds are bonds issued by companies with less than stellar balance sheets, hence they must pay higher interest rates on their bonds to compensate investors for the additional repayment risk they represent. The 10-year Treasury yield is the average yield on a US government bond with a maturity of ten years. Investors gauge the difference in yield on high yield corporate debt when compared to the 10-year Treasury. The Bloomberg’s CSI BARC index, which tracks the difference in those two yields, has the lowest spread in its history going back to 1987. The low spread implies investors are not being compensated for the additional credit risk that the high yield bonds can represent especially if things were to change. While the spread can remain low for long periods of time, providing a sense of calm, eventually, like a coiled spring, it can rise precipitously during periods of market turmoil. Like a canary in a coal mine, this indicator can be an early warning signal around more sustained issues within the markets and the economy. As any early warning signal deserves, the spread between high yield bonds and Treasuries bears watching at these rich levels.