Market Update

The global economy continued to recover in the second quarter assisted by the rollout of COVID-19 vaccines, U.S. fiscal stimulus programs, and supportive monetary policies from major central banks. U.S., Canadian and global equity markets ended the quarter stronger than when they started. U.S. Treasuries, government bonds, and investment-grade corporate bonds also recorded positive returns.

The pandemic still cast its shadow on the quarter. India was hit with an aggressive COVID-19 variant in May. At its peak, cases exceeded 400,000, leading to more restrictions and lockdowns, but by the end of the quarter cases had begun to decline. Japan experienced rising COVID-19 cases in Tokyo and other large cities, just a few months prior to the Olympics. This escalation led to an increase in the rollout of Japan’s vaccination program, and cases have since started tapering down.

The Federal Reserve left U.S. interest rates in the 0 to 0.25 % range and said it would continue buying Treasuries and mortgage-backed securities to stimulate borrowing and spending. The Fed did raise its forecast for inflation though, to 3.4% by the end of this year. As a result, the Fed signaled it may act sooner than previously planned to start hiking rates – possibly twice by late 2023.

The Bank of Canada also held interest rates at 0.25% saying it expects the economy to strongly rebound this summer. The bank added this recovery would be led by consumer spending as vaccinations continue and provincial governments ease restrictions.

As in the U.S., Canadian inflation went north. Statistics Canada said a 3.6% CPI increase in May was the largest yearly increase in a decade and outpaced the 3.4% posting in April. The Bank of Canada reiterated it was ready to raise rates should inflation come in persistently above its 2% inflation target. However, it noted this recent bout of higher inflation was likely temporary, mainly driven by rebounding gasoline prices and calculations based on last year’s depressed levels.

The S&P/TSX Composite Index ended the quarter up 8.54 %, led by the Financials, Energy and Materials sectors. The S&P 500 Index posted a 6.95% return led by the Information Technology, Health Care, and Consumer Discretionary sectors. The MSCI Europe/Asia/Far East Index was also in positive territory with a 3.83% return.

For the year to date, the S&P/TSX Composite Index increased 17.28%, marking the best six-month return in 21 years. Meanwhile, the S&P 500 Index (CAD) rose 12.02% and the MSCI EAFE Index (CAD) was up 6.12%, all on a total return basis. In aggregate, the MSCI World Index (CAD) finished with a 9.88% total return.

Global markets rallied despite inflation, cryptocurrency volatility and higher COVID-19 cases in several Asian countries after the Fed reiterated its accommodative monetary stance. U.S. equities climbed on increasing economic optimism and news President Biden would propose a US$6 trillion federal budget for the 2022 fiscal year. Emerging markets equities rallied as well, as a weaker U.S. dollar and higher oil prices helped exports.

In fixed income markets, U.S. Treasuries and government-related bonds recorded positive total returns. Within corporate credit, investment-grade bonds advanced on the back of lower U.S. Treasury yields. Local currency and U.S. dollar-denominated emerging market debt also rose. Eurozone government bond yields increased in April and then remained largely unchanged for the remainder of the quarter.

In foreign exchange markets, the U.S. dollar depreciated against most major currencies as well as those of many emerging markets. This drop was again due to lower Treasury yields, increased U.S. fiscal spending, falling COVID-19 cases, increased vaccinations and continued hopes of a global economic recovery.

On the commodities front, WTI crude oil prices continued their rapid ascent closing the quarter out at US$73.47, up a whopping 52% year-to-date. Meanwhile, gold prices dropped meaningfully in the second quarter to finish at US$1772, now down 7% on the year.

Milestone Strategy and Outlook

The global economy should see an acceleration of the reopening of trade into and through the summer months. We expect to see a wave of pent-up demand particularly in services industries such as travel, dining out, and sporting events. This enthusiasm will be fueled by elevated household savings, continued fiscal and monetary support and the ripple effect from strong housing and equity markets. Global year-over-year growth is peaking but will remain solidly above trend. While the proliferation of the Delta strain is likely to trigger another wave of COVID-19 cases this summer, the economic impact will be far smaller than during past waves.

Although the re-opening of some parts of the global economy remains hindered by the pandemic, the U.S. was an early mover and now Europe, Canada and other regions are moving quickly in the same direction with improved outlooks. This upturn is thanks to an increasing rollout of vaccines, falling new cases and decreased hospitalization. Combined, this will provide a solid boost to economic activity in the months and quarters ahead. Overall, the global economy appears to be in great shape as we enter the second half of this year, with consensus growth estimates for many economies continuing to be adjusted higher.

Looking at the U.S. consumer, the average savings rate over the past year and half has been 16%. The extra capital is mostly due to the reluctance or inability to spend money on travel and entertainment. If even a reasonable portion of these funds are spent over the coming quarters, it should provide a solid boost and fuel above-average economic growth. Add in the wealth effect from a record high stock market and rising housing prices, this should result in strong growth that outweighs any potential reduction in monetary stimulus.

Looking underneath the hood of broader markets, we have seen a substantial rolling correction among equity sectors and interest rates (fixed income markets). The first quarter was marked by a big rise in long-term interest rates resulting in strongly negative return numbers for long-term fixed income vehicles especially government bonds, and relative outperformance from Financials and cyclical sectors like Industrials, Materials and Energy (value over growth). The second quarter we have seen a reversal of this trend and a fear of ‘peak everything’, with long-term interest rates partially coming back down and growth sectors like technology leading the way again.

This macro and market transition through the rolling correction has been in conjunction with new highs for market-weighted indices, while equal-weighted indices for small and large caps have been in correction/consolidation since February and May, respectively. Our view is that this rolling correction is most similar to the economic, monetary, and fiscal transitions in 2004 and 2010 after liquidity and economic growth peaked temporarily following the initial ramp off recession lows. We see the current period in the same light; more of a consolidation, rather than something more ominous.

The next rotation of this rolling correction may be into the economic recovery theme driven by higher U.S. Treasury yields and perhaps once again favoring value over growth. Our long-term view is that the recent decline in interest rates is more of a temporary correction or consolidation, and that the long-term effects of a massive increase in the savings rate and the M2 money supply should continue to influence inflation to the upside and thus force interest rates to grind higher, potentially into the 1.75-2.0% range by year-end for the U.S. 10-year Treasury yield. Therefore, although we have seen growth sectors like technology come back to life lately, we believe it may be time to add to or stick with value sectors after their Q2 absolute and relative weakness, and to continue to avoid long-term government bond exposure. Our fixed income strategy remains one of lower duration and higher yield, predominately corporate credit, with added components such as preferred shares and private debt.

Although we are modestly defensive in our near-term outlook (2-3 months) for equities, our long-term positive fundamental core thesis remains the same. It is important to note that our positive core thesis is centered on the direction of earnings, because the SPX and the TSX correlate mostly to the direction of earnings per share (over 0.90 correlation factor), not the rate-of-change. This principle means that absent a credit-based recession which we view as extremely low at this point, any market correction/consolidation caused by slowing in the second derivative of stimulus measures and economic growth rate should prove temporary.

The risk-reward profile for stocks has somewhat deteriorated since the start of the year. Nevertheless, with few signs that the global economy is heading towards another major downturn, we lean towards a modest equity overweight on a 12-month horizon, and favor cyclicals, value, and a gradual increase in international equities vs. the US. Emerging markets may spring back to life in the fall once vaccine supplies increase and Chinese fiscal policy turns more stimulative. In fixed income markets, we maintain below average interest-rate duration exposure and a higher weight towards corporate credit vs. government.

On balance, we remain positive on risk assets in general, with a watchful eye on year-over-year economic growth and inflation, as well as interest rates over the second half of this year. Although peak inflation is likely to be mostly transitory, we also believe the base effects may be more long-term in nature with inflation relatively higher going forward than what we have seen the past decade (2-2.5% range as opposed to 1.5-2% range). As we have stated in previous comments, we believe the event-driven recession of 2020 reset the economy into a new 3–4-year positive economic cycle, one which we believe is still within the secular bull market that began in 2009 and likely has years to go. Within this framework, in a new environment of gradually rising rates and inflation, we believe it will benefit an active management style with a focus on credit markets, equity sector tilts and inclusion of non-correlating strategies (real assets and absolute returns) to help mitigate short-term volatility.

Regardless of where we are in the market cycle, it is important to take a disciplined approach to investing and stay focused on one’s long-term financial goals. This strategy helps keep one’s emotions out of investing – typically buying high and selling low like many investors do. We continue to believe one should maintain a diversified mix of asset classes to maximize potential returns and minimize risk.

Thank you for your continued trust in Milestone as we navigate the tides ahead, and for the opportunity to assist you in working toward your financial goals. We are with you every step of your investment journey, identifying strategies and opportunities, reviewing performance, and rebalancing your portfolio to help you remain on track. Should you have any questions regarding your portfolio, please do not hesitate to contact us.

Here is our Milestone Market Report on economic data, capital markets, commodities, and currencies through June 30th: (click image for PDF version)