With the green light to spend, the Fed plays an important role in this political situation because it will need to monetize a significant portion of government spending—something it has so far appeared willing to do to sustain the pandemic recovery. At its most recent meeting in June, the Federal Open Market Committee (FOMC) also endorsed further large spending bills by maintaining both the pace of its quantitative easing program as well as its zero-interest rate policy, until at least 2023.12 Yet recent inflation readings are rising.13 According to the U.S. Bureau of Labor Statistics, the Consumer Price Index rose 4.9% for the year ending May 202114—its largest year-over-year increase since September 2008.13 The Fed believes these elevated readings will soon subside as they are partly the result of the anniversary effects of the significantly depressed prices from last year. But this explanation does not account for the increased prices in either commodities or housing, which are critical to economic recovery and are also front of mind for consumers, businesses, and investors.

The final piece of the accommodation puzzle, the bond market, is the most important. Another quote from James Carville comes to mind here: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”15 By late in the first quarter, the 10-year Treasury yield had increased substantially from 0.5% during the depths of the pandemic to 1.75%.2 On a price basis, longer term bonds declined by over 20%.2 Rising interest rates means bond prices moved lower—a signal from investors that they required a higher yield to purchase U.S. government debt. Higher yields would not only cause the government to spend more on interest payments but also cause a tightening of financial conditions that could disrupt the recovery. However, the 10-Year Treasury yield has moved substantially lower in recent weeks to below 1.4%.2 This comes in the face of increased fiscal spending proposals and higher inflation readings, so for now the bond market appears willing to tolerate continued fiscal spending, debt monetization, and elevated inflation.

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MARKETS

Declining interest rates likely influenced the relative outperformance of large cap growth stocks over large cap value stocks during the quarter. That is because when the discount rate used in calculations falls, the present value of longer duration growth assets increases. Large company growth companies, gained 12% during the quarter, leaving them up 13% for the year. Large company value Index gained 5% in the quarter and are up 17% so far in 2021. Over the past twelve months, these two asset classes have produced nearly identical returns with value, up 44%, outperforming growth by 1%. Within smaller companies, value slightly outperformed growth during the quarter. Small company value stocks gained almost 5% in the quarter and are now up 27% for the year. Small company growth stocks were higher by 4% for the quarter, leaving them up 9% for the year. Over the past twelve months, small company growth stocks 51% return trails value by 22%. The interest-rate sensitive utilities sector was the only sector to produce negative returns during the quarter, down less than 1%, and has trailed for the year, returning just 2%. Top-performing sectors for the year include energy, up 46%; financials, up 26%; and real estate, up 23%. Energy and real estate companies alike have benefited from the continued economic re-opening while financials have benefited from the re-opening and steeper yield curve.

International stocks trailed their U.S. counterparts during the first half of 2021. Developed International equities were higher by 5% in the quarter and are up 9% for the year. Emerging markets also climbed 5% for the quarter and are now up nearly 8% for the year.

Municipal bonds, as measured by the Bloomberg Barclays Municipal 1-10 Year Bond Index, fared much better than investment-grade taxable bonds during the quarter as they gained 0.6%, leaving them up 0.4% for the year. The Bloomberg Barclays High Yield Index was able to absorb the rise in interest rates and post a gain of 2.7% and is now up 3.6% for the year.