As we pass the halfway mark of this year, we continue to see signs of a return to relative normalcy, at least in the US and much of the developed world. Whether they impacted a trip to the local supermarket or a trip overseas, COVID-19 restrictions are gradually lifting, and with summer beginning, many are looking to take full advantage. Indeed, if what we have seen in recent weeks is any indicator, this summer will likely look a good deal more like that of 2019 than 2020.
While this return to normal implies for many a return of social gatherings and packed holiday destinations, markets too appear to be returning to typical summer patterns. It is no secret that there is a strong tendency for markets to be rather quiet this time of year, with this lull in activity frequently becoming more pronounced as the summer goes on. Volatility, by most typical measures, has already fallen a good deal from the elevated levels seen last year, and little has succeeded so far in changing that. At the same time, global equity markets have continued their move upward, with many major indices recently marking new all-time highs.
While likely a “Goldilocks” scenario for some, this current combination of muted volatility and buoyant equity markets gives us pause, especially as we consider other accompanying circumstances. Market volatility, though currently quite low, tends to subsequently mean revert through sudden, dramatic spikes. While that in and of itself is unsettling, we have recently noticed what appears to be a rather pronounced drop-off in U.S. equity volume as compared to the elevated levels in the first quarter:
Source: Bloomberg (as of 30 June 2021)
While we recognize this decline comes off the unprecedented trading volumes seen at the beginning of this year, and thus may simply represent yet another reversion to the mean, we cannot help but wonder whether this could be reflective of waning liquidity or diminishing retail interest in equity markets. Though monetary policy as a whole remains quite loose, there have been changes at the margins. For example, recent adjustments in the Fed’s overnight reverse repo facility have made it a more attractive “parking place” for cash held by large financial institutions. With balances in this program ballooning dramatically as of late, we believe this may indeed be one place (of many) that liquidity may be flowing.
We should note that this seeming reduction in liquidity has had little impact on equity markets so far. This time last year, we pointed out that U.S. equity valuations were reaching levels unseen since the late 1990s and early 2000s, a clear sign to us that investors were best served to take caution going forward. Since that time, valuations have only gotten more extreme:
Source: Bloomberg (as of 30 June 2021)
While many have argued that, at least on a relative basis, ultra-low interest rates justify these lofty valuations, we cannot help but note that even with a recent decline in rates, the 10-year U.S. Treasury yield has still risen by nearly 75 basis points in the past year. The fact that valuations have only gotten more stretched in that time tells us this argument may not be as robust as some would like to think and may more be a function of investor exuberance than anything else. Should that enthusiasm begin to dissipate for whatever reason, we believe a rerating of equity valuations could occur somewhat swiftly. Though low volatility and rising markets may create the appearance of an attractive market, shallow liquidity could mean the valuations seen today may be fleeting.
While we do not wish to present an alarmist outlook, we do feel these circumstances reinforce our view that one is likely best served treading carefully in this environment. At the moment, risks abound, both to the upside and downside. Consider the current conundrum facing the world’s major central banks, especially the Federal Reserve: On the one hand, the strength of the post-pandemic recovery insofar has been rather robust, thanks to loose monetary and fiscal policy. This has led many to fear the specter of an enduring inflationary environment and calls for a reining in of the stimulus. While the Fed has generally dismissed recent price rises as “transitory”, one can easily envision a scenario where they find themselves behind the curve, with inflation ultimately weighing on the valuation of risk assets. Conversely, should central banks act too quickly to nip inflation in the bud, they run the risk of choking off the progress that has been made, likely hampering the growth markets are expecting. While the former scenario has continued to resonate with us more, we remain open-minded and flexible for what may lie ahead.
With markets priced to perfection despite these risks, we continue to retain a defensive positioning in client portfolios. This has meant a lower-than-typical weighting to risk assets, whether that risk is coming from equities, credit, or rates. At the same time, we have sought out opportunities where we believe there remains an attractive risk/reward proposition in the context of both fundamentals and valuations. Recently, we have identified several companies in the materials and energy spaces where we believe, even absent significant inflation, market expectations have drastically underpriced their future prospects. While we will continue to seek out such opportunities, we must once again reiterate that they have remained relatively scarce in the face of ever-rising markets.
Should you wish to know more about where we are seeing opportunity or wish to discuss your specific portfolio positioning in greater detail, we encourage you to reach out to set up a time to talk. Markets have shown a stunning combination of resilience and seeming irrationality as of late, which can make sticking to a fundamentals-based, prudent approach to investing difficult for many. As such, we greatly appreciate your support and trust as we seek to navigate what has been a challenging environment. Please alert us promptly to any changes in your financial situation and investment objectives or if you wish to impose any reasonable restrictions as to how your portfolio is managed. As the world begins a return to something that resembles normal, we wish you a happy, relaxing summer, and all the best as we move into the second half of this year.
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