The second quarter of 2021 saw the lifting of mask mandates, global supply chain tightening and tangible evidence of a possible new age of inflation. Below is a brief summary of what happened in financial markets between March 31 and June 30, 2021 followed by some perspective on markets in both the present and the future.

Market Review
The modest, upward stock market trajectory of the first quarter accelerated slightly into the second quarter as the S&P 500 finished up 8.6% and the Russell 3000 added 8.2%. Internationally, stock market returns lagged the domestic market with the MSCI EAFE up 5.2% and the MSCI Emerging Market Index up a similar 5.1%. Growth stocks swung back into favor across the size spectrum with large growth stocks having the strongest performance over Q2.

Year-to-date, equity markets have been quite strong as vaccination numbers increased and economies reopened. For the first half of the year, the S&P 500 and Russell 3000 grew 15.3% and 15.1%, respectively. The domestic market has been significantly more resilient than international markets with the MSCI EAFE adding 8.8% and the MSCI EM Index up a more modest 7.5%. Small value stocks have led the charge this year with larger growth stocks taking a breath after a prolific post-COVID run.

In fixed income markets for the second quarter, the yield curve flattened with longer rates dropping and shorter rates slightly increasing. Corporate spreads finished tighter. Bond performance improved this quarter with the core US government and credit market up 1.7%, outperforming global bonds but trailing high yield credit.
Despite strength this quarter, the bond market has gone through a tougher start to the year with all categories being flat-to-down except for high yield. Fixed income outside of the U.S. has been the weakest sector of the bond market.

Market Perspectives
Few market concepts are as relatable as the pressures felt by price inflation. While someone may make the same amount of money or even marginally more money than they did in a previous year, they generally feel worse off when prices are higher because their paycheck does not buy them as much as it used to. A disconnect between wage inflation and price inflation can cause serious pain to the typical consumer. Further, inflation can erode the real returns of investors.

What is inflation?
Put simply, inflation is the rising price of goods or services over a period of time. If a shopper went to a grocery store one year ago and purchased their weekly supply of groceries for $100 only to return to the store and purchase the exact same cart full of products for $105 today, the inflation rate over the year would be 5%. If the consumer’s weekly paycheck was still the same, they would feel a reduction in purchasing power due to the higher price of goods that outpaced the increase in their wage.

Why are consumers and investors experiencing inflation?
In the doldrums of the global pandemic, economic activity across the world was, more or less, at a standstill. While a specific set of companies saw demand for their products and services skyrocket, many businesses saw customer numbers decline rapidly or disappear altogether.

Generally, when demand declines significantly and supply remains robust, prices must fall for product demand to match the overwhelming supply of products in the market. As economic activity dried up during lockdown, prices broadly declined as businesses sought to move inventory while demand was weak. During this period of low demand, several businesses either closed their doors or drastically reduced production capacity to avoid wastefully producing products.

Unfortunately, as the economy reopened with the proliferation of vaccines and herd immunity, businesses were slow to bring production capacity back online and demand across several products and services exceeded the available supply. This imbalance has pushed prices even higher than they were pre-pandemic and is representative of the inflation that consumers are feeling which has reduced their purchasing power.

What is the inflation debate?
Inflation is present, as indicated by Bureau of Labor Statistics data, and consumers see it around themselves every day. The current debate is not whether inflation exists, but rather whether or not this inflation regime will be long-lasting.

Transitory inflation is the short-lived kind. Often times, those who believe inflation is transitory will mention the term “base-effect”. In regard to inflation, base-effect is the low starting point for prices mid-pandemic that is making the percentage change to post-pandemic prices look quite high. Transitory inflation proponents expect these hot inflation readings to be short-term in nature with the ultimate assumption that these imbalances will quickly correct and the U.S. will return to its previously modest inflation environment.

Structural inflation would be longer-lasting. Those who believe we are undergoing a structural shift in the inflation environment believe that the structural factors of globalization, technology enhancement and low bargaining power with regard to wages which previously supported a low-inflation environment are being replaced with an imbalance between aggregate supply and demand, the potential for a wage spiral and the Federal Reserve’s new policy framework. Only time will tell which philosophy is the correct one.

How can investors deal with inflation?
Investment returns are eroded by inflation. Uninvested cash (which excludes money market investments) tends to be the worst traditional asset class in a high-inflation environment as it loses value by the day. Investments with a fixed stream of income like traditional bonds also tend to be negatively affected by higher inflation. On the other hand, investments in companies with pricing power, real assets and inflation-protected securities have characteristics that allow them to better handle periods of above-average inflation.

In Summary
Inflation is a byproduct of a recovering economy. While it can pressure consumers and investors, inflation should not surprise anyone as this increase in prices is what has allowed companies to return to profitability and what has pushed stock prices higher. However, lasting inflation can derail both stock and bond market returns if left unchecked.

It is now that we remind you markets are forward looking. Inflation expectations are being built into market prices every day, and it is important to let the risk and return objectives of each individual investor drive their allocation as opposed to changing allocations in attempt to time macroeconomic changes.

At WoodTrust, we maintain a healthy and appropriate allocation to companies with pricing power in accordance with the goals and objectives of each client. In addition to a wealth of other benefits, this stock allocation tends to mitigate the short-term risk of high inflation for clients. As always, we thank you for your trust and look forward to meeting with you in the near future.