“Market Outlook. Q3 2021” with a screen of stock tickers in the background

We are heading into Q3 feeling the same way we did entering Q2: cautiously optimistic.

The re-opening of the economy has most people feeling like a more normal life is emerging this summer. Retail, recreation and transportation activity is on the rise, fueling our optimism. The consumer is confident, and pent-up demand for experiences (travel, eating out, a trip to the salon) is palpable. The potential for an unexpected acceleration in the reopening story, supported by increased spending, could benefit the market.

Some of the uncertainties that emerged in the second quarter could carry over to the third quarter, including inflation and the Federal Reserve’s plan for monetary policy (i.e. interest rates and bond buying). Earnings and gross domestic product (GDP) growth could begin to slow from the outsized growth recorded in the first half of the year, which isn’t the trend investors prefer, but growth could remain above historical levels.

It might be another quarter that gives us a lot to digest, though. Even though the S&P 500 has historically been flat-ish in the third quarter — only advancing 0.7% on average since 1950 — that type of outcome could come with increased volatility. The larger picture is likely to be the bigger driver of the overall market this quarter.

Graph titled The Slowest Quarter According to History charts the S&P 500’s average return by quarter since 1950 with the third quarter highlighted. The first quarter average is 2.1%; the second quarter average is 2.0%; the third quarter average is 0.7%; and the fourth quarter average is 4.0%.

Reopening – Is it fully priced in?

You’ve probably heard financial experts talk about how the reopening of the economy is already factored into the price of the market. Often, they mention the S&P 500’s price-to-earnings (P/E) ratio is around the highest it’s been in almost 20 years.
 
Chart titled Higher Earnings Could Help Valuations Return to Normal tracks the S&P 500’s 12-month forward price-to-earnings ratio against the S&P 500’s 12-month forward earnings per share from 2002 to 2021.The price-to-earnings ratio was at about 25 in 2002 and dropped to about 10 in 2008 before slowly rising back up to about 22 in 2021. The earnings per share was at about $50 in 2002 and was rising up to $100 before it fell back in 2008 before rising again up to about $180 in 2021.
In the early stages of a recovery, this valuation ratio can be high because it takes time for earnings per share (EPS) estimates to catch up with the recovery. But as EPS projections move higher, the multiple typically moves back to more normal levels. This has already started to happen. In June 2020, the P/E for the S&P 500 topped 25x. However, better-than-expected earnings in the past three quarters have helped bring the P/E ratio down. S&P 500 profits grew 34% year-over-year in the first quarter of 2021, and that growth is expected to peak at 55% in the second quarter, according to S&P Capital IQ. Wall Street estimates earnings growth could slow to an average of 17% in the second half of this year. While that is much lower than the first half of this year, it is much higher than the average growth rate of 8.4% per quarter going back to 2002.

Stimulus spending by consumers has been a key driver of corporate revenue (and ultimately EPS beats). Stimulus is evolving with many of the larger COVID benefits fading (direct payments, eviction moratorium, mortgage forbearance) and others, like the child tax credit, to be deployed in the coming months. A reduction in overall stimulus worries some investors, but now isn’t the time to doubt the power of earnings.

The savings rate is still elevated at 12.4%, and consumers have nearly $17 trillion in cash on hand or deposited at banks. This combined with pent-up demand is driving increased retail traffic, and demand for airline travel suggests that the consensus EPS estimates may not correctly anticipate the type of profit growth that is still ahead of us.

Corporations are also flush with cash, which could result in more buybacks and mergers and acquisitions that benefit EPS growth. Hopefully, it also leads to more capital spending on drivers of operational growth, like investments in people, research, technology and equipment.

All told, better-than-expected earnings in the second half of this year could allow the market to continue growing into a more normal multiple (perhaps in the high teens), which could make the market more attractive to investors in the process.

The Fed Offset

As mentioned at the start, we are cautiously optimistic as we look forward to the second half of the year, but it’s always important to consider what items could potentially derail the outlook.

At the heart of this discussion is the Fed and how long they will continue to accommodate a post-pandemic economic recovery. Chair Jerome Powell has committed to waiting for a full recovery of the U.S. labor market before considering raising interest rates. At the most recent FOMC meeting earlier this month, the Fed’s long-term projections called for short-term interest rates to likely remain near zero until 2023.

Investors have been sensitive to news from the Fed because, over time, rising rates can contribute to the market peaking. That said, a peak doesn’t typically happen at the beginning of a rate tightening cycle.
 
Chart titled Stocks Rarely Peak After the First Rate Hike tracks the Fed funds rate and highlights S&P 500 peaks between 1971 and 2021. The S&P 500 peaks occurred in 1973, 1980, 1987, 2000, 2007 and 2020. The Fed funds rate had peaked in 1980 at about 18% before generally dropping down to nearly 0%.
When will we reach a full recovery in jobs? According to government data, there are still 7.6 million U.S. jobs that were lost during the pandemic that have not yet been replaced. Even as many companies signaled they’re actively looking to hire, payrolls figure showed growth moderating in April and May.

There are several possible reasons why companies can’t hire as quickly as they appear willing. To put things into perspective, if the U.S. added 500,000 jobs a month, it would still take more than a year to recoup the COVID-19 labor losses. Also, the Fed doesn’t expect the unemployment rate to reach its pre-COVID low of 3.5% until next year at the earliest.
 
Chart titled A Long Road to Jobs Recovery tracks the change in total jobs since February 2020. Starting with 153 million jobs in February 2020, nearly 23 million jobs were lost in March 2020. The climb back up has been slow. As of May 2021, we’re still 7.6 million jobs down from February 2020.
Because of the Fed’s stance on returning to full employment before raising rates, it remains a key metric for the financial markets in the third quarter and beyond.

Inflation Preparation

One reason why the Fed is so focused on the employment picture these days is the firm belief that rising inflationary pressures we’ve experienced as the U.S. economy reopens could prove temporary. It takes time to restart a large integrated system from a standstill and many industries, from semiconductors to basic food, energy and industrial commodities, are facing significant supply/demand disruptions.

That’s led to rising prices across the globe: first at the producer/business level (up 2.9% year over year in May) and then steadily passed along to consumers (up 3.8% year over year in May) throughout 2021.

The Federal Reserve did acknowledge rising inflation, as measured by the core Personal Consumption Expenditures price index (up 3.4% year-over-year in May), at its June meeting; however, their longer term outlook maintains that price growth will return to a more reasonable 2% in 2022 and beyond.

Either way you look at it, whether it’s tapering off the $120 billion of monthly asset purchases or an eventual increase of interest rates, the next move from the Fed will likely be viewed as more restrictive than their current stance.

As a result, our view is this:

1) There’s little reason to fear the Fed for now.

2) It’s best to be prepared for inflationary pressures to stick around longer and be happy if they don’t.

How could this impact your investments?

Inflation doesn’t have to doom your portfolio, though. Historically, inflation has dampened stock returns, but the market has still performed moderately well over time as long as the economy has still grown.

In this environment, it may be wise to look for growth at a reasonable price to find investment opportunities. Our research shows that materials companies with direct commodity exposure could perform well, as well as financials. Small-cap stocks and mid-cap stocks also remain at a discount to the larger companies that dominate the broader market averages.

Inflation Doesn’t Have to Doom Your Portfolio

Compound Annual Rate of Return by Asset Class

Asset Class 1980s 1990s 2000s 2010s 2020s
Consumer Price Index (Headline) 5.1% 2.9% 2.6% 1.7% 2.8%
S&P 500 17.5% 18.2% -0.9% 13.6% N/A
Russell 2000 11.7% 12.4% 3.5% 11.8% N/A
Treasuries 12.2% 7.4% 6.2% 3.1%% N/A
Cash/Short-term Treasuries 10.0% 5.3% 3.0% 0.6% N/A

Source: Ally Invest, Strategas, Bloomberg

The Bottom Line

After broad double-digit gains for U.S. stocks in the first six months of 2021, the macroeconomic environment is likely to keep investors on their toes in the third quarter. Some areas of the market are likely to benefit more than others. Yet we see little reason to dramatically alter our outlook entering the second half of the year. As long-term investors, we continue to favor a diversified mix of investments leveraged to a post-pandemic recovery.

At the same time, it’s important to remain flexible and adapt as conditions change, because business and investment market cycles don’t generally move in a straight line.

The summer is often seen as a slower period for the financial markets. This can be a good opportunity to re-assess your portfolio and make sure you’re positioned for what may lie ahead.

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Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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The opinions expressed here are not meant to be used as investing advice. For more information, visit our website.