Insight
KCS Quarterly Market Review for Q2 2021
July 23, 2021
Summary
Stocks continued to march higher during the second quarter of 2021, with the ACWI global equity benchmark now up +12.3% through June 30. Why are stocks performing so well this year? Because investors are piling into equities at an unprecedented rate, aided by massive liquidity and a lack of viable alternatives. Most investors appear uninterested in allocating more funds towards bonds, with their historically low or even negative interest rates. Meanwhile, the euphoria around cryptocurrencies has waned, leaving stocks as one of the only attractive games left in town.
Despite the apparent euphoria and some stretched valuations, we think that the shift from fixed income to stocks is a rational response to a growing economy and ultra-low bond yields that fail to even cover inflation. And while there will likely be repercussions from this imbalance down the road, for now, equities remain attractive. As we believe that the expansion cycle is still in its early innings and bond returns are likely to remain below average for a while, we think stocks have quite a bit further to run in this bull market.
Q2 Review
Equities built on their first-quarter gains during the second quarter of 2021, with the benchmark MSCI All Country World Index (ACWI) moving up another +7.4%. This time, market strength was broad based, unlike in Q1 when “value” meaningfully bested its “growth” counterpart. Nearly every major region, sector and style contributed to this quarter’s results, with notable bright spots including energy, real estate and technology stocks. Performance laggards included utilities, consumer staples and Japanese stocks, typically known for their “defensive” characteristics. The run up in Q2 brought global equities to a robust +12.3% gain for the first half of the year.
Fixed income returns during the period were far less impressive, with Barclays Global Aggregate bond index eking out a small gain of +1.3%. Bonds were aided by a decline in interest rates along with a continued tightening of credit spreads, leading investment-grade corporate and high yield bonds to outperform other sectors. However, this bounce back was not enough to make up for the pummeling bonds received during the first quarter, which was one of the worst quarters for bonds in decades. The net result is that the “safer” asset class of global bonds remains down by –3.2% for the year.
KCS’ portfolios also performed well during the second quarter. In our individual stock portfolios, our exposure to rebounding value stocks helped offset our relative underweight to technology. At the same time, our bond performance was boosted as the reopening of the economy aided our more credit-sensitive positions, adding to our strong Q1 performance. We are particularly pleased that our bonds continue to contribute positively to our portfolios in an otherwise down bond market.
What keeps driving stocks higher?
The solid start to equities this year, coming on the heels of a powerful rebound during the last 9 months of 2020, begs the question: “What is causing such strength in the stock market?” And while a litany of explanations can be provided, the most obvious reason is also the simplest: more and more investors want to own equities. The chart below illustrates this by showing the global flow of funds into stocks for each of the last 20 years. In just the first six months of this year, purchases of stocks have nearly surpassed the amount bought over the last twenty years combined.
This apparent euphoria (and greed) may give some investors pause, but we are comforted by this: these flows are rational in a world with severely depressed interest rates. As Warren Buffett noted in his last letter:
“Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at year-end – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt. Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.”
We wholeheartedly agree, and said another way, who other than a global central banker is truly interested in the 1.1% average annual yield provided by the global bond market? It ensures a loss in purchasing power each year after inflation, and recently, even the interest rate on “junk” bonds (the debt of the riskiest companies that issue bonds) failed to cover inflation, something that hasn’t happened before in the past two decades (see graph below). We view the signal here as loud and clear: stocks may be pricier than normal, but bonds are downright exorbitant.
In a world simultaneously awash with liquidity and crippled by low interest rates, stocks seem more attractive than ever. Not only are their returns historically higher than bonds, stocks have the added benefit of providing inflation protection, which is especially important in an era of unprecedented growth in the money supply.
This same calculus is playing out across the globe. In fact, the urge to shift from bonds to stocks is most acutely felt by overseas investors, who have historically been more conservative and less invested in stocks than Americans. On top of this, over $12 trillion of their debt yields less than 0%, adding urgency to the desire to shift.
So long as the rates of return on fixed income remain paltry, we believe that incremental wealth will continue to flow into equities. Furthermore, for reasons discussed below, we think we are still early in this process, even though equities are now up over 100% from their March 2020 lows.
Why do we think the shift to equities is still in its early innings? First, we are only one year into the recovery from a major market downturn. Such sharp market drawdowns are almost always followed by several years of sustained outperformance. Second, while valuations are stretched by historical standards, equities remain priced to provide decent (we estimate 6%–8%) returns over the long run. Especially when factoring in today’s historically low interest rates, we think valuations are appropriate. Finally, we are early in the stock/bond rebalancing process, as the fund flows chart above shows that, in 2019 and 2020, funds flowed out of stocks. Until rates normalize, equity markets could see several more quarters of strong investor contributions.
Bonds (and alternative investments) still have a place in your portfolio
After reading the above, you’d think that we believe no one should own bonds today. This is simply not the case. Bonds still have a role to play in a diversified portfolio, though earning outsized returns is not currently one of them. Instead, bonds continue to serve their most basic function: to smooth out portfolio returns, reducing volatility and helping you sleep better at night. Not everyone can nor should be invested aggressively, and an all-equity portfolio is clearly overly aggressive for many individuals.
If you have a range of possible exposures between stocks and bonds, now might be a good time to lean more toward stocks (but be sure to discuss this with your advisor). Remember that any such leaning should be gentle and not outside your comfort zone. Also, though we believe that the fixed income market as a whole is not attractive right now, there are some segments of the bond market that offer reasonable rates of return and some inflation protection, while still serving to dampen portfolio volatility. It’s these areas that we are currently emphasizing in KCS portfolios, and which have helped KCS weather the recent bond bear market.
The term “alternative investment” basically refers to anything that isn’t a stock or a bond. These include such areas as direct real estate, hybrid securities such as convertibles, private equity, commodities, hedge funds, venture capital and the like. KCS has always included “liquid” real estate and hybrids in its portfolios, and we recently added a small slice of commodities to help our fixed income portfolio better weather higher inflation. We continue to evaluate other alternatives, most likely as a carve-out from our bond allocation, that meet our criteria for safety, reasonable cost and attractive expected return.
What about Bitcoin?
We’d be remiss if we didn’t at least briefly touch upon cryptocurrencies, the alternative asset du jour. After more than doubling early this year on fears of money printing and a declining dollar, “digital commodities” such as Bitcoin retrenched significantly during the second quarter, with many cryptocurrencies falling by -40% or more. The recent pullback brought Bitcoin returns year-to-date below those of the S&P 500. Even after the astronomical rise many cryptocurrencies have had over the last few years, we struggle to articulate their fundamental value, and thus don’t consider them to be attractive options in—or alternatives to—a diversified portfolio.
Why own Bitcoin or other cryptos at all? They are just commodities (and defined as such by the Commodity Futures Trading Commission). But unlike gold, copper, oil and other physical commodities, cryptocurrencies have no intrinsic value, as they can’t be used to make jewelry, wire homes or power cars. While they can be traded to buy things (or illegally extort people), they are not equivalent to currencies, which are backed by the taxing power of governments. Their built-in “scarcity” is meaningless if one can simply create more coins (Dogecoin, for example) or if demand for them falls.
In sum, cryptocurrencies are pure speculation, which is fine if gambling, rather than investing, is your goal. Take a look at the graph below: in 2021, Bitcoin provided equity-like returns with far more volatility. Why take more risk than necessary to earn a given return? Barring a major change in the investing landscape, we will continue to avoid buying or recommending Bitcoin and other cryptocurrencies.
KCS Portfolio Positioning
In light of these trends, how are we positioning our portfolios at KCS? As mentioned above, in fixed income we continue to navigate through challenging markets to the best of our abilities, seeking opportunities with attractive yields for the level of investment risk. This past quarter, we significantly trimmed our exposure to high yield (junk) bonds, as many of these holdings were yielding less than 3% even before credit defaults. With the proceeds, we targeted attractive individual bonds (preferred stocks, convertibles and US agencies) and a small position in commodities, as the “yield” from inflation-sensitive commodities seems better than the returns on many bonds.
With stocks, by contrast, we continue to find attractive long-term opportunities, but now less so in “value” names and more in franchises benefitting from compelling, long-term global trends. We think investors underestimate the next ten years of global growth, as digital transformation and a significantly expanding middle class throughout the developing world should lead to substantial increases in demand and improving profits. Furthermore, we continue to favor international equities, as we think we are in the early stages of a major rebalancing there, with investors shifting from negatively yielding debt towards more reasonably valued foreign equities. By targeting attractive individual securities and modestly overweighting less pricey international equities, we aim for competitive returns with carefully managed levels of risk.
A Final Word
You may have noticed that we didn’t mention COVID-19 even once in this quarterly newsletter. The omission was deliberate, for two reasons: 1) We’ll discuss the status of the pandemic and its effects on the economy and the markets in upcoming “Quick Takes”; and 2) the pandemic, though far from over as a health crisis, is no longer impacting the economy the way it did only a few months ago. Why? Because rising cases in various regions throughout the world are unlikely to lead to the kind of lockdowns that occurred during prior waves of infections. This is most obvious in the UK, where all COVID restrictions were lifted just a few days ago amid a surge in case counts, but only a modest rise in hospitalizations and deaths. Going forward, the latter will become the most important measures of the impact of the virus in place of case numbers.
In sum, though the coronavirus pandemic isn’t over yet, it is no longer the most important issue moving markets. That spot has been reclaimed by more traditional influences, such as consumer demand, industrial production, and interest rates. Economically, at least, the world is finally back on the road toward normal.
Yours truly,
The KCS Investment Team
KCS Wealth Advisory is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with personalized financial, estate and tax planning services.
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