EXPECTING THE EXPECTED

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

July 23, 2021

Your Questions Answered

Stocks have resumed their upward trajectory after a dramatic sell-off early this week, offering a gentle reminder: Regular equity market drawdowns are normal. As we reflect on recent asset performance we note relatively unsurprising results, aligning with our view that growth and inflation will come off the boil yet remain risk-asset-supportive as the recovery matures.

Below are five observations to keep in mind as we near month-end and reflect on recent portfolio performance.

1

That was fast.

After a very rough start, global equities ended the week with an over 1% gain, led by robust returns for U.S. stocks in particular as investors regained focus on the strong fundamental backdrop. We continue to advise that investors should “expect the expected,” noting that the drawdown we experienced on Monday was quick but mild relative to what occurs quite regularly in equity markets. As a reminder, 5% corrections tend to occur every 10 weeks and 10% corrections every 34 weeks. As of this week, it has been 36 and 67 weeks, respectively, since a 5% and 10% correction. Each can occur during bull markets, and both certainly test investors’ resolve. Maintaining a longer-term perspective and sticking with your investment plan is the best advice. We have experienced strong returns from risk asset markets, and higher volatility, as well as a market sell-off, is to be expected, particularly as we transition from the early-cycle economic “boom” to a mid-cycle normalization.

2

A Manic Monday.

The spread of the Delta variant was widely blamed for the risk-off sentiment on Monday; however, we do not believe that the increase in COVID-19 cases will have a meaningful impact on economic growth. We do believe that case counts will rise significantly in the U.S. over the coming weeks, but that public health policy focus will be on mitigating hospitalizations and serious illness, not case counts. While the Delta variant appears to be considerably more transmissible, the instances of serious illness are lower, and hospital capacity remains sufficient in most areas. Additionally, vaccines have proven to be very effective at preventing serious illness, and over 55% of the U.S. population is at least partially vaccinated. Our experts foresee 70-75% of the U.S. population having some sort of immunity by fall, whether through vaccination or natural infection. In the meantime, mobility data suggests that people are getting on with their lives and not reacting significantly to the spread of the Delta variant.

3

The market is coming to our view on interest rates.

While equity markets recovered and have reached new highs, U.S. Treasury yields remain subdued. We believe this is partly due to the view that both growth and inflation will likely peak soon, but the sharp move down in yields may also be a function of some market technicals. The dearth of supply, exacerbated by the $80B monthly Fed purchases and the wind-down of the Treasury General Account, along with still-insatiable demand, have combined to create significant pressure on yields. We believe demand will remain robust as cash reserves remain extremely high and as institutional investors continue to rebalance portfolios after robust equity returns. Going forward, however, net supply will increase and, absent an unexpected negative economic shock, 10-year Treasury yields will stabilize within our 1.25% - 1.75% range, most likely toward the low/mid-point of that range. We have remained steadfast in our lower-for-longer outlook for interest rates, even as the 10-year yield climbed above 1.75% in March — believing that, ultimately, the headwinds to higher rates that were present pre-pandemic will begin to re-emerge, leading to lower growth and lower inflation.

4

So far, so good.

We are still at the beginning of the 2Q earnings reporting season; so far, nearly 90% of companies are beating consensus analyst estimates, confirming investor optimism embedded in high stock price valuation measures. We anticipate that significant upside surprises will continue as strong consumer-led demand remains robust, but the magnitude of the “beats” may diminish as analysts increase their earnings estimates. There is no question that the fundamental backdrop is extremely strong: Companies are beating on both the top and bottom lines, corporate balance sheets are healthy, credit is readily available and borrowing costs are low. Importantly, profit margins remain high, as companies have been able to successfully pass on price increases. Going forward, we believe that more attention will be paid to the outlook rather than the results, and visibility into the persistence of some of the supply chain disruptions, the increases in raw material costs and, most importantly, the persistence in demand will be critical. It is likely that the earnings growth rate has peaked, although we are far from the peak in actual earnings. The backdrop will remain constructive for equities.

5

Is there more fiscal gas in the tank?

It does appear that the bipartisan infrastructure deal is inching forward and toward a potentially successful outcome. The $579B bipartisan deal appears to be moving closer to becoming a reality and could be put up for a vote in the Senate on Monday. Having missed the aggressive Wednesday deadline this week, sleeves have been rolled up and pencils sharpened to present a spending package that is likely to gain traction ahead of the August recess. Although we have yet to see the CBO scoring for this bill, it is important to recognize that both the size of the spending package, as well as the pace of anticipated spending, are unlikely to change the trajectory of economic growth meaningfully.

Disclosures

This document is a general communication being provided for informational and educational purposes only and is not meant to be taken as investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions or inflation. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Northern Trust and its affiliates may have positions in, and may effect transactions in, the markets, contracts and related investments described herein, which positions and transactions may be in addition to, or different from, those taken in connection with the investments described herein.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.

PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RESULTS. Periods greater than one year are annualized except where indicated. Returns of the indexes also do not typically reflect the deduction of investment management fees, trading costs or other expenses. It is not possible to invest directly in an index. Indexes are the property of their respective owners, all rights reserved.