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The calendar has officially hit the halfway mark, providing investors with an opportunity to take stock of their portfolios, evaluate what has worked as expected, and craft a plan for the second half of the year. Can risk assets continue their ascent? And within equities, does cyclical leadership have further to run? Our assessment of the economic environment leads us to respond “yes” to both questions. Elevated volatility in the second half of this year is likely at some point as we expect a 5% to 10% correction before year end.  Notwithstanding any such consolidation, we also expect domestic equities to end the year 5% or so higher than current levels. We are therefore positioning client portfolios with an overweight to risk assets, a mild preference for cyclicals, and plenty of diversification across asset classes and factors.

First half recap: A tale of two quarters

The first half of this year resulted in a very strong 15% total return for the S&P 500, with the index logging a positive return for five of the six months. The 10-year Treasury yield increased by 56 basis points (0.56%). U.S. stocks outperformed their non-U.S. counterparts.

But these figures gloss over a stark reversal in interest rates and market leadership between the first and second quarters (Figure 1). While the first quarter was dominated by higher interest rates and dramatic outperformance of cyclical and value equities (i.e., those that trade at a discounted valuation and may be more dependent on the economic cycle for profit growth), the second quarter saw the 10-year Treasury yield retrace to as low as 1.35%, paving the way for a resumption of command by growth-oriented, tech-related, and more expensive securities.

The economic trend is still our friend

Our view for the overall equity market, as well as factor leadership beneath the surface, hinges on expectations for the economy and monetary policy as we approach and enter 2022.

The U.S. economy likely grew at an annualized rate of 8% – 12% in the second quarter, and the median estimate among Wall Street economists (according to Bloomberg) is for U.S. GDP growth of 6.6% for calendar year 2021. We are anticipating stronger growth than consensus estimates for 2021—approximately 7.5% GDP growth—but weaker growth than consensus in early 2022 as the burst of demand from post-pandemic reopening and government relief payments fades.

While all indications point toward an economy that is at or just beyond the peak pace of growth for the cycle, we are still optimistic. Consumer spending and capital expenditures represent solid pillars to support above-historical-trend growth through 2022. Consumers have accumulated more than $3 trillion of excess savings above the pre-pandemic trend, which we expect to be deployed more heavily into the services sector of the economy. The labor market has deep scars, but there is room for rapid improvement as we head into the fall. There is little disagreement that the slow improvement in the labor market is an issue of labor supply rather than demand, as job openings currently sit at record levels. Capital expenditures are also poised to move higher, following their historical relationship with corporate profits.

Please see important disclosures at the end of the article.

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