Q3 2021: Reopening brings growth, but risks too

Look out for potential elevated volatility amid shifting expectations for monetary policy.

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Key takeaways

  • We expect increased potential for elevated volatility in the coming year, as shifting expectations for monetary policy could push markets toward more inflationary or disinflationary outcomes
  • The post-World War II shift to a peacetime economy, which catalyzed a cyclical rebound of growth and inflation, may be the closest historical analog to the upcoming post-COVID era where vaccination and reopening gain steam over the course of 2021 and 2022.
  • Global liquidity surged during Q2, and we expect liquidity growth to slow in the coming months, raising the prospect of higher market volatility.
  • While technology and other factors have kept inflation in check, we believe greater policy experimentation and "peak globalization" trends will eventually cause long-term inflation to rise faster than expected.

Market summary: Crosscurrents and market gains amid a fitful reopening

Economic reopening underpinned widespread Q2 gains for US assets, marking the first half of 2021 as another period of exceptional US equity performance. Commodity prices also rallied sharply during Q2 amid constrained supply and surging global industrial activity. Most bond categories posted positive returns this period as longer-term interest rates dropped following their steep run-up in Q1.

See our interactive chart presentation for an in-depth analysis.

Prices for riskier assets extended their rally amid the US reopening, global economic progress, and supportive monetary and fiscal policies. Bond yields moderated, however, and market leadership rotated as the near-term outlook grew murkier due to rising COVID cases globally, supply shortages and disruptions, and the uncertain path toward monetary normalization. Elevated valuations present a challenge to asset markets. We see increased potential for elevated volatility in the coming year, as shifting expectations for monetary policy could push markets toward more inflationary or disinflationary outcomes.

Economy/macro backdrop: Global expansion progressing in an uneven manner

The US shifted fully into the mid-cycle phase, as a broadening expansion accompanied the economy's reopening. Major economies are on differing trajectories, with a number of developing countries inhibited in particular by their relatively limited vaccination and reopening progress. The global cycle's momentum is widening, with staggered re-openings likely leading to ongoing improvement, even if in fits and starts.

The post–World War II shift to a peacetime economy, which catalyzed a cyclical rebound of growth and inflation, may be the closest historical analog to the post-COVID era. Strong postwar demand from healthy consumer balance sheets combined with a lagged supply response created upward pressure on prices. Today, a shifting mix of growth and inflation may arise amid global supply disruptions and domestic labor shortages.

Corporate earnings generally were up during the past few quarters as sales accelerated, and many companies were able to pass through higher input costs to consumers. Market expectations for 2021 earnings have been revised higher to a robust 36% year-over-year growth rate, with double-digit growth expected to continue into 2022. Companies' ability to maintain high profit margins remains key to the earnings outlook.

Global liquidity surged during Q2, as major central banks' QE and a drawdown of the Treasury's general account at the Fed injected more than $1.5 trillion of incremental liquidity into the financial system. This backdrop supported asset prices and bond market supply/demand dynamics, helping push down bond yields. We expect liquidity growth to slow in the coming months, raising the prospect of higher market volatility.

Inflation during Q2 rose well above the Federal Reserve's target. The Fed has indicated patience with an inflation overshoot as it watches for progress toward its inclusive employment goals. Our poll of Fidelity equity and fixed income research analysts shows an overwhelming majority expect the companies they follow both to experience rising input prices and to raise their selling prices in the months ahead, but market measures of inflation expectations indicate a widespread belief that inflation pressures will be transitory and diminish in the years to come.

Firms posted the highest rate of job openings in 2 decades, but unemployment rates remained elevated. Job gains continued, but shortages should ease over the next three months as extra jobless benefits expire and child care and schools fully reopen. However, some of the 3.5 million people who left the labor force during the pandemic, especially older workers, might not return, implying some of the supply-demand gap may persist.

Wages regained their pre-pandemic peak in just 8 months, led by gains for lower-paid workers, who bore the brunt of the layoffs. Recent wage resilience contrasts with the prolonged employment weakness experienced after the 2008 recession, and surveys suggest both workers and businesses expect wages to continue rising in the months ahead.

Decades of rapid technological change and policies have concentrated economic gains in the upper tiers, and income inequality has reached 100-year highs. But political trends are shifting toward policy changes aimed at reducing inequality, directionally similar to the postwar, "Great Compression" era. This may include broad public investments, a more progressive tax regime, and greater support for low- and middle income workers.

After nearly $3 trillion of emergency stimulus this past fiscal year, the 2021 fiscal deficit may once again reach the 2020 peacetime record, but less fiscal support is likely next year. If enacted, Biden administration proposals for investment in infrastructure and other areas, funded partially via higher taxes on corporations and high-income individuals, likely would add a pro-growth flavor to the near-term policy mix.

The dramatic worldwide rise in public and private debt in recent decades reflects monetary and fiscal policymakers' proclivity to use low interest rates and government support in an attempt to boost growth rates. While technology and other factors have kept inflation in check, we believe greater policy experimentation and "peak globalization" trends will eventually cause long-term inflation to rise faster than expected.

Asset markets: Rotation toward large cap and growth stocks during Q2

Riskier asset classes rallied and ended the first half of 2021 with strong, broad-based returns, but Q2 experienced a different leadership tone than the prior 2 quarters. Large cap US growth stocks, including the technology and communication services sectors, led the gainers. The drop in bond yields boosted fixed income returns across almost all categories and may also have contributed to strong gains for real estate equities.

Trailing earnings growth moved to positive territory on a year-over-year basis after contracting for more than a year across all major global markets. Forward expectations indicate analysts believe earnings will continue to push higher over the next 12 months, with double-digit growth rates anticipated in all regions, led by emerging markets.

Global equity valuations ticked modestly lower during Q2 amid the strong earnings rebound, but their trailing price-to-earnings (P/E) ratios remained elevated relative to their historical averages. US valuations are particularly rich, even when incorporating next 12-month earnings projections. The US dollar also remains somewhat expensive. Forward-looking P/E ratios for developed- and emerging-market valuations are expected to fall below their long-term historical averages.

Due in part to robust financial and monetary liquidity conditions, longer-term Treasury bond yields ticked down during Q2. Inflation expectations remained near multiyear highs, but real yields dropped and erased much of their Q1 rise. Nominal yields were still roughly 100 basis points higher than the all-time lows reached in mid-2020, but extraordinary global monetary policies are likely contributing to the persistence of negative real Treasury yields. Corporate spreads dropped further during Q2 and finished the quarter at some of their tightest levels in recent history.

The business cycle can be a critical determinant of asset performance over the intermediate term. Stocks have consistently performed better earlier in the cycle, whereas bonds tend to outperform during recession. While we believe a business cycle approach to actively managed asset allocation can add value, portfolio returns are expected to even out over the long term (20 years), regardless of the starting point of the cycle phase.

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