Second Quarter, 2021

Stock markets globally continued their spectacular post-pandemic rebound in the second quarter, as economic and earnings growth soared. But inflation well above average has led some central banks to reduce stimulus sooner than planned. We expect inflation to moderate, but not to the unusually low level that prevailed before the pandemic. In this letter, we explain our new framework for assessing the outlook for short- and long-term inflation, and explain how we incorporate this insight into Thematic portfolios.


The Market Rebound

The S&P 500 continued to set new all-time highs in 2021’s second quarter, generating a total return of 8.6% for the quarter and bringing the first half’s return to 15.3%. In the 15 months since its pandemic-induced low in late March 2020, the S&P 500 has delivered a total return above 95%. No prior bull market has generated such strong returns so quickly.

Driving the market rebound were the economic reopening and extraordinary fiscal and monetary stimulus. Reported earnings for U.S. equities soared 52% in the first quarter of this year versus the first quarter of 2020. The Wall Street consensus expectation is for year-on-year earnings growth of 63% in the second quarter.

But valuations are stretched for most asset classes. The S&P 500 is trading at 21.6 times expected earnings, far above its 15.5 times average for the last 20 years. The 10-year Treasury yield is 1.43%, less than half its 20-year average of 3.1%. In Europe and Japan, 10-year government bond yields are at zero or negative.

Other aspects of the current environment are also concerning:

  • Market strength has narrowed, with fewer stocks driving performance.
  • U.S. households have allocated a larger share of their portfolios to stocks than ever before.
  • Global economic growth is likely to slow to merely healthy levels as pent-up demand is sated, contrary to the expectations reflected in global equities.
  • Some central bankers are beginning to raise interest rates or signal modest raises ahead, because they believe emergency measures are no longer necessary.

We expect choppy markets through year-end, but given staggering liquidity and central banks’ still relatively dovish stance, we think a large equity correction is unlikely this year.


Inflation Returns

Beyond 2021, we expect equity market performance to hinge on inflation. If it remains relatively high, it is likely to weigh on financial asset returns. Historically, stock markets have generated almost all their excess returns during periods of low inflation.

Consumer price inflation in the U.S. has risen to 5% this year, well above the long-term average of nearly 3.5%, let alone the average rate of less than 2% that prevailed for most of the last decade. High inflation’s sudden return has prompted much new writing, but to date, we have not found much that is helpful to us as investors. We are particularly interested in understanding how the drivers of inflation differ over various time periods and the impact inflation has on equity performance.

We created our own methodology for analyzing inflation over different timeframes. First, we identified the distinct drivers of inflation over the short-term compared to the long-term. The drivers of short-term inflation (next 12 months) are cyclical. The drivers of long-term inflation (next decade) are secular factors, some of which relate closely to our investment themes. Second, we rated each driver of inflation on a quantitative scale ranging from -5 to +5, with -5 indicating strongly deflationary and +5 strongly inflationary.

The tables below show the state of each driver in 2021 and after the Global Financial Crisis (GFC) 10 years ago, in 2011, along with the inflation experienced in the period that followed.


Chevy Chase Trust Inflation Framework

(Drivers of Inflation over Different Timeframes)


The Short-Term Inflation Outlook

Typically, inflation rises after a recession. As consumer balance sheets and wealth recover from recession-driven declines, consumers spend more. The period after the GFC was atypical because high household debt levels and declines in personal income restrained spending. Inflation remained subdued for the decade that followed.

By contrast, during the COVID-19 recession, aggregate household net worth expanded by $6 trillion, as personal savings increased by $2 trillion and debt levels rose only modestly. We expect the increase in consumer wealth during this recession to be the largest contributor to higher near-term inflation.

Pent-up demand resulting from more than a year of pandemic-related restrictions, as well as widespread shortages and supply-chain disruptions, are also contributing to inflation. We expect them to continue to do so for the next several months.


The Long-Term Inflation Outlook

We expect inflation to recede after its initial rise, as pent-up demand is satisfied, but we don’t expect it to decline to prepandemic levels. Two major factors drive our outlook: the manufacturing sector’s shift from relying on global supply chains to regional ones, and the potential shift from fossil fuels to green energy.

Manufacturing and its supply chains globalized after China joined the World Trade Organization (WTO) in 2001, in response to China’s unique combination of competitive advantages: infrastructure of first-world quality and wages at third-world levels. China’s allure as a manufacturing hub increased further after the GFC, when the Chinese government invested heavily in high-speed railways, airports and other infrastructure. This build-out made it possible for China to locate export production in inland areas and allowed hundreds of millions of China’s inland workers to join the global labor force en masse.

The pandemic highlighted key risks of relying on optimized global supply chains. Hospitals were unable to obtain medical supplies produced overseas. Consumers and manufacturers were unable to procure items ranging from furniture to bicycles to semiconductors. Some governments are now moving to require local or regional sourcing of key products. Building these redundant supply chains may help emergency preparedness, but it will also raise production costs.

We expect the potential switch from fossil fuels to green energy to be inflationary for many years. The world’s energy infrastructure was built over decades, and its value has been almost fully depreciated, although it could be used for decades to come. Replacing it with renewable energy may be necessary to save the planet but it will not be cheap. More stringent environmental regulations around the world will also increase the cost of producing energy. Since energy accounts for roughly one-third of the input costs of consumer goods, rising energy prices will raise prices for a wide array of products.

Two other factors are likely to drive higher long-term inflation to a lesser degree. First, the slow growth in working age populations almost everywhere except India and Africa creates upward pressure on wages. In the U.S., COVID-19 accelerated the retirement of baby boomers, leading to the first ever contraction in the U.S. labor force. Second, the price declines for technology that reduced overall inflation in the last two decades are slowing as chip makers are now encountering physical limitations in making semiconductors smaller.


Inflation as Both Investment Theme and Research Lens

Most of our themes tend to be longer-term and secular in nature, transcending business cycles. Normally, we apply our research insights into cyclical swings to determine appropriate weights for our themes. Occasionally, however, a macroeconomic shift appears to have larger and longer implications so that the change itself becomes a theme. That’s what occurred in the third quarter of last year, when we began to express our inflation perspective in portfolios by adding a new theme, “The End of Disinflationary Tailwinds.”

For the first time in seven years, we began to overweight energy stocks, given their history of outperforming in periods of high inflation. This move proved prescient. The Energy sector has outperformed the S&P 500 by over 60% since October 2020. We continue to favor energy stocks. The global economic recovery, coupled with low levels of capital spending, relatively easy monetary policy and a relatively weak U.S. dollar, are a recipe for high oil prices. The sector is also more attractively valued than the equity market overall.

Our inflation view led us to increase our weightings in two other themes.

  • Next Generation Automation As shrinking labor forces put upward pressure on wages, we anticipate increased investment in automation across multiple industries.
  • Long-Term COVID-19 Beneficiaries We focus on companies that restructured operations during the pandemic or are enabling other companies to restructure to improve productivity and capitalize on the pandemic-induced changes in how we all live and work.

Higher productivity is often the antidote to inflation and the source of true wealth creation. Improved productivity is at the heart of many of our investment themes. The post-pandemic productivity boom could be larger than most. Recessions typically upend only one or two economic sectors. The COVID-19 pandemic upended many.

We are studying productivity intensely now. Our initial assessment is that productivity growth in the decade ahead will pick up from the very low levels of the past decade, but it won’t rise soon enough to counteract the cyclical and secular inflationary forces underway.


Identifying the Next Decade’s Winners

Trends don’t last forever. Every decade seems to begin with a common area of focus uniting most of the world’s 10 largest stocks, as measured by market capitalization. In 1990, all but two were Japanese. In 2000, technology and telecommunications companies dominated the top 10 list. In 2010, most of the top 10 were commodity producers benefiting from China’s boom. Today, most are Internet-related. Very few companies have remained in the top 10 for more than a decade.


Top 10 Equities by Market Capitalization by Decade

Source: Gavekal/Macrobond


New themes will arise as this decade unfolds, and some existing themes will become more important. We expect Molecular Medicine to be among the latter, due to the rapid progress in gene editing technology. In 2012, Drs. Jennifer Doudna and Emmanuelle Charpentier first published research that showed the promise of editing DNA using a molecular toolkit known as CRISPR. Eight years later, the pair won the Nobel prize. In late June of this year, Intellia Therapeutics, a company Dr. Doudna co-founded, presented data showing the efficacy of using CRISPR to edit human DNA to treat a dreadful genetic disorder. This was a historic breakthrough. Most new biotechnologies have taken 30 years to bear fruit. CRISPR has reached patients in just a decade. As CRISPR-derived treatments move into broader clinical use, the ability to cure previously incurable diseases with a one-time genetic modification will likely change the practice of medicine as we know it.



We expect some choppiness in global markets as central banks seek to manage rising inflation and still-elevated unemployment levels by adjusting interest rates. At some point in the next several years, we expect equity markets to experience a correction. Equity markets don’t go up in a straight line. Often, they take the stairs—with some steps down. Global equity markets boomed between 1990 and 2000. Over the next decade, they fell, recovered, and fell again, ending more or less flat. Since 2010, markets have soared, with only a brief pandemic-related drop. With equity market levels and valuations at all-time highs, returns over the next decade may be uninspiring.


Performance of S&P 500 Price Index 1871 – 2020

(Log Scale)

Source: Robert Shiller, J.P. Morgan Asset Management, FactSet


This backdrop makes it even more important for us to use our Thematic Investing process to identify stocks that can do better than the market and to avoid stocks likely to lag. Of course, we won’t get every stock right or time our moves perfectly. No one can. But we believe that with thoughtful research and diligent risk management, we are well positioned to deliver on our commitment to you over time.


Important Disclosures