During the second quarter, global equity markets extended their strong performance. The MSCI ACWI returned 7.5%, bringing its year-to-date return to 12.7%. Under the surface, markets remained highly rotational from regional, sector, and factor perspectives.

In our April outlook, we noted the first quarter outperformance of U.S. equities was driven initially by strength in large-cap growth names, but the market shifted its focus toward Covid vaccination rates as the quarter concluded. Against this backdrop, cyclicals and Covid-reopening beneficiaries led the markets higher. Heading into the second quarter, our view was that the acceleration of vaccination rates throughout Europe would likely support a shift in leadership to European cyclicals and Covid-reopening beneficiaries. This indeed was the case in April and May, as European equities returned 9.5% and outpaced the MSCI ACWI’s gain of 6.0%. Unfortunately, many countries have delayed reopening because of the threat of the Covid Delta variant and the reduced efficacy of the nonmRNA vaccines that have been more prevalent overseas. For example, China intends to keep its pandemic border restrictions in place for at least another year to mitigate the risk of disrupting the 2022 Winter Olympics and the Chinese Communist Party Congress. Japan has banned spectators at the Toyoko Olympics. Meanwhile, the U.S. has benefited from its early lead in vaccinations, with economic reopening proceeding at a brisk pace, although Delta variant cases are now rising in the U.S. as well.

In addition to ongoing concerns about Covid, market participants have become less certain about the firmness of monetary policy support, specifically the Federal Reserve’s commitment to its new policy framework. As expected, inflation data has accelerated sharply, and there is much debate as to whether this is a temporary spike due to low base effects or whether we are in the early stages of a more durable shift upward. The Fed has been clear that it views the current inflation readings as “transitory” and that monetary policy will remain highly accommodative through 2022. But following the FOMC’s June meeting, investors found reasons to question the central bank’s resolve as rate projections and commentary by various FOMC members signaled earlier-than-expected rate hikes.

As Delta-driven Covid cases rose and the Fed’s timeline became less certain, investors downgraded their expectations for global growth, and the U.S. Treasury yield curve flattened late in the quarter. Against this backdrop of weaker growth expectations, the U.S. dollar strengthened, commodity prices (excluding oil) fell; U.S. equities outperformed; and market leadership rotated toward secular growth and away from cyclical growth, disrupted industries, and reopening beneficiaries.

Holding Pattern: Synchronized Global Recovery Delayed, Not Dismissed

We believe the market is overstating the risk that the Fed tightens too early. The “dot plots” that unnerved the markets are based on notoriously terrible forecasts. Chairman Powell has said as much on many occasions, including at the Fed’s June press conference. Also, FOMC members are likely to change over the next year. Given the current fiscal backdrop, it seems unlikely that openings will be filled by policy “hawks.”