US equity markets rose meaningfully during the second quarter of 2021, accompanied by a consequent drop in volatility as reopening expectations continued to gather steam. Expectations of reopening fervor began to be realized through the quarter. Other factors such as inflation fears, a steepening yield curve and treasury taper-oriented risks, all of which had been a part of that move, began to relent, counterintuitively.
As a result of increased foreign treasury buying and technical issues in the bond market, we began to see the US yield curve flatten, contrary to the improving fundamentals of US growth and inflation. While difficult to pinpoint the exact cause of this treasury strength, it seems that increasing concerns about the Delta variant in international markets and anti-speculation steps taken by Chinese authorities in the commodities and financial markets generally increased interest in US Treasuries. Most strategists had been expecting the beginning of global growth pivoting to international markets. The somewhat uncharacteristic Dollar strength at this point of the recovery highlighted that the flattening of the yield curve could be a sign of dropping inflation or growth expectations.
These realities helped revert some of the damage that high PE and growth stocks had experienced in Q1 and slowed down the buoyant value-cyclical trend that had driven the Q1 S&P 500 returns. With robust US reopening expectations and continued accommodative financial conditions, the equity markets took the yield curve flattening and rotation towards growth in stride. In fact, the flattening yield curve, and slight drops in inflation expectations through the quarter, supported a drop in most tangible risk measures, such as the VIX and MOVE (treasury) Index, through the quarter. This was because it confirmed the idea that the FED would be appropriately vigilant but not excessively hawkish until the data warranted it.
During the quarter, the Hedged Equity strategy provided a 2.75% return and a 2.29% net return vs the S&P 500’s 8.55% return. In this reduced-volatility environment, the strategy captured 32% of the index’s Q2 return, while continuing to operate with substantially less volatility than the broad market – 66% lower during 2Q21. With only one modest drawdown period of approximately 4% in early May, realized volatility of the S&P 500 did not provide any meaningful opportunities for the strategy to monetize put spreads. In addition, the domestic equity market’s steady march upwards made the short calls less effective compared to a more range-traded or volatile period. Investors should remember that we have experienced periods like this in the past. Often, we find that they are followed by a mean-reversion or regime change towards increasing volatility, which benefits our approach.
Looking ahead, we believe economic strength and the potential for a rapid hiring increase of US labor into the Fall will begin to legitimize FED taper expectations. We think that reality could be accompanied by an international recovery that struggles with the Delta variant, complicating the FED calculus. We also see elevated equity valuations and longer-term earnings expectations that look ambitious, especially in the context of the above concerns. With low implied- and realized-correlation levels driving domestic stock-picking returns this year, we think the risks to investor portfolios may be substantially underestimated, especially when tapering conversations start in earnest. We continue to see wisdom in our approach: consistently defend against downside and correlation risks through all markets. We hope you will not hesitate to contact us should you have any questions on our approach.
Returns are gross-of-fees representative account. Easterly EAB Risk Solutions LLC is an investment adviser registered with the SEC. Registration does not imply a certain level of skill or training. All information in this communication has been obtained from sources believed to be reliable but cannot be guaranteed. There can be no assurance that the investment objective for these strategies can be achieved and past performance is no guarantee of future results. The S&P 500 is an index of unmanaged securities, and the indices are not securities that can be purchased or sold.