How long could the current rally run?

U.S. stock markets surged to record highs in the first half of 2021 as vaccine optimism and momentum behind the re-opening of the economy helped investors overcome concerns about rising inflation and interest rates. Stock investors remained remarkably resilient, adopting a “glass half full” mindset on the improving economic picture.

Many tailwinds for the equity rally remain in place heading into the second half of the year, including accelerating growth and rising corporate profitability. However, much of this good news is already priced into current valuations. Given the reliance on fiscal and monetary support, the primary risks to the market are those that could alter these policies, specifically inflation and interest rates.

What’s been notable about stocks’ rally so far this year is the shift in market leadership. Large-cap tech stocks fell from favor over the last six months and small caps outperformed. Value stocks outpaced growth in the first half of 2021, mainly due to the explosion in prices for nearly all commodities, from lumber to gasoline. Commodity price inflation has largely benefited cyclical market sectors such as energy and materials.

Flows into stock funds have come in at a scorching pace so far in 2021. Households increased their equity holdings to 41% of total financial assets, the largest percentage on record dating back to 1952. Investors really have had no choice in how to allocate, given still historically low bond yields and the tightest investment-grade credit spreads since 1997. Investor sentiment surveys reached levels of extreme optimism in April but have since turned more neutral and receded from their earlier peaks.

Bond fund flows remain positive but are coming in at a slower pace than in previous years. Rising long-term rates have led to negative returns for many fixed-income instruments, so it’s uncertain how bonds investors will react to negative returns in these investments.

“Don’t fight the Fed” is a familiar adage among market participants, but this year could be replaced by “Don’t fight D.C.” We are in the midst of a sugar rush thanks to ongoing monetary policy support from the Federal Reserve and fiscal support in the form of stimulus checks and enhanced unemployment benefits. It’s unclear, however, if this momentum can be sustained if and when fiscal and monetary support fade.

Inflation is climbing, with supply chains tight and pricing power improving, but the Fed appears convinced that the broader impact on the economy is transitory. If inflation pressures become more pervasive, the central bank could be forced to taper asset purchases and/or raise the Fed Funds rate sooner than they would like.

With increased inflation expectations, interest rates ended Q2 higher than they were at the start of the year. Higher interest rates are likely to put pressure on the federal budget, which has seen debt grow from under $12 trillion at the end of the 2007-09 financial crisis to over $22 trillion by the end of last year. This increase has been largely masked by the low-rate environment, but rising rates are likely to “crowd out” other spending.

Higher heights seem to be the path of least resistance for stocks going forward, though the gains seen over the past year are unlikely to continue due to elevated valuations. Valuations don’t necessarily signal an imminent correction, but higher valuations are more likely to limit intermediate-term returns.