“I used to think that if there was a reincarnation, I wanted to come back as president or pope or a .400 hitter. But now I would like to come back as the bond market. You can intimidate everybody.” — James Carville
First Quarter Market Recap
Early in 2021, global financial markets diverged in more ways than one. Equities rose, with value, cyclical and secondary (smaller cap) indices doing especially well in the first six weeks. As March progressed, market leadership rotated into oversold
growth and larger cap technology stocks.
On the other hand, fixed income markets had their worst quarter since 1980, with longer maturities impacted the most. U. S. 10-year Treasury saw its yield spike from 0.91% to 1.74%. This caught many investors by surprise, not by the upward direction but by the magnitude of the increase. Other international bond markets sold off to a lesser extent. Commodities were mixed, with grain and industrial metals prices rising while precious metals fell. Meanwhile, the U.S. dollar confounded many bearish economists by increasing for the quarter.
Investor sentiment approached an exuberant level – not surprisingly, a few blow-ups occurred. Retail investors from Robinhood squeezed short sellers in stocks such as Gamestop and AMC Entertainment which had fallen into the speculative category. Wrong way bets by Archegos Capital Management led to a margin call and liquidations of a few stocks including Discovery and ViacomCBS. Fortunately, the damage was confined to these areas while the rest of the market emerged largely unscathed.
A Long, Cold Winter then a Spring Thaw
The year began drearily enough with Covid-19 worsening again both here and abroad. Numerous states and municipalities responded by imposing restrictions on movement which also curtailed economic activity. A sharp February cold snap hit Texas and the mid-section of the country, aggravating supply chain issues caused by the pandemic. To add to the misery, the 200,000-ton cargo ship Ever Given ran aground in the Suez Canal and blocked traffic for a week, further snarling global trade.
Meanwhile, a number of good things also happened. Congress passed a $1.9 trillion stimulus package, the third since last April. A $2.25 trillion infrastructure bill was proposed by President Biden to shore up and sustain the economy into the future. The vaccination effort ramped up significantly and now about a third of the U.S. population has had at least one dose. As warmer temperatures returned, the number of new cases lowered in most regions of the country.
“Hurry Up and Wait” – for Clarity on Inflation and the Infrastructure Bill
The U.S. stock market has had an unprecedented rally off its lows a year ago. Valuations are high, with the forward price/earnings multiple of the S&P 500 Index at over 20 times; this is being offset by lingering low yields on fixed income instruments.
Interest rates remain important to equity market performance. Although a gradual rise in rates reflects a recovering economy, a rapid upward spike is destabilizing and provides stiffer competition for stocks. Interest rates often take their cue from inflation, which should pick up this year. Key to the inflation question is whether the increase will be transitory or the beginning of a trend.
The Federal Reserve and most economists believe that the increase will be temporary, largely reflecting a rise from the depressed levels of last year. We probably won’t know the answer until the second half of 2022, as a tug of war plays out between rising commodity prices due in part to supply chain issues and subdued wage growth due to slack in the labor force. Indeed, even with a robust March employment report of over 900,000 new jobs added, over 8 million jobs still need to filled to get us back to pre-pandemic levels. It will be difficult to get wage inflation without attaining full employment.
A rapid increase in economic growth expected for the rest of 2021 should help stocks “grow into” their valuations. Real GDP (Gross Domestic Product) growth is projected to be in the 6-8% range, with estimates rising considerably since January.
Passing an infrastructure bill in some semblance of its current form would have mixed results for the economy and the markets. Stimulus components such as “pick and shovel” projects would be countered by an increase in the corporate tax rate from 21 to 28%. Just like the inflation outlook, we won’t know what the final form of the infrastructure bill will be (assuming one passes) until summer.
The Outlook
- We remain constructive on equities, though returns going forward will be moderate. Rapid economic growth along with more gradual increases in longer interest rates will support stocks, though full valuations and an uncertain outlook on inflation and future legislation will temper gains.
- We are underweight in bonds and have reduced maturities.
- International equities now include selected developed countries along with emerging markets.
- Not forgetting we are still exiting a pandemic, we assume that the current trajectory of vaccinations will hold and the new variants of Covid-19 will continue to respond to existing vaccines.