Spring 2021 Market Perspectives

<b>David S. Lynch, CFA</b><br>Chief Investment Officer

David S. Lynch, CFA
Chief Investment Officer

April 15, 2021

Market Perspectives


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The first quarter of 2021 saw a continuation of the stock market rotation and reopening optimism from the end of 2020. The laggards of 2020 were the outperformers in Q1, while last year’s big winners underperformed in the quarter. Optimism about an end to the pandemic brought some negative consequences for the bond market in the form of inflation nervousness and less demand for bonds. Depending on each portfolio’s investment strategy and asset allocation, the combined result was Q1 returns ranging from small losses to modest gains.
 
Consistent with our patient and long-term approach, we are reluctant to draw strong conclusions from any single quarter of performance. For example, some of the trends of Q1 have already been partially reversed in the first part of April. It is setting up as a volatile and unusual year once again. The ups and downs of virus variants versus vaccine roll outs will be present for months to come. In addition, tax hikes loom as a risk while a multi-trillion-dollar infrastructure plan could be another boost to the economy, particularly in the short term.
 

Market Outlook and Q1 Summary

 

Overall Asset Allocation

We retain a general recommendation to be neutral equities, underweight bonds, and modestly overweight cash with some of that cash reallocated into gold and diversified commodities. Because of the unique nature of the pandemic, we expect the market mood will continue to bounce between euphoria for reopening and disappointment over delayed or false starts. The historical market cycle of greed and fear is now amplified by the wide range of human emotions connected to lockdown versus freedom.
 
Finding a stable and self-supporting economic balance will be a process of over- and under-correcting, both in terms of mood and market valuation. When does good become “too good” or hot become “too hot?" Policy errors have interrupted prior business cycles and bull markets. The issue this time will not be one of tightening too soon—Chairperson Powell and the Federal Reserve have already sworn to that.  Instead, the risk is that speculative excesses and inflationary disruptions could result from overcompensating, overstimulating, and tightening too late.
 
As shown in the graphic below, the countercyclical substitution of fiscal deficit spending to make up for shortfalls in private sector investment is not characteristic of the current environment. The fiscal stimulus is on and expected to stay on for some time to come despite private sector investment being strong and expected to stay strong. This is a very potent combination. Importantly though, this dynamic is well known and mostly priced into current valuations. The market is already looking forward to what happens next and assessing if the economy can eventually be weaned off its dependency on stimulus, quantitative easing, and low rates without massive dislocation. 

Source: JP Morgan

Global Equities

The S&P 500 was up 6% in Q1, with the Nasdaq posting a 3% gain, a rare lagging quarter for the tech and growth heavy index. Growth stocks were up 1% while value was up nearly 12%. The value outperformance was driven by COVID reopening and reflation optimism boosting energy, financials, industrials, materials, and real estate. There were some quality and worthy recipients of investor buying, but there were also speculative, unprofitable, and low-quality companies that rose significantly. We are participating in some of these tactical rotations but retain a quality discipline in our portfolios and are not chasing many of the lower quality names that are rallying. 
 
Despite the optimism growing in the US, the international news was not quite as good on virus control and vaccine rollout. As result, overseas markets unperformed the US and were up 3% in Q1. The longer-term expectation is that a synchronized global upswing should eventually help areas like Europe and Japan to rally due to the greater prevalence of cyclical and value stocks in those indexes than in the S&P 500. Emerging markets should also see greater participation but remain in a terrible COVID situation (Brazil being a tragic example).
 
Quarterly earnings season is getting underway. Earnings quality will be closely watched, as always, but will be particularly difficult to decipher since the comparisons versus a year ago will be extremely distorted from the beginnings of the global lockdown in March of last year. These numerical anomalies (known as “base effects”) will continue to challenge analysts to decipher for the rest of the year.
 
In many sectors, supply chain bottlenecks, materials shortages and growing demand have drawn down inventories to extremely low levels:


Source: Evercore ISI

One company’s need for inventory is another’s source of revenue and earnings. The rebuild of inventories will create robust economic activity, but the key question is: at what price and profit margin?  In other words, there will be revenue flowing, but the task is to identify which companies have the pricing power to sustain quality earnings. For example, as shown below, operating margins in the industrial sector are not back to where they were pre-pandemic due to commodity and input costs that have not yet been passed through to customers, if they can at all. 

Source: Strategas

The winners and losers from these dynamics should create opportunities for sector and stock picking. Our research focus remains on finding longer-term investments that ideally can be held and grow capital for multiple years. 
 

Fixed Income

Bonds were down for the first quarter, primarily due to US Treasury bond weakness as the market started pricing in the possibility of a surging economy spurring inflation that forces an end to the low interest rate environment sooner than expected.  The word of the moment is “transitory." The Federal Reserve continues to emphasize that though upcoming inflation reports will be noticeably higher from the base effects of last year’s weakness, the inflation is only transitory and therefore not overly worrisome. Bond investors are not as thoroughly convinced, considering the pent-up consumer demand and excess savings waiting to be unleashed once the country fully re-opens.

In Q1, long maturity US Treasury bonds were down 15% after being up 19% last year. Short and intermediate term bond benchmarks were impacted less with the Barclays Intermediate Government/Credit Index down 2% and the 1-10 Year Municipal Bond Index essentially unchanged. With economic optimism creating less demand for Treasury bonds and more willingness to take on credit risk, mortgage-backed securities, corporate bonds, and lower-rated debt outperformed as spreads tightened.  Performance of these credit sectors ranged from down 1% to up 1%, except emerging market debt which was down 5%.

Bond yields might look unexciting to most investors, but to many large institutions, particularly those international investors facing even lower home-country yields, US bonds start to get attractive a lot sooner than US domestic investors might realize.  These foreign buyers, along with other institutions rebalancing or liability matching, have been a buffer to how fast bond yields can rise (and prices fall) in the US. The rise in yields during Q1 brought many of these buyers back to the table.
 

Other Asset Classes

The Bloomberg broad commodities index was up 6% for the quarter on economic activity resuming. Oil was up 22% and copper was up 14%. The rising appetite for risk and the strong dollar took some demand away from gold, which was down 10%. We have been adding diversified commodity exposure to client portfolios to offset rising inflation risks and diversify beyond solely stocks and bonds. (Client portfolios in our Sustainable & Responsible Investing strategy have not participated in the commodities trade, but we are actively considering renewable energy and other opportunities for those strategies). 
 
In other assets, some of the market’s excess cash is flowing to unique areas outside of mainstream, large cap, liquid markets. Examples include Bitcoin, GameStop short squeezes, non-fungible tokens (NFTs), Special Purpose Acquisition Companies (SPACs) and more speculative venture or small/micro-cap opportunities. There are headline-grabbing successes in some of these areas, but on a risk-adjusted basis, the risk/reward profile is inconsistent with our approach and not as attractive in most cases.


Conclusion

Our team debates seek to balance a healthy respect for improving fundamentals, positive capital flows, and market technicals that are pushing stocks higher while also resisting the temptation to follow short-term trends that are less fundamentally sound and more volatile. Considering the mixed global outlook, especially in terms of uncertain policy and virus outcomes, we believe client portfolios are well positioned to participate in market upside in stocks and commodities while remaining liquid and diversified with bonds and cash to weather volatility. We are optimistic and rooting for a return to normal life as soon as possible.  We do expect good news will keep coming but must acknowledge that much of the good news is already expected by the market and may not lead to meaningfully higher prices once it arrives.