Apr 06, 2021
As we pen this first quarter update amidst the comfort of markets residing around all-time highs, we can’t help from looking back at our Investment Update this same time one year ago. The extreme uncertainty of that moment still comes through in our commentary, as does the hope that the best and brightest in our scientific community would be our ultimate way out of the woods.
We have all learned a lot from the early days of the pandemic. A year later, the market’s resiliency to look through an economy in tatters still seems remarkable. We can also better comprehend the sheer might behind the powers of the Fed, Treasury, and Congress when they decide to go all-in. Though there is more work to be done, from today’s perch of a fully recovered equity market, we now have the visibility to expect the same from the underlying economy.
Key Investment Issues
- The growing optimism of the previous quarter carried through into the new year as signs of an abating pandemic, job growth, rising mobility (more people getting out of the home), and corporate profitability all became more visible.
- As confidence grew, so did investors’ tolerance for risk. A general rotation from growth stocks to value stocks continued in the first quarter, as did a shift from the largest dependable growth stocks to more speculative, unprofitable growth stocks. Additionally, there were pockets of craziness, highlighted by stock prices driven by social media chat rooms (GameStop), strong demand for newly listed companies yet to determine what business they were in (SPACs), and the stunning performance of bitcoin and numerous companies that have tied their fortunes to digital currencies. Some of the speculative outperformance had already unraveled by the end of the quarter.
- Absent for decades, this quarter saw the return of the “bond vigilante”. This is a reference to the bond market pushing back on Central Banks for monetary policy that is thought to be inflationary or irresponsible. Forcing bond rates higher, this becomes a form of monetary tightening that works to undermine the Fed’s efforts to promote economic growth. This led to the worst quarterly performance of the Treasury market (-4.6%) in over 40 years.
- The unified cooperation between Federal Chair Jerome Powell and the Treasury Secretary Janet Yellen has so far been to the equity market’s liking. The combined fiscal and monetary stimulus to the economy now represents approximately 25% of GDP. This compares to the 8% jolt over a longer period of time that followed the Great Financial Crisis. Additionally, the Fed’s willingness to tolerate inflation readings above their 2% target for an extended period of time is a new approach, designed to avoid the risk of tightening credit prematurely.
- Asset mix: We maintain a fully invested allocation to equity targets, given the magnitude of the existing and expected fiscal and monetary support. It is also timely to revisit policy guidelines with clients to consider rebalancing back to targets for risk control. While providing the intended safety, we expect fixed income will contribute little to portfolio returns unlike last year.
- Economy: Well-above-average growth should prevail over the next year, at least as economic and consumer activity approaches pre-pandemic conditions. Fed policy will become more challenging next year.
- Valuation: Stocks remain historically overvalued. Those at extreme valuations have been more vulnerable to multiple compression with the increase in bond yields. Much of the momentum trade that drove growth returns over the past several months has unwound.
- Equity Style: Value should continue to perform well as the economy reopens and the yield-curve steepens, but less at the expense of growth from here. It’s worth noting that the S&P 500 ended at new highs, while several of its largest components (Apple, Amazon, Tesla) were down in the quarter. Longer-term, a growth tilt should fare well when the need for government support runs its course, bringing secular growth stocks back in favor.
- Stocks: Mega-cap tech companies remain a core holding for our growth strategy, although we are underweight the benchmark. Semiconductors remain an industry overweight as the backbone for continued technological advancement. The Value and Yield-Focus overweight positioning in energy and financials is consistent with a stronger recovery and higher bond yields.
- One of the lessons the pandemic has ingrained on investors is that the economy is not the stock market. If that had not been clear before, it should be now. This may be just as relevant as investors now expect an extended stretch of economic prosperity. With the S&P 500 already selling at 22 times earnings, there may be more reason to be confident about economic growth than continued strong equity returns, as odd as that might seem.
- In support of higher stock prices, corporate earnings have been rising at an increasing rate, prompting further upgrades from analysts. Another revelation of the past year was how well corporate America could perform under pandemic, lockdown conditions. Understandably, there was no precedent to know this. While personal consumption patterns are likely to change (shifting demand back to services from goods) corporations will likely ramp up their investment in equipment and technology to become even more productive. That should bode well for continued earnings growth.
- The rally in value/cyclical stocks has been swift. This initial move was led by the most beaten down companies. Eventually, these shifts typically move from the cheapest, lowest quality names to stocks that look attractive based on stronger fundamentals like free cash flow. This is a key component in our quantitative work and should position us well for the continued strength in value investments.
- A major issue the markets will be focused on is the proposed $2 trillion “infrastructure and jobs” plan and the accompanying tax increases. So far, the markets do not seem to be troubled by the tax component. At this very early stage, we will await further analysis before commenting on the longer-term investment implications.