What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, was up more than 6% in Q1.
- The developed markets of Japan was up more than 9%.
- Europe was up about 8%, the U.K. up more than 5%.
- Emerging Markets were up about 2% and Asia (Ex-Japan) was up almost 3%.
- Global fixed income returns were mostly negative during the quarter barring the High Yield market seeing positive returns.
Where Do We Stand?
- The First quarter gave us the fourth consecutive quarter of positive equity returns.
- Valuations remain extremely stretched while growth now looks set to renew by the summer.
- Current cash levels are trending downwards as I continue to look for opportunities to invest.
- I continue to rebalance your accounts accordingly to ensure targets are within acceptable ranges.
Click here to listen to the Market Update for 1Q21!
The first quarter of 2021 was accented with rising bond yields and a shift in leadership for equity markets. As we mentioned in our February missive: “A nice test for the markets will be to see whether or not they can sustain in the face of higher yields. If markets falter significantly it will show us that that the recent rally in asset prices was more speculation-driven than fundamentally driven. However, if the markets can take a punch and keep on climbing (or at least not retreat) we may have the makings of a real recovery bull market.”
While yields did in fact rise, the equity markets barely registered a blip in their climb higher. The Ten-year yield started the year below 1%. By the end of the quarter it was sitting in the 1.7% range. Concurrently, the S&P 500 moved higher by about 6%.
The Positives
The drivers of these moves have been mostly positive. The Democratic victory in Georgia paved the way for more fiscal stimulus culminating in the recently passed American Rescue Plan. Furthermore, the continued success of the vaccine rollout across the developed world further bolstered the hope for a clean and quick recovery. Investors are clearly looking ahead to a sustainable recovery of economies around the world. However, there is still a significant chance for hiccups along the way.
One of these hiccups could come in the form of run-away inflation. The size of the US stimulus thus far has run well past $5 Trillion. Combine that with all the policy responses around the world and there is a lot of money flowing through the system right now.
Inflation
Too many dollars chasing too few goods leads to inflation. A reasonable level of inflation in a normally running economy is not a bad thing. The term “inflation” has a bad reputation due to the experiences of run-away inflation in the late 70’s / early 80’s. Many people alive today still remember that experience. The economy could not grow, unemployment was rampant and no one could afford to buy a car or a home because interest rates were pushing 20%. This led to the stock market losing 50% of it’s value and high numbers of personal bankruptcies. Many associate this era with long lines at gas stations due to OPEC oil pricing. Because of this, many blame OPEC for the inflationary disaster of the time but the reality is it was poor monetary policy that got us there.
Better Today
Today we are in a different place. Monetary policy has improved drastically since the 80’s and the likelihood of a full scale inflationary borne disaster is much diminished. Certainly, the scale of monetary and fiscal stimulus in the system could lead to inflationary pressures. Certainly, these pressures could lead the Federal Reserve to tighten monetary policy to a point that would effect equity markets. The Fed has clearly stated that they do not believe inflation will run above target for some time. In fact, their target now for potentially raising rates is not until 2024. I like what I hear but I’m not fully committed to taking their word for it. Inflation and interest rates can be finicky beasts, rearing their heads at the most inopportune times. This is something that bears watching.
Interest Rate Test
Another hiccup along the path to continued recovery is unexpected moves higher in interest rates. The market doesn’t like unexpected events. Whether these moves come from the market itself or the Federal Reserve could determine the severity of the hiccup. During the months of February and March the Ten-year Treasury bond yield moved up from about 1% to about 1.6%. This was all driven by the bond market itself as the Federal Reserve has remained within the same policy stance since March of 2020. In fact, at their March meeting the Fed kept rates at 0.00% – 0.25% and basically stated that inflation is not a concern. Wall Street disagreed and moved interest rates higher anyway.
The Bond Market is telling us that the recovery is underway and inflation is moving higher, for now. The concern here is that if inflation does indeed arrive and runs too high, the Federal Reserve will be behind the curve on containing it. They then would have to raise interest rates unexpectedly and that risks derailing the economic recovery. For now though, the market has shrugged off these concerns and passed it’s first “interest rate test”. The market is of the belief that monetary policy does not mimic the mistakes of the early 80’s.
The Sweet Spot
Between now and the time that inflation is a problem, the markets and economies are in a bit of a sweet spot. The companies that were most negatively effected by Covid have begun to recover but still have room to continue. At the same time, the companies that benefitted most from Covid have been underperforming but not terribly so. Even if Treasury Yields continue to move higher, I think this market can continue to recover. Albeit it will likely be at a slower pace than the previous 12 months and with likely higher levels of volatility.
If the vaccines remain effective against all variants of this virus, growth will likely boom a bit from here. Remember, we still have millions of fewer people working than we did when the pandemic started. Restrictions can continue to be lifted and people and families can begin to re-introduce themselves to our consumer economy. Travel will alight anew, restaurants will be full and all that pent-up demand for the things we have missed these past 12 months will come to light.
Around the Globe
While all positive, the rest of the world has had varying degrees of success in reopening their economies. The Eurozone has vaccinated about 11% of their populations but has seen a decent rebound in demand for goods. Cases there have seen an increase which could delay their recovery but it is heading in the right direction. Japan’s markets rebounded significantly even though only 1% of the population is vaccinated. In contrast to Europe though, Japanese cases of the virus have been few.
Manufacturing in the UK saw a strong expansion while the services sector there saw a very noticeable improvement. With 58% of their population vaccinated the UK saw much improved consumer confidence and signs that pent up demand was coming to fruition. This is likely the best indicator for what the US is about to experience. We are not far behind them with over 37% of our population vaccinated.
Lastly, Emerging Markets saw some struggles and China endured some small policy tightening initiatives. However, markets there remain attractive as we come out of the pandemic and the need for their labor and factories begins to come back.
The Magma Below
I would equate the economic environment right now to the seemingly increasing number of volcanoes around the world that have become active. Watched from afar, these eruptions have proven to be quite the spectacle. As we know, these events are preceded by years of pressure building up underground before the magma can escape. If all goes well, the volcano erupts, no one gets hurt and new land is formed. It’s all natural, and beautiful.
The global economy has been capped underground for more than a year now. The pressure has been building to reopen and the pent-up demand I have often spoken of has risen to the surface. Once the vaccination process is behind us (June?), I would expect the economy to flow again freely and the process of renewal to ensue. Let’s hope no one gets burned when that happens.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
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