April 2021
Market Recap
Global stock markets celebrated the one-year anniversary of the pandemic-induced bear market low (March 23, 2020) with another strong quarter of
returns. The S&P 500 Index gained 6.2%, developed international stocks rose 3.5%, and emerging-market (EM) stocks gained 2.3%.
From the low on March 23, 2020, these benchmarks are up an astonishing 80.6%, 74.8%, and 74.6%, respectively. In fact, the S&P 500’s one-year return
from the low was its best since 1936. Clearly, it paid not to panic and get out of the markets last spring, despite the natural fear, anxiety, and uncertainty
everyone was feeling at the time.
The first quarter also saw a continuation of the “reflation rotation” trend that has been happening beneath the market surface over the past several
months. Specifically, smaller-company stocks have trounced large caps, with the Russell 2000 Index gaining another 12.7% in the first quarter. And
value stocks maintained their new-found edge overgrowth stocks: The Russell 1000 Value Index returned 11.4% versus 1.1% for its large-cap growth index
counterpart.
Looking at it from another perspective, cyclical (meaning more economically sensitive) stocks were the strongest performers. Energy and financials were
the top-performing sectors in the S&P 500, gaining 30.9% and 16.0%, respectively. In contrast, utilities, consumer staples, and health care—considered
“defensive” sectors—were among the worst, registering just slightly positive returns. The technology sector was also one of the bottom performers for the quarter.
As we will discuss in detail below, the reflationary winds tore through the fixed-income markets as well. The benchmark 10-year Treasury yield jumped nearly 75 basis points from year-end to close the quarter at 1.74%, a 14-month high. Correspondingly, the core bond index lost 3.4% for the quarter. This is its worst quarterly performance since 1981 and the fourth-worst return in the index’s history back to 1976. Core municipal bonds did better with a loss of 0.3% for the quarter.
On the flipside, floating-rate loans, which benefit from reflation, gained 1.8%. The high-yield bond index was up 0.9% for the quarter, while its yield dropped below 4% for the first time ever in February.
Finally, to the surprise of many in light of the reflationary/inflationary market mood, gold had a rough quarter, declining 10%. This is actually not that surprising in hindsight though, as the price of gold tends to be inversely correlated with real (inflation-adjusted) interest rates. Along with nominal bond yields, real yields also rose in the first quarter, with the 10-year TIPS yield increasing roughly 40 basis points from negative 1.0% to negative 0.6%. The U.S. dollar, which is also typically inversely correlated with the price of gold, halted its multi-month decline and posted a roughly 3% gain for the quarter.
First Quarter Portfolio Performance & Key Performance Drivers
The broad reflationary market trends in the first quarter had a positive impact on our portfolios’ performance. Our additions to high yield and actively managed, flexible fixed-income strategies added meaningful excess positive returns over the past 12-months. Our positions in alternative strategies also outperformed core bonds by a wide margin. On the equity side, our overweight to EM stocks relative to U.S. stocks was slightly negative, as EM’s recent run of outperformance reversed late in the quarter. Our active EM fund managers in aggregate trailed the broad EM index. Our U.S. equity active manager performance was mixed relative to the market index, with some managers outperforming and others trailing for the quarter. As expected, most of our more value-oriented managers strongly outperformed.
The Macro Backdrop
Once again, we find it most useful to frame our discussion of the macroeconomic backdrop around the two key variables we have focused on since the COVID-19 pandemic began a year ago:
•The virus spread and severity; and
•The monetary and fiscal policy response
Both variables currently imply a positive base-case outlook for a strong economic recovery in the United States this year. Looking further out, absent a COVID-19 resurgence or a negative geopolitical shock, the recovery is likely to continue for several years as a positive self-reinforcing economic cycle kicks in. A policy mistake (for example, premature monetary policy tightening or a policy-induced inflationary spiral) is a very low near-term risk but is at meaningful risk of triggering a recession in longer of our five-year time horizons.
COVID-19 Spread & Severity
Substantial progress on vaccines is reason for cautious optimism. Over the past two months, the United States has seen very sharp declines in daily new cases, current hospitalizations, and daily new deaths from COVID-19. Meanwhile, the rate of COVID-19 vaccinations has soared to 2.8 million per day; more than 93 million Americans (nearly 30% of the population) have now received at least one dose, including 51 million who have been fully vaccinated. At the current pace, experts estimate the United States could achieve herd immunity by late summer.
From an economic perspective, getting the pandemic under control will enable increased activity, employment, household income, consumer spending, economic growth, and corporate earnings.
Clearly, we are not out of the woods yet. There is increasing risk from the spread of new, more infectious variants, as is happening in several European countries leading to renewed lockdowns and fears of something similar playing out (with a lag) here. The United States could reopen local economies and/or relax social distancing and public health restrictions too quickly, leading to another virus surge. But overall, the light at the end of the pandemic tunnel certainly appears to be getting brighter (to use everyone’s favorite cliché).
Monetary & Fiscal Policy: Full Speed Ahead
U.S. monetary and fiscal policy are both highly supportive of an economic recovery.
After the March FOMC meeting, Fed chair Jerome Powell summed up the Fed’s current stance as follows: “The economy is a long way from our employment and inflation goals, and it is likely to take some time for substantial further progress to be achieved. We will continue to provide the economy the support that it needs for as long as it takes.”
As such, the Fed kept its policy interest rate (the federal funds rate) unchanged at near-zero percent and gave no indication it is planning a reduction (or tapering) any time soon in its $120 billion per month quantitative easing (QE) asset purchase program. Moreover, the median FOMC member (11 out of 18 members) still does not expect the Fed to even start raising rates until at least 2024.
This is despite the Fed sharply increasing its median forecast for 2021 U.S. GDP growth to 6.5%—driven by the accelerating vaccine rollout, declining virus spread, and the passage of the $1.9 trillion American Rescue Plan (ARP) in March. In contrast, at the Fed’s December FOMC meeting three months ago, its median 2021 GDP growth forecast was 4.2%.
The Fed’s latest forecast of the year-end unemployment rate dropped to 4.5%, compared to their prior forecast of 5.0%. (The headline unemployment rate currently stands at 6.0%.) Finally, the Fed increased its forecast of core inflation to 2.2% for 2021, from 1.8% previously. (Core PCE inflation is currently running at 1.4% year over year.)
The chart below shows the Fed’s current and prior economic and fed funds rate forecasts as well as its long-run “equilibrium” estimate for each variable. Note
that after the upsurge in 2021, its forecasts for GDP growth and inflation drop back in line with its prior forecasts. We will discuss the inflation outlook and inflation risk in
a separate section below.
Moving to fiscal policy, the big news was the passage of the $1.9 trillion American Rescue Plan Act (ARP), equivalent to roughly 9% of U.S. GDP. While most observers
expected the Biden administration to enact a large fiscal package, many were surprised Congress passed the full $1.9 trillion initially proposed. Adding in the prior two pandemic-relief fiscal packages passed in March and December 2020, the total fiscal stimulus equates to more than 25% of GDP. This is a huge number and roughly five times the fiscal response during the 2008 Great Financial Crisis. It also contributed last year to the largest federal budget deficit since World War II, at 15% of GDP. The 2021 budget deficit is projected to be the second-largest, at 10% of GDP.
Not all of the $1.9 trillion will be immediately spent; a meaningful portion of it will go into household savings and to pay down debt. According to Oxford Economics,
Americans have accumulated $1.8 trillion in excess savings in the 11 months since the start of the pandemic. Oxford estimates this could rise to $2.5 trillion by this
summer. That’s a lot of potential pent-up spending—more than 10% of GDP.
But the ARP should still produce a big short-term boost to GDP growth—and economists (as well as the Fed) have been revising up their 2021 forecasts accordingly.
However, the effect on GDP growth will be temporary as the relief programs are set to expire later this year. Without additional stimulus, the positive fiscal growth impulse
this year will turn into a fiscal drag next year—what some are calling a “fiscal cliff.”
But if the Fed and Wall Street consensus GDP forecasts are at all in the ballpark, the U.S.economy in 2021 will generate its strongest real GDP growth in 37 years.
What About Inflation?
Before turning to our outlook for the financial markets, we’d like to spend a bit more time on what we view as the key economic risk over the next several years: inflation.
Apparently, we are not alone in our focus on this topic (see the chart below, web searches for inflation have spiked).
Part of us would be satisfied summing up the debate on inflation with the words of the great investor Howard Marks, who recently wrote, “Is inflation a threat anytime soon? The answer’s clear: who knows?”
The primary catalyst for the recent sharp uptick in inflation fears is the combination of the positive macro factors we discussed above: (1) the expected reopening of the economy as the pandemic is brought under control, (2) ongoing highly accommodative monetary policy, and (3) unprecedented fiscal stimulus/support and the prospect for more to come from the new administration and Congress.
Market-based measures of short- to medium-term inflation expectations have shot up since year-end. For example, as shown in the chart below, the five-year “breakeven inflation rate” (the difference between the five-year nominal Treasury yield and the five-year inflation-protected Treasury, or TIPS, yield) hit a 13-year high recently, at just above 2.5%. The 10-year inflation breakeven is around 2.3%, a seven-year high.
In the next few months, the headline inflation rate will spike higher (likely into the 3%-plus range). This will be due to a combination of the flow-through from recent commodity price inflation, temporary supply-chain bottlenecks, and most significantly, so-called base effects—meaning the year-over-year inflation calculation based off the temporarily depressed price levels during the early months of the pandemic. As the months roll on, the base effects from a year earlier will roll-off.
But expert opinions diverge as to whether this is likely the beginning of a sharp and sustained rise in inflation, potentially on the order of what the economy experienced in the stagflationary 1970s, or just a temporary blip before it settles back to around 2% or lower.
We continue to think the weight of the evidence leaning toward a low likelihood of a major sustained rise in the inflation rate, at least for the next few years. The two key reasons behind our learning are: (1) the economy still has tremendous slack—in terms of the gap between current and potential GDP and to reach maximum employment; and (2) the pandemic-related fiscal stimulus is temporary. Structural disinflationary forces also remain, such as demographic trends and technology, automation, and digitalization adoption, with the latter accelerating during the pandemic.
While GDP growth should sharply rebound this year, it is likely to take at least a few years to close the labor market gap. The economy is still roughly 8.4 million jobs below where it was in February 2020. Accounting for the natural growth in the labor force since then puts it even farther behind the full-employment curve.
Moreover, even at the February 2020 unemployment rate low of 3.5%, core PCE inflation was only 1.8%—still below the Fed’s 2% target. So the economy was probably not yet at maximum employment even then. This is an important part of the reason the Fed says it is no longer going to rely on unemployment-driven inflation forecasts and preemptively tightening monetary policy.
As long as there is still slack in the labor market, a sharp rise in broad wage inflation is not a high risk. And wage inflation is necessary for an inflationary spiral to take hold: a wage-price spiral where workers demand higher wages in response to rising prices, and businesses then raise prices further in response to rising labor and input costs, leading to higher inflation and increasing wage demands, etc.
Portfolio Positioning
Moving from the macro to the markets, how does our current economic view impact our financial market and asset class outlooks and portfolio positioning?
On balance, we have a positive shorter-term view on higher-risk assets, consistent with the supportive macro and policy backdrop. In fixed income markets, valuations have returned to pre-pandemic levels in most sectors, and we think high yield and emerging markets bonds should perform well in a reflationary environment.
First, we’ll highlight the keys to a successful Second Quarter: stable interest rates, broad gains in corporate earnings, and vaccine progress.
Interest Rates
Recent spikes in bond yields incited mini “taper tantrums” in stocks, moderate versions of the 2013 market retreat when yields soared after the Fed hinted at a pullback in easy policy. Stocks may continue to react to rate moves, as low yields on bonds are a key contributing factor to the relative attractiveness of equities. Rising rates can undermine support for equity valuations.
Importantly, however, today’s Fed is not contemplating near-term tightening, as it was in 2013, and interest rates are still very low on a historical basis. While future rate-related panics are likely, we expect rates to remain low for some time as central banks globally look to maintain support and see economies to full recovery. Ultimately, rates may only return to the average seen following the 2008 Great Financial Crisis, as we see no real structural changes in the economy that would suggest a growth trajectory far different from where we began.
Earnings
Fourth-quarter earnings strongly beat consensus analyst estimates as well as what was mostly conservative company guidance. We generally see the pattern continuing this year. Though that should be good for the stock market broadly, we don’t expect real clarity on the earnings picture until the third- or fourth-quarter earnings seasons.
Economically sensitive sectors and stocks have the most potential to surprise to the upside, easily beating dismal prior year earnings. Growth companies that excelled in 2020 will find it much harder to exceed prior-year levels.
Many of the so-called stable sectors that did well in 2020 have poorer earnings momentum. Mega-cap technology stocks, long bastions of stability, also bore the brunt of the recent rates-related pain. Because these large tech stocks are long duration in their cash flow and growth prospects, they reap the greatest benefits from low rates and, in turn, have gotten hurt most as rates normalize upward.
We give cyclical stocks and reopening plays, in general, the advantage for the moment, while remaining watchful for signs of a cycle transition as the recovery moves forward potentially returning the upper hand to growers.
Vaccine progress
Markets are priced for positive vaccine news, and while positivity is our base case, any disappointments in vaccine supply, distribution, or adoption – or increased risk from virus variants – could stoke volatility.
The Biden administration has indicated the U.S. will have enough vaccines for all adults by the end of May. Efficacy data shows the current vaccines are effective in preventing severe disease and hospitalizations, which is what is needed for economic re-opening. The variants are perhaps the biggest risk to the restart, yet clinical data has shown current vaccines demonstrate sufficient efficacy against the known mutations – enough to provide immunity and alleviate hospitalizations.
In addition, the technology used to make the vaccines means formulas can be quickly adapted. The major vaccine makers are ready with boosters once initial doses are administered. All of this gives us confidence that vaccination programs will continue to do the hard work of combatting the virus and facilitating economic and market recoveries.
Portfolio Summary
In terms of our overall risk exposure in our balanced portfolios, we are positioned slightly on the aggressive side of neutral, due to our modest overweight to equities. However, within our risk asset exposure, we have a bias toward reflationary assets: We favor EM stocks and prefer smaller to larger U.S. stocks, and high yield and flexible active bond strategies over core bonds. We also see value in high-yield municipals.
Closing Thoughts
We don’t see a high likelihood of an imminent market paradigm shift. But we are alert to it and see the odds increasing as time goes on. As such, our fixed-income exposure and overall equity-risk management are more diversified than simply owning core bonds.
As we’ve described in prior commentaries, what has worked so well for the past 10, 20, 30, 40 years—a simple 60%/40% U.S. stocks/core bonds balanced model—won’t work nearly as well over the next five to 10 years, even without an upsurge in inflation. We are already accounting for this in our portfolio positioning. As the macroeconomic regime evolves, we will tactically, but prudently, adapt and adjust our portfolio exposures based on our assessment of the risks and potential returns.
In the meantime, we believe the most likely scenario over the next year at least is a reflationary one, enabling solid to strong returns (mid to upper single or low double digits) from global equities—favoring smaller U.S. companies and emerging market stocks—and decent to solid returns from credit-oriented fixed-income strategies that should handily outperform core bonds given their yield advantage and active management flexibility. We also expect our diversifying and lower-risk alternative strategies funds to outperform core bonds.
We believe our portfolios are well-positioned for further gains this year as the U.S. and global economy continue to recover. We expect many of the asset markets and market sectors that have been laggards over the past five to 10 years to continue to rebound as part of the broad reflation rotation described above. Related, we believe this environment also offers excellent opportunities for active management across both equities and fixed income to add value relative to core market indexes.
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