Economic Market Update - May 6, 2021
History and Trends
Continuing the trend established in the final three quarters of 2020, stocks posted strong gains in the first quarter of 2021. The bellwether for U.S. stock returns, the S&P 500, finished the quarter up 6.17% on a total return basis, which puts the quarter in the top 25% of all Q1s dating back to 1926. For the trailing one-year period, the index was up 56.35% on a total return basis, the fourth-best four-quarter return in history. The only better four-quarter return periods all occurred in the 1930s as the nation recovered from the Great Depression, putting Q1 2021 at the top of the list for the post-WWII period. After such a strong period of equity market returns, the question naturally arises about whether the trend can continue.
Looking to past market history can provide helpful perspective. The second-best trailing four-quarter period since the end of WWII occurred from Q2 2009 to Q1 2010 as markets recovered from the Great Financial Crisis. The third-best occurred from Q3 1982 to Q2 1983. Each period represented the start of a long-term secular bull market for U.S. stocks that lasted for several more years. If history is any guide, the equity market rally off the COVID-induced lows still has more room to run.
In another continuation of the trend from 2020, small-cap stocks, as represented by the Russell 2000, outperformed their large-cap peers in Q1, with the index returning 12.70%. Adding in the returns from Q4 2020, small-cap stocks outperformed their large-cap peers over a two-quarter period by the most in the history of the Russell 2000 Index, which dates back to 1979. U.S. equity performance also continued to vary widely by style during Q1. The trend of secular growth outperformance was reversed, however. Beaten-down value stocks rebounded substantially on hopes of a broad economic reopening, leading value to outperform growth across all market cap tiers. The Russell 1000 Value Index, which is comprised of both large and mid-cap firms, returned 10.30% on a total return basis for the quarter vs. the 1.29% return of the Russell 1000 Growth Index.
Sector and Industry Performance
Performance also varied widely across sectors and industries; leadership in the first quarter of 2021 came from the sectors most beaten down during the depths of the COVID crisis. The S&P 500 Energy sector returned 29.27% in the first quarter, nearly doubling the return of its closest rival, S&P 500 Financials. Industrials, Materials, and Real Estate sectors all posted strong returns on the quarter as well. Information Technology, which significantly outperformed during the crisis, posted the second-lowest return on the quarter at 1.74%, besting only the Consumer Staples sector. To sum up Q1 2021 in U.S. equity markets in a sentence, COVID winners lagged and COVID losers led on optimism around the reopening of the economy.
Turning internationally, the first quarter of the year ushered in a broad-based rally in global equity markets, with all seven major MSCI geographic regions returning in excess of 3%. The MSCI EAFE Index of major developed international equity markets returned 7.59% in local currency terms, outperforming the MSCI U.S. Index for the first time in two years on a quarterly basis. U.S. markets outperformed in USD terms, however, as international fixed income market flows (the details of which will be discussed below) unexpectedly reversed pressure on the USD that had resulted in dollar weakness in 2020.
Due to these structural factors, we have moved to a more neutral stance on the U.S. dollar for 2021. The growth/value reversal was present internationally as well, with the MSCI EAFE Value Index returning 7.44% vs. the -0.57% return of the MSCI EAFE Growth Index in USD terms on the quarter. Emerging markets posted the lowest returns of any segment on the quarter, but were still up 3.96% in local currency terms to end March. Emerging market stock returns were less affected by U.S. dollar appreciation during the quarter because a significant number of emerging market central banks employ either an explicit hard peg to the U.S. dollar, or operate with an implicit soft USD peg. The MSCI EM Index returned 2.29% on the quarter in USD terms, exhibiting significantly less currency drag than in developed markets. The index was stung, however, by broad-based weakness across South American equity markets, a region where governments have struggled to contain the virus.
Summing up equity markets globally for the quarter, the MSCI ACWI Index, a proxy for the global stock market, returned 5.85% in local currency terms and 4.57% in USD terms.
Poor Performance for fixed income investors
In contrast to the broad-based strength seen by equity investors, the first quarter delivered historically poor returns for fixed income investors. The same forces that elevated stock markets around the globe also put upward pressure on risk-free interest rates, one of the fundamental drivers of bond prices across the fixed income universe. The pressure was particularly acute at the long end of the yield curve, where policy makers have fewer tools to control rate levels. The yield on the benchmark 10-year U.S. Treasury Note, which yielded 0.91% at the start of the year, closed March at 1.74% - an increase of 90.6%. The yield on the longer duration 30-year U.S. Treasury Bond rose from a starting level of 1.65% to hit an intra-quarter high of 2.45% in mid-March before pulling back slightly to finish the quarter at 2.41%, an increase of 46.6%. The quarter also saw an uptick in selling from international holders of U.S. Treasury debt, a phenomenon that put upward pressure on the U.S. dollar.
Bond prices move inversely to moves in interest rates; the upshot of this sharp move upward in rates was one of the worst quarters for fixed income investors on record. The Bloomberg Barclays U.S. Aggregate Bond Index, a broad measure of the performance of investment-grade fixed income markets in the U.S., lost -3.6%, the worst quarterly return since 1981. Long-term U.S. Treasury bonds, one of the few safe havens during the market turmoil that erupted in March of last year, went in the opposite direction in Q1, as the prospects for a swifter economic reopening brightened over the first three months of the year. Long-term Treasuries closed the quarter down -13.5%, the worst quarterly decline since 1980. Despite their higher coupon rates, which typically serve to reduce a bond’s interest-rate sensitivity, investment-grade corporate bonds offered no shelter from the fixed income storm. The Bloomberg Barclays U.S. Credit Index ended the quarter down -4.5%, the worst quarterly return for investment-grade corporate bonds since the depths of the Great Financial Crisis in 2008.
Positive Performers in fixed income sectors
International diversification was little help during the quarter, in large part due to the strength of the U.S. dollar. The Bloomberg Barclays Global Aggregate Bond Index, a proxy for the global investment-grade credit universe, lost -4.4% during the same period. This represented the second-worst quarterly return in the 30-year history of the index, second only to Q4 2016, when the expected path of U.S. trade policy under the “America First” agenda of the newly elected Trump administration resulted in a reset of the international interest rate environment.
Despite these historic losses in bellwether fixed income sectors, Q1 did have a few bright spots. Floating rate debt – securities that feature a quarterly interest rate reset based on the
prevailing interest rate environment – finished the quarter up 1.78%. U.S. high yield bonds fared far better than investment-grade securities, ending the quarter up 0.85%. Tax-free bonds also outperformed their taxable counterparts, bolstered by the fiscal policy support provided to state and local governments in the American Rescue Plan Act.
After such a poor quarter for fixed income returns, it bears remembering that a bad year for the bond market is similar to a bad day in the stock market. Fixed income investments continue to serve a valuable purpose in investment portfolios, acting as a ballast in times of market stress.
Inflations role in cycle length
The stage is set for a booming economy in 2021, and the risk is overwhelmingly to the upside. As such, inflation will be the key determinant of the length of the current cycle. The exogenous nature of the COVID crisis created substantial supply shocks in addition to artificial reductions in demand. These supply constraints were also initially artificial, the result of government mandates limiting economic activity. As economic activity has rebounded, however, the constraints are becoming increasingly tangible. These supply chain issues, recently exacerbated when the accidental grounding of the cargo ship Ever Given blocked traffic in the Suez Canal for six days, come just as the mountain of pent-up demand built up over the course of the COVID crisis is starting to be unleashed. High-frequency data from the first half of March suggest that the expected spending deluge may have already begun. Card spending data from that period is consistent with a 6.5% increase in consumer spending month over month; actual consumption growth for March is likely to come in even stronger, given that the cutoff date for the available data set occurred prior to distribution of the $1400 stimulus payments enacted by the American Rescue Plan.
Inflationary Pressure: Transitory or sustained?
Surging demand in the face of widespread supply constraints is a natural recipe for inflationary pressure. Higher inflation prints over the course of 2021 are virtually assured, especially in light of the base effect created by year-over-year comparisons to the depths of the crisis in March and April of last year. The overwhelming consensus expects above-target inflation prints in the months ahead – one would be hard-pressed to find even a single dissenting voice among experts. April, in particular, is expected to produce high year-over-year inflation readings since the trough in economic activity occurred in April 2020. The various models of estimated economic activity relative to the pre-COVID baseline indicate that current economic activity is 30-40 percentage points higher today than it was at the nadir.
The more important question is whether this inflationary pressure will be transitory, which is the Fed’s view, or more sustained. Our baseline view is in line with that of the Fed. Historically, two economic preconditions have been required for sustained inflationary pressure. First, the level of economic production has to exceed estimates of potential output. Actual output remains significantly below both the long-term average output gap and the current estimate of potential GDP. We will be monitoring this data point closely because we expect that the output gap will potentially be closed in the back half of the year, but this precondition is currently not met.
Second, the unemployment rate has to be below the estimate of the Non-Accelerating Inflation Rate of Unemployment (NAIRU). NAIRU does not have a precise level, but the current Federal Reserve estimate of NAIRU through 2030 is between 4% and 5%. Unemployment now stands at 6.0% after an extraordinarily strong March jobs report, so this precondition has not been met yet, either. We expect a robust labor market recovery in 2021, so we will be closely monitoring this data point as well. While our base case is that the higher inflation levels expected in the months ahead will be transitory, the risk of inflation is overwhelmingly skewed to the upside.
Shifting frameworks of monetary policy
Whether the expected near-term uptick in inflation is transitory or more lasting is crucial because of shifts in the monetary and fiscal policy frameworks. The Federal Reserve has explicitly stated that it will not preemptively tighten monetary policy in response to above-target inflation or labor market tightness, which was the prior framework baseline. Under the new framework announced last year, not only will the Fed hold off on tightening at the first sign of inflationary pressure, but it is also explicitly seeking above-target inflation for a period to compensate for the low inflationary levels of the past decade. In essence, the Fed is signaling that its objective during this recovery cycle is to run a high-pressure economy. The fiscal policy framework of the Biden administration is similarly accommodative, signaling that they hope to enact two additional fiscal support bills exceeding $2 trillion on top of the $5 trillion of support already flowing through the economy.
This impulse is driven by the post-GFC experience, and is rooted in the dual belief that far more policy support was initially required, and that policy makers erred by tightening their policy stance far too soon. In hindsight, few could argue with that position. But the evolution of an economic cycle is highly influenced by the prevailing financial conditions at the start of the recovery, and on that basis, the Great Financial Crisis and the current cycle look nothing alike.
During the Great Financial Crisis, fiscal policy began to tighten in 2010, when the economy still had not recovered to its pre-recession levels, inflation was anchored below 2%, and the broadest measures of unemployment, such as U-6, indicated that the jobless rate remained around 17%. When the Fed tightened monetary policy and set off the Taper Tantrum in December of 2013, the economy still had not recovered to its pre-recession path, inflation was 1.6%, and broad unemployment exceeded 13%. The combination of extraordinarily accommodative current and future policy impulses and the turbo-charged nature of the current recovery cycle increase the likelihood of a policy error, which has been the most frequent trigger for recessions over the past 100 years.
Possible paths for economic cycle from here
How the cycle evolves will have important implications for investment strategy. We see multiple potential paths from here, each with its own implications for portfolio positioning. The recovery will almost certainly play out across two stages. The first stage will determine if inflationary pressure is transitory or here to stay. If inflationary pressure is transitory, this cycle will be a repeat of recent history and have a longer duration. Under this scenario, the second stage of the cycle will not be a concern for investors in the near term. If inflationary pressure looks here to stay, however, then investors must concern themselves with the end game of what will likely be the shortest economic cycle in the past 40 years.
Path One: The “Goldilocks” Scenario
The most likely path represents the “Goldilocks” scenario, with the economy running neither too hot nor too cold. Growth optimism would remain elevated and expectations for the initiation of policy tightening would remain far off. Under this scenario, asset returns would mirror the pre-COVID environment, similar to calendar years 2017 and 2019. U.S. large-cap growth stocks would return to the leadership position. Emerging markets, particularly Asian manufacturing hubs, would see strong performance. Fixed income returns would be low, relative to equities, but would still be positive. Most assets would experience positive returns, and market volatility would continue to decline further from current levels. Should this be the case, this cycle will mirror recent history by having a longer duration, and investors need not concern themselves with additional stages of the cycle for the near future, as a lengthy expansion is likely. This represents our base case, which we estimate has a 70-80% chance of coming to fruition.
Path Two: Reflation Acceleration Ending with a Rate Shock
A second possible path would see an acceleration of the ongoing reflationary environment, meaning that the cycle would burn hotter, but would also likely be shorter. This path would be marked by a further increase in growth optimism from already elevated levels, but it would keep expectations on the timeframe for policy tightening off in the distance. Asset performance under this scenario would largely mirror that of the quarter just completed. Equity returns would be strong and broad-based, and cyclical value stocks would continue to lead.
International stocks would likely outperform on a local currency basis. Small-cap outperformance would continue. Commodities (ex-precious metals) would see continued price appreciation. Increasing growth expectations would flow through to interest rates in the form of increased expectations for future inflation, and in turn, fixed income would continue to be a drag on portfolio returns. Volatility levels would likely remain anchored. Should this be the scenario that plays out, investors will need to start thinking about an endgame that would likely involve a rate shock. An oft-repeated phrase in economics is that recessions don’t die of old age, but they are murdered by the Fed. This would represent that exact scenario, with the cycle ending much sooner via tightening monetary policy. Real yields would move significantly higher and start to act as a drag on economic growth. Should this occur, returns would be the polar opposite of the “Goldilocks” scenario and would look directionally similar to calendar year 2018, when cash was the only major asset class to post a positive return. Most assets would see negative returns; there would be little place to hide inside a traditional 60/40 portfolio aside from (possibly) short duration credit. At the margin, value would outperform growth, but returns would be ugly across the board. Emerging market assets would likely suffer the most as volatility would spike, hitting the riskiest asset classes the hardest.
The resulting downturn would likely be short-lived because policy makers would be able to reverse their mistake. We put the likelihood of this scenario playing out through both stages at 20%-29%.
Path Three: Reflation Acceleration Ending with a Growth Shock
The third possible path is also dependent on the same acceleration of reflation as discussed in Path Two, but the endgame would involve a growth shock, featuring a sharp decline in growth optimism. Monetary policy traditionally acts as a buffer in the midst of a growth shock, but with central banks the world over already pressing the monetary policy gas pedal to the metal, policy makers would have little remaining fuel available to offset fears over a deceleration of economic growth. Asset class returns under this scenario would largely resemble the return patterns of the COVID crisis itself. A growth shock would set off a massive spike in volatility, equities would experience a substantial drawdown, and commodity prices would crater. Cyclical and small-cap stocks would suffer the most. Bonds would outperform other asset classes, and long-term Treasury bonds would see significant appreciation. Other safe have assets such as gold, the U.S. dollar, the Swiss Franc, and the Japanese Yen would rally as well. This scenario is extremely unlikely given current conditions, but the remote possibility still exists (1%).
Joe Biden’s victory in the presidential election this past November was the catalyst for a reflation rally. A further acceleration in reflation expectations occurred in January, once Democrats sealed control of the Senate after run-off elections in Georgia, albeit with an extremely narrow margin. Should the current reflation rally persist, the risk of a transition to scenario three (a rate shock) or scenario four (a growth shock) increases. These risks increase as the duration of the reflation rally lengthens. Based on the initial financial conditions at the start of the recovery, the risk of a growth shock over the next 12-18 months is low – a growth shock would likely require an exogenous event. Should our base case not hold, and the reflation rally accelerates, the most likely evolution would be a transition to scenario three, a rate shock. Based on the March FOMC meeting, we expect that it will take sustained inflation levels of 2.2% or more to trigger a rate hike, but there is ambiguity about the length of the time period the Fed would consider “sustained.” The risk we are currently most concerned about is not runaway inflation, but that the Federal Reserve’s response to rising inflationary pressure is too costly.
The Taper Tantrum in 2013 and the market sell-off that occurred in Q4 2018 demonstrate the magnitude of the cost if monetary policy tightening is not well-received by market participants. The key metric to monitor that will signal that the risk of a rate shock is rising as the cycle evolves will be the U.S. breakeven inflation expectations curve. This curve is the difference between the yield on a nominal U.S. Treasury security and a U.S. Treasury Inflation- Protected security of the same maturity, and can be interpreted as the market’s expectations for inflation over the time period of the bond’s maturity dates. Currently, this curve is inverted, which indicates that the market is expecting that higher near-term inflationary pressure will be transitory. Should this curve flatten as a result of the longer end of the curve rising, it would imply that the market is starting to anticipate that higher inflationary pressure will be more sustained. If this scenario plays out, it will signal that a more defensive posture is warranted.
We remain committed, as always, to focusing on your long-term financial goals and priorities, and to constructing portfolios designed to reach those goals while minimizing risk. The volatility environment experienced over the past several years demonstrates the value of disciplined professional management.
Our clients’ interests always come first, and as the current recovery unfolds, we will continue to adjust our investment strategy and positioning to help you navigate the potential potholes that could lie ahead in what may be an accelerated cycle. Our goal is to continue to separate the signal from the noise and focus on what truly matters to the economy and markets to help you achieve your investment goals.