Q1 2021 Market Perspective
The equity markets have staged a historic recovery over the past twelve months, fueled by expectations for a swift economic rebound from the COVID-19 induced recession. However, it has been far more difficult for individual investors to gain confidence in the market recovery at hand. Sensing a disconnect between market appreciation and the current state of the economy, investors have been hesitant to leave behind an overwhelming feeling of skepticism. We bring this up because it is important we address and understand the behavioral life-cycle an investor experiences and reiterate the need to remove emotional biases from our decision-making process. With the equity markets near all-time highs, investors have slowly become more optimistic.
What are the next stages of emotions and what should we be prepared for? Generally speaking, optimism is a good thing. As it relates to current day, investors are optimistic that a meaningful economic recovery is underway and that the worst of the pandemic is now behind us. Investors are comfortable taking risk, believing that accommodative policies will continue to be a positive catalyst for stocks. When optimism reaches its peak, however, it is referred to as euphoria. Euphoria is an investor emotion that often leads to excessive risk taking, as confidence in the markets goes unchecked. This behavior is viewed as the peak of the investor behavioral life-cycle and often precedes the reality check that markets don’t always go straight up.
As you know, one of the key tenets of Altium’s investment philosophy is to remove emotional biases from our decision-making process. We are not overly concerned that investors today are increasingly optimistic, yet we are mindful of euphoria. Similar to our resounding call to stay committed to your plan during the lows of the emotional cycle last year, we reiterate the same message today. We continue to recommend that long-term investors adhere to their investment policy and avoid any desire to engage in market timing based on emotions, regardless if it’s the result of extreme fear or optimism.
2021 First Quarter Market Highlights
· Index returns:
Major Asset Class Returns in Q1 2021
*Source: 2021 Total Return as of 3/31/21, Bloomberg; See Chart A in Appendix
· Thus far in 2021, the S&P 500 index has continued its impressive rally off last year’s lows. Investors remain optimistic that economic growth will exceed expectations, driven mainly by the vaccine distribution and additional fiscal stimulus. After struggling to keep pace in 2020, small and mid-cap U.S. stocks significantly outperformed the large cap segment during the quarter.
· International and emerging market stocks also recorded positive gains in the quarter. While these global assets have underperformed U.S. stocks, historically, this is not always the case. Thus, with more favorable stock price valuations and prospects for economic recovery that will lag the U.S. cycle, we continue to favor owning global stocks as part of a well-diversified portfolio.
· Fixed income assets mostly fell on the heels of higher interest rates, yet high quality bonds (such as US Treasury Bonds) continue to offer diversification benefits when added to stock portfolios based on historically negative correlation (meaning the two asset classes tend to have price movements in opposite directions, as they did in the first quarter).
What Investors Are Monitoring
The Rate of Economic Expansion
The outlook for U.S. annual GDP growth in 2021 has improved over the past few months. When we last wrote in January, the Federal Reserve’s median projection for real GDP growth in 2021 was 4.2%. Now it is at 6.5%. We stated at the time that additional stimulus along with a quicker reopening of the economy would lead to GDP growth outpacing expectations. It will be a few months, however, before we have a good read on the pace of GDP growth for the first half of 2021.
A key driver of GDP growth is employment. The unemployment rate has been hovering near 6% over the past few months, which the Fed now sees trending down toward 4 or 5% later this year. One possible (and favorable) explanation for why the unemployment rate has stayed flat is that more individuals have re-entered the labor force, in turn offsetting what would have otherwise shown a reduction in the number of unemployed workers.
The world is still trying to recover from COVID-19 and rebuild for the future. Vaccine distribution is well underway and people are slowly resuming normal activities. We understand that there is a long road ahead us, but signs continue to show that we are moving in the right direction.
The Movement of Interest Rates
The accommodative positioning by the Fed is not a new story. The Fed funds targeted interest rate remains near 0% and the Fed has announced that it expects to maintain short-term rates at these levels for as long as it takes to complete the recovery. Investors will, however, continue to keep a close eye on the movement of longer-term rates. A quick spike in rates earlier this year resulted in unexpected market volatility during the quarter. Rates seem to have stabilized here in the near-term and we believe the most important factor now is the rate at which interest rates do go up (when they do go up).
We could argue that inflation is much greater than the current inflation rate suggests (i.e. increasing prices in the housing market and stock market), yet the Fed’s measure of inflation remains within their target range. Inflation will remain a key theme for the market as an unexpectedly hot inflationary environment would bring volatility to the markets. Anticipated volatility is accounted for in our portfolio design process and in the creation of your investment policy statement.
At the time of this letter (late April), we are partially into the Q1 earnings reporting season. The question for the market has been: will corporate earnings grow at a level great enough to bring stock price valuations down towards more normalized levels? Currently, earnings have outpaced expectations at historically high levels, which has helped ease some valuation concerns. Again, it is early in the Q1 reporting period and it will become increasingly difficult to significantly beat expectations later in the year as earnings estimates go up following these strong Q1 results.
Paying for the tremendous amount of approved stimulus and the proposed Infrastructure package will most certainly come with increased corporate and personal taxes. However, one thing we know about the market is that it handles clarity much better than uncertainty. Biden’s platform has always included a tax overhaul so this is not a surprise to the market. Tax law changes should be discussed with your advisors.
Altium’s Expanded Views of the Fixed Income Landscape
The biggest story of the first quarter was the selloff in Treasury bonds, which had their worst quarter in years. We began the year with the yield on the 10-year Treasury bond at .90% and ended the quarter at 1.70%. While the absolute level of rates is still low, the size of the move was historic and many watching the markets wondered whether Fed Chair Jerome Powell and the Federal Reserve might be forced to change their accommodative policies. The result was losses across most bond categories (as yields rise, bond prices fall). The iShares 20+ Year Treasury bond ETF (a good proxy for long dated government bonds) was down -13.90% in the quarter. The Bloomberg Barclays US Aggregate Bond Index, a broader measure of bond performance, was down -3.37% and Investment Grade Corporate bonds were down -4.64%. Municipal bonds outperformed on a relative basis as investors sought the tax-free benefits of muni’s ahead of potential tax increases, but the Bloomberg Barclays US Municipal Bond index was still down -.35% for Q1.
As stated earlier, we have seen an unprecedented improvement in optimism about the economy during the quarter. This optimism, and concerns about inflation, caused the market to pull forward its expectations for when the Fed would raise interest rates. This led to the sell-off in Treasury bonds and increased volatility in the equity markets.
As we write this communication in late April, the markets have stabilized. The yield on the 10-year government bond is near 1.56%, and the equity markets are back near all-time highs. In the Fed’s most recent comments, forecasts show officials do not expect to raise interest rates before the end of 2023 even as they upgraded projections for growth and employment this year. They played down the risk that inflation could get out of control as the pandemic recedes and believe any price increases will be temporary.
We believe the purpose of holding bonds in your portfolio is to generate income and provide capital preservation. We continue to manage the duration and credit quality while adding floating rate structures, where appropriate, that should perform well if we see another spike in interest rates.
There are many reasons to remain optimistic about the equity markets today, namely the economic recovery that is underway and the aggressive accommodative policy that is expected to remain in place. As always, we caution investors from making financial decisions that are based on emotions, even when the feeling is rooted in optimism. We are mindful of euphoria, as this behavior may tempt investors to make emotional decisions that deviate from the rules of their investment policy. While the broad market indices have appreciated at a relatively steady rate over the past twelve months, there has been a great deal of volatility within the asset classes, market sectors and specifically individual stocks. We expect this to continue.
Volatility is always a present risk when investing in the equity markets. Market corrections are normal and to be expected (even in years of positive returns; see chart B in Appendix). We plan for this risk by setting your investment strategy rules within the construct of your specific investment policy statement. Thus, we are always prepared to act, without emotion, to any changes within your financial situation or to take advantage of any portfolio-based opportunities that present themselves (i.e. portfolio rebalancing and tax loss harvesting).
Gregory Slater, CFA, CFP®, CIPM®
Chief Investment Officer
Chart A: 2021 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2021 Total Return, International, Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes
Chart B: S&P 500 Index Positive Years since 1928 with Annual Drawdown
Source: Bloomberg; S&P 500 Index Historical Returns & Drawdowns
1 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
2 - https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20201216.htm
3 - https://tradingeconomics.com/united-states/unemployment-rate
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