Stuck in the grip of the pandemic, the US economy, as measured by GDP (Gross Domestic Product), declined by 2.4% in 2020. Growth moderated in the fourth quarter following a rebound of 33.4% in the third quarter. The resurgence of the virus and the subsequent restrictions placed on economic activity caused the slowdown. Congress, fearing another recession, passed a second stimulus of $900 billion in late 2020 and a third one of $1.9 trillion dollars later in the first quarter. This stimulus, along with the rollout of vaccines, injected new life into the economy. By the end of the first quarter, the virus threat had waned and economic growth accelerated. GDP for the first quarter will not be known until later in April but some estimates have the economy expanding at a double-digit rate. Estimates for the second quarter are even more bullish as most of the stimulus will be felt then and a great majority of people will have received the vaccine. If Congress enacts the new Biden infrastructure plan – $2.3 trillion now and $2.0 trillion later – growth prospects for the year would be further enhanced. Chairman Powell of the Federal Reserve (Fed) stated last year “the pace of the economic activity depends on the course of the virus and the distribution, acceptance and effectiveness of the vaccines.” The virus is coming under control with vaccines that are highly effective and are being accepted. Due to the improving virus situation and the new stimulus funds, the Fed raised their estimate of growth for 2021 from a respectable 4.5% to a great 6.2%.
The economy is improving but the labor market is still feeling the effects of the virus. There are over 9 million fewer jobs now than before the pandemic. This is more job losses than were logged in the entire 2008-09 Great Recession. Every industry has been affected, some more than others. Restaurants, airlines and hotels have been devastated as have most other service businesses. The unemployment rate has declined from the recession high of 14.8% to 6.0%. While a dramatic improvement, it is still well above the prepandemic 3.5%. Fed Chairman Powell has “placed restoring a strong labor market” at the heart of the Fed’s agenda, noting that in addition to the unemployed, there are 4 million Americans that have stopped looking for work and are not counted as part of the labor force. Chairman Powell at a recent meeting stressed that the Fed wants to see a “substantial improvement in the job market and the economy before they reverse their low interest rate policy.” With Fed policy remaining accommodative and more and more people being vaccinated, the economy should continue to improve. Low interest rates and the availability of stimulus funds should result in more businesses and industries reopening and the unemployment rate declining further. The Fed estimates that the unemployment rate will decline to 4% by year-end.
There are inflation risks associated with excess stimulus and a lenient monetary policy. Since the pandemic began, Congress has enacted stimulus bills totaling $5.2 trillion and President Biden will be asking for another $4 trillion. The Fed also intends to leave policy accommodative until their goals of 3.5% unemployment and inflation above 2% are achieved, not just forecasted. This is a change from the past as they want to see some inflation before using policy to prevent it. Referring to their low interest rate policy, Chairman Powell recently said “our best view is that the effect on inflation will be neither particularly large nor persistent.” The Biden administration does not see the danger of piling on debt either. Treasury Secretary, Janet Yellen (and former Fed Chair) is not worried about inflation. Recently she said, “I don’t think that (inflation) is going to happen. We had 3.5% unemployment before the pandemic and there was no sign of inflation increasing.” She said further, as has Chairman Powell, if it becomes a problem “we have tools to address that.” While chances are that inflation will not be a problem for some time, as the employment picture improves and consumer spending is combined with business and aggressive government spending, it could become an issue.
Of course, no one seems concerned with adding to our national debt of over $28 trillion which is about 100% of our current GDP and on which we have to pay interest annually. Looking forward we are confident that 2021 will be a good year. The vaccine rollout will continue and the virus will become less of a burden. Growth will become less dependent on stimulus checks as businesses and industries reopen and jobs become available, adding strength and durability to the recovery. Consider getting vaccinated and remain positive.
I mentioned in this commentary last quarter about the stock market ending 2020 with a “Mic Drop” performance. It followed that up with a nice encore in the first quarter of 2021. However, the leadership for the market in 2021 is very different than we witnessed in 2020. More on that in a minute. Regardless, the year-over-year numbers in the table at the end of this commentary look video-game-like as we lap the lows from the pandemic last year. These “base effects,” to borrow a phrase from Fed Chairman Jay Powell, are going to make many comparisons eye-popping in the coming weeks and months. For example, on April 4, air travel in the US measured by TSA checkpoint pass-through was up 1,165% from a year earlier. Of course, a year earlier, we were all fighting to get toilet paper (not flying anywhere) – you get the point. As we move away from these extreme readings toward a more normalized economic and earnings backdrop, the question is, can the market momentum continue? Before we answer that, let’s review what happened in the first quarter of the New Year.
With the exception of a couple of pullbacks, one in late January and one in early March, the market was fairly one directional in the first quarter. This is despite the year starting with the storming of the Capitol in January, the GameStop craze later in the month, an Empire-State-Building-sized ship stuck in the Suez Canal and several high profile hedge fund blowups. Small-cap stocks again led the charge higher, rising 18.2% for the quarter, as measured by the S&P 600. Domestic large-cap stocks held their own, with the S&P 500 Index ending higher by 6.2%, including dividends. International stocks were positive for the period but relatively underperformed as the US dollar rose and China cracked down on technology companies. Developed International Markets gained 3.6% for the quarter (as measured by the EAFE Index). Emerging Markets (EM) fared slightly worse, rising just 2.2% for the quarter (using the MSCI Emerging Market Index). Putting the US and International markets together, the MSCI All-Country World Index (ACWI) rose 4.7% for the quarter and 55.4% for the past 12 months. A solid start to 2021 and an incredible twelve-month period.
While all eleven S&P 500 sectors were positive for the most recent three-month period, leadership was decidedly different from the full year 2020 results. Rather, sector performance continued a trend from the fourth quarter of last year, with the cyclical and “reopening trade,” in focus. Energy, Financials, Industrials and Materials were again the top four sectors during the quarter, rising between 9% and 31% for the period. Consumer Staples, Utilities, Healthcare and Consumer Discretionary were joined by an unlikely member in the bottom half of the sector performance, Technology. While these sectors were still positive, gaining between 1% and 3%, Technology finished as the second worst sector of the quarter. It stayed out of the “basement” only after a strong rally on the final day of March. This is an unusual place for this sector, especially over the past several years; however, we should not get too negative here. Over the trailing twelve months, it is still up 67%, handily outperforming the S&P 500 return of 56% over the same period. Real Estate and Communication Services were squeezed in the middle for the quarter, higher between 8% and 9%. All totaled, six of eleven sectors outperformed the broader market.
I asked the question last quarter in this commentary, how much of the good news about reopening and vaccinations are discounted in the market already? Clearly not all of it, given the performance so far in 2021. I believe the increased stimulus passed this year along with continued accommodative monetary policy and faster vaccine rollouts have contributed to the continued positive momentum in the market. So, what is the next catalyst? The upcoming earnings reporting season could be one, or perhaps the newly proposed infrastructure bill, part 1 and 2. Still, we have to be on the lookout for risks, including increasing virus cases abroad, rising interest rates and the possibility of a “growth hangover” in 2022. All things we have on the radar as we move through 2021.
Rates accelerated their move higher producing a very challenging quarter for fixed income performance. In fact, all three months to start the year were negative, producing the worst quarterly return for bonds in 5 years. While the Federal Reserve remains committed to keeping interest rates low, inflation expectations are rising and longer term rates are reflecting this concern. Even though the 2-Year Treasury Note ended the quarter at 0.16%, only 4 basis points higher than the beginning, the 10-Year Treasury Note vaulted 83 basis points higher to 1.74%. The quarterly total return for the 10-Year and 2- Year Treasuries were -7.10% and -0.03%, respectively. The spread difference between the 10-Year and 2-Year yields of 158 basis points is the widest since 2015. With the Democrats having won the majority in Congress, albeit a narrow one, from the results of the Georgia runoff elections, a more ambitious agenda requires a greater debt load. Continuing to find additional buyers of this debt will be a challenge. It is important to note that the 10-Year yield is comfortably above the dividend yield of the S&P 500 and this could bring some buyers back to bonds. We remain underweight duration overall, but look for opportunities to add exposure to longer-dated bonds with the move higher in rates.
Corporate bonds were relative outperformers for the quarter due to favorable credit conditions, but could not escape the drag of underlying yields. The total return of ICE BofA 1-10 Year Corporate Index was -2.06%. High-yield bonds continue to be the beneficiaries of the benign credit environment and investors’ desire for more yield. They produced a positive return for the quarter and outperformed investment grade bonds by over 300 basis points. With corporate bond spreads at historically narrow levels and absolute rates moving higher, individual bond selection will continue to be the most important aspect of portfolio performance. Issuers continued to take advantage of still low yields and narrow credit spreads. A few companies ended the quarter with very large deals pushing new supply nearly to the record of this time last year.
Municipal bonds performed well on a relative basis also. The Barclays 5-Year Municipal Index ended the quarterly period with a total return of – 0.31%. Municipal yields moved higher with Treasury yields, though the ratio of these yields is lower than the long-term average as investors continue to favor tax-exempt income. We are a long way from the passage of the administration’s ideas put forth for an infrastructure bill, but state and local governments appear to be beneficiaries. Additionally, municipal budgets were not as negatively affected as feared last year and property taxes associated with strong real estate markets have generated further optimism. Investor demand should continue to be strong with individual tax increases on the horizon.
|QTD 2021 Total Return1||YTD 2021 Total Return2||52 Week Total Return3|
|MSCI Emerging Markets||2.21%||2.21%||58.85%|
|Barclays Int. Gov’t/Credit||-1.86%||-1.96%||2.01%|
|Barclays Aggregate Bone||-3.37%||-3.37%||0.71%|
|Barclays 5-Year Municipal||-0.31%||-0.31%||5.07%|