Bank of Blue Valley
Quarterly Market Review Q1 2021

Quarterly Market Review: Q1 2021

A New Roaring Twenties?

Maybe, but for how long?

Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer

The Roaring Twenties of a century ago share so many parallels to today that it seems an impossible coincidence. The events may not align quite right on the calendar, but just as then we are now exiting a global pandemic that depressed economic activity and had people arguing over the wearing of masks.

Troops were returning from conflict abroad. New, cleaner modes of transportation (internal combustion cars then, electric vehicles now) were rapidly replacing dirtier technology (horses, cars) at an exponential rate.

Other advances in technology, especially in communication, entertainment, and conveyance propel economic activity in both eras. Unemployment fell and labor union participation declined. The concentration of wealth today is akin to that of the 1920s, each reflecting the two highest peaks on a chart. This is partially due to the extraordinary rise in equity markets which amplifies the wealth of those who invest over those who lack the means to do so.

Anti Mask League

Quarterly Market Review: Q1 2021

A New Roaring Twenties?

Maybe, but for how long?

Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer

The Roaring Twenties of a century ago share so many parallels to today that it seems an impossible coincidence. The events may not align quite right on the calendar, but just as then we are now exiting a global pandemic that depressed economic activity and had people arguing over the wearing of masks.

Anti Mask League

Troops were returning from conflict abroad. New, cleaner modes of transportation (internal combustion cars then, electric vehicles now) were rapidly replacing dirtier technology (horses, cars) at an exponential rate.

Other advances in technology, especially in communication, entertainment, and conveyance propel economic activity in both eras. Unemployment fell and labor union participation declined. The concentration of wealth today is akin to that of the 1920s, each reflecting the two highest peaks on a chart. This is partially due to the extraordinary rise in equity markets which amplifies the wealth of those who invest over those who lack the means to do so.
 

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In hindsight, the rise in equity markets in the 1920s became a mania and a bubble that burst. This is not to say that we are facing anything akin to that even if valuations are nearing peak levels by some measures in some markets. There is an apparent mania for cryptocurrency that may or may not evolve into something worthwhile, but when your recently immigrated barber talks to you about Bitcoin, one is reminded of J.P. Morgan’s shoeshine boy and his stock tips.

Now, About That Roar

That the economy is recovering strongly from the pandemic and concomitant shutdown is obvious from the data. Economic growth in the first quarter (in advance of any revisions) was 6.4% and market expectations are that for the year we are likely to see an expansion about the same rate. This would make 2021 the best year for GDP growth since 1984.

Some of the growth is a return towards trend following the recession, but much is also due to fiscal and monetary stimulus that succeeded in cushioning the blow from the pandemic but has continued to excite economic activity well into the recovery. Low interest rates have translated into a burst of housing-related activity and checks sent out from the US Treasury have helped to both maintain consumption and increase personal savings – a transitory impact likely to support consumption levels in the future.

What remains uncertain is the future path of the current extraordinary stimulus. As far as the Federal Reserve has indicated, monetary policy may well remain accommodative for an extended period. Fed officials have stated that they believe that recent increases in inflation are transitory and will normalize over the coming months. That part of the recent rise in the CPI to 2.6% y/y reflects a base effect from last year as well as temporary supply shortages from Covid-related shut downs. The argument is that this is a replay of inflation dynamics in 2010-2011 following the Great Recession and related stimulus efforts at that time.

US Home Sales
US Inflation

Regardless, should inflation run slightly higher than it has in recent years, the Fed has stated that some of that would be welcome under their relatively new policy of targeting a symmetrical range for inflation around the 2% long term annual target. In their most recently released “Dot Plot” forecast for when the Fed might raise rates, the average estimate is not until the end of 2023. And in terms of their continued monthly purchase of $120 billion in US Treasury and Mortgage Securities, there has been no signal that they are ready to taper those purchases. The implication of all this continued easy money policy should be supportive of higher growth and more robust markets even if there are risks of overheating.

In terms of the Federal Government’s stimulus program, the Administration has proposed following up on the already passed $1.9 trillion American Rescue Plan with a $2.3 trillion American Jobs Plan focused on infrastructure projects and a $1.8 trillion American Families Plan aimed at assistance for lower income families and to reduce child poverty. The two newer plans are a combination of direct spending by the Federal Government along with significant tax credits and would roll out over 10 years. The proposed taxes that would be used to cover the costs are directed at the wealthy and corporations, in part by undoing some of the 2017 tax cuts. While less stimulatory in the immediate term than the already enacted Rescue Plan they are ambitious in design. As of this writing, it is impossible to know how much of each plan will move forward given the divided Senate.

Implied Fed Funds Target Rate

Nice Recovery You Have There, Shame if Something Were to Happen to It

Overall, the economic outlook for the US in 2021 is bright with strong growth; expectations for a surge in investment and a continued decline in unemployment rates and most of this due to a reopening of the economy as the pandemic eases. There are some concerns, however. One is that while the vaccine is - or will be - available to all Americans in the very near future, vaccine hesitancy may put off the much hoped-for herd immunity. On current trends, it now appears that while much of the population will be protected from the original strain of the virus, and largely protected from variants, too many will not. One implication is that Covid-19 will become a perpetual infection risk, joining its cousins, the coronaviruses, that make up a portion of the common cold.

The global outlook for recovery from the pandemic is much more mixed. Europe has lagged the US in vaccination but should begin to catch up. Other countries and regions, notably India and other Eastern nations, as well as much of Latin America and Africa, are very much still impacted by the pandemic. This throws into doubt a global, synchronized, recovery. The US is poised to start delivering vaccines it will no longer require to other countries and this should eventually help augment efforts already underway. In the meantime, there exist more opportunities for variants to emerge and for global supply chains to remain vulnerable.

There is also the risk that the economy will overheat and that the Federal Reserve is wrong about inflation. This could lead to the Fed needing to tap on the brakes before the market has had a chance to adjust for such a move. As with the Taper Tantrum in 2013, such a surprise could set the markets back significantly, deflate the housing boom and slow the economy prematurely. This is not the base case but when enough voices like Warren Buffet and many Wall Street economists warn of it, one should be cautious. While the Fed does not consider commodity price increases as presenting a risk to longer term inflation (due to their volatility) when all charts move up and right it makes one pause.

Copper Corn Wheat Manheim US Used Vehicle Index

 

Much Like the 20s, the Markets Push Higher

Renewed enthusiasm of a broad economic recovery and the notion that the Federal Reserve will remain supportive is providing a major tailwind to the stock market. The fact that corporate earnings are supporting that thesis makes it even better.

With roughly 88% of the S&P 500 companies reported, Factset has indicated that the blended growth rate for Q1 earnings is 49%. That would be the highest level in over 10 years. Of S&P 500 companies, 85% have reported a positive EPS surprise and 76% of S&P 500 companies have reported a positive revenue surprise. The 85% rate would be the highest level since Factset began tracking earnings surprises. Strong earnings growth and positive surprises increases investor confidence that “normalized” earnings will quickly grow to justify current market levels.

Investor confidence helped push the S&P 500 to all-time highs while experiencing historically low volatility. By the end of April, the S&P 500 posted an 11.8% year-to-date return with average volatility levels reaching the lowest in over a year.

Just like the end of Q4 2020, the market has favored small, low quality, economically sensitive companies so far this year. Small cap earnings quality is low (over one-third of Russell 2000 companies lose money) and leverage is high. Near-zero interest rates support unprofitable businesses and few asset classes benefit more than small-cap equities. The Russell 2000 was up 15.1% in the first four months of 2021, 74.9% over the last 12 months, and up over 123% (40% greater than the S&P 500) since the market bottom on March 20, 2020.

Index Returns

The beginning of a new economic cycle was also a major catalyst supporting value stocks, which are more sensitive to economic strength and traditionally do well coming out of a recession. The Russell 1000 Value Index (15.7%) was the best performing index year-to-date, beating the Russell Growth Index (7.8%) by almost 8%. The Value outperformance was driven by the more cyclical economic sectors. Industrials (15.4%) were a primary benefactor of the post-COVID optimism and Energy (31.6%) benefited from a surge in commodity prices. Financials (23.6%) were helped by a steepening of the yield curve (difference between long and short-term interest rates) which is a primary driver of bank profitability. As the largest sector in the Value Index, Financial sector performance will be critical to whether Value stocks continue to outperform other asset classes.

Developed International Stocks outperformed late in Q4 2020 but quickly took a back seat to the U.S. in 2021, as it became apparent the U.S. road to recovery would be more powerful and monetary and fiscal support much greater. MSCI EAFE finished with a total return of 6.6% year-to-date. MSCI Emerging Markets equities (4.8%) benefited from a rise in commodity prices, but were hurt by relative weakness in China, ending the four-month period as the worst major equity class thus far in 2021.

Bond markets priced in stronger growth and higher inflation and the yield curve steepened. While short-term rates were little changed, the ten-year treasury yield increased from .92% to 1.72% by March 30, 2021, and then settled back to 1.58% by April 30, 2021. The U.S. Intermediate Aggregate posted a 1.1% return while longer duration indices fared much worse. The U.S. Corporate High-yield Index was the best performer at 2.0% year-to-date.

Consensus (for now) is That the “New 20s” May Have a Different Ending

Fundamentals have continued to improve, particularly in the US, and the market is expecting a strong recovery in 2021. As the reopening process continues, fiscal and monetary policy measures, inflation, and the direction of interest rates will be instrumental in the market’s direction.

Record growth could lead to runaway inflation but excess economic capacity (low capacity utilization, high unemployment) should keep inflation at bay and interest rates reasonable, at least for now. Growth with only moderate inflation has typically been good for equities. The stock market can usually handle higher yields, especially if they are a result of economic growth and not premature tightening of monetary policy. Value stocks have been rebounding since last September but remain cheap relative to growth. Value tends to do well early in the economic cycle, where modest inflation and rising interest rates persist.

The forward 12-month P/E ratio for the S&P 500 is 21.9 - above the 5-year average 18.0. While expensive relative to history, the expectation for earnings to “grow into” that multiple keeps it reasonable. Developed international (16.9) and Emerging Markets (15.0) each sell at significant discounts to the U.S. A discount seems warranted given the different growth profiles in the short-term: however, a 25-30% discount seems extreme and we would expect valuation spreads to normalize after years of underperformance.

The “low-quality” rally that has driven valuations higher has likely run its course, but it should give way to value-oriented, high-quality companies in the future. A market that discriminates based on company fundamentals would likely be a positive for actively managed funds.

S&P Forward 12 Month

Tax reform could prove a bump in the road should it garner the necessary support. Among other items, it targets higher marginal income tax and capital gains rates for high-income individuals, increases the corporate income tax to 28% from 21%, and imposes a global minimum corporate income tax of 21%. In all, the proposed package totals $3 trillion over 10 years. $300 billion per year is 1.35% of GDP and would represent the largest tax increase since 1968.

It is surprising that the tax proposal has been met with little fanfare. Perhaps because, to get it passed, it will require a level of compromise that dilutes the proposal to levels that would have minimal economic impact. Or perhaps investor confidence is so high around the economic resurgence that higher taxes just aren’t going to matter that much. Time will tell if new tax legislation gets passed, but until then, it remains a risk to a market that has already priced in a fair amount of optimism.

Assuming the recent rise in stocks is more a sober distillate of future economic prospects and not a result of low interest rates, significant leverage, and exuberance (rational or otherwise), then perhaps the nearest thing we have to a 1920s' bubble analogy is crypto currencies. Bitcoin, at a market cap of over $1 trillion, is by far the largest and best known, and has skyrocketed in 2021.

There are hundreds of crypto currencies and many have already been proven to be frauds and others will likely be seen for what they are: mere speculation. While the underlying technology may have a place in the future of finance, the currencies themselves have no intrinsic value beyond what someone is willing to pay and seem ripe for a correction at some point, assuming the recent mania for them is exactly that: A bubble.

To the argument that Bitcoin and other cryptocurrencies are being increasingly accepted as payment, one could opine that in 1634 Elon Musk would likely have accepted tulips as payments for whatever the equivalent to a Tesla would have been.

Bitcoin

 

 

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