Altair Insight: Taking Off (1Q21) – Quarterly Market Review
“Commencing countdown, engines on…” – “Space Oddity,” by David Bowie
If you want to test your memory, an old saying goes, try to recall what you were worrying about a year ago. No one would fail that test today. COVID-19 was on the rampage, claiming lives at an accelerating pace. People stood in line for hours for groceries and toilet paper. Those who could began working from home for a prolonged period. Investors were still anguished about the stock market following a collapse that sent the S&P 500 down 34% in five weeks. The economy was hobbled by lockdowns.
Noah Kroese Illustration for Altair Advisers
Thankfully, the picture now is vastly improved. Vaccines and therapeutics have finally weakened the coronavirus pandemic after more than 3 million deaths worldwide, nearly a fifth of them in the United States. The market has not only fully recovered but has climbed repeatedly to record highs. And economic growth is poised to ascend to its highest rate in decades.
All of this is not to say we expect stocks to soar the way they did for much of last year. A reversal of last year’s head-scratching disconnect between financial markets and the economy is possible. Instead of stocks taking off while the economy struggles to regain its footing, this may be a year in which GDP outshines the S&P. We maintain a positive outlook for both, however.
Plenty of risks exist that could threaten markets’ advance. Millions of lost jobs have yet to return and there is no guarantee they ever will, as many may be permanently lost from the impact of the pandemic. The trillions of dollars in stimulus have pushed federal debt as a share of GDP above 100% for the first time since World War II. Stock valuations are the highest since the dotcom bubble of the late 1990s. Mutant strains of the coronavirus could cause a resurgence of the pandemic. Geopolitical risks involving China, Russia, Iran and North Korea linger. Concerns about rising rates and inflation have grown. The U.S. government or Federal Reserve could make a policy error.
Yet a vibrant economy can overcome many such vulnerabilities. And the U.S. economy is in the process of being launched into a steeply higher trajectory, towing the global economy with it, thanks to the largest stimulus and relief effort in history, inoculations and the forthcoming full reopening.
We believe some concerns have been overstated, as we explain in the discussion below. While there are unanswered questions about the repercussions of the Biden administration’s emphasis on heavy spending and potential tax increases, we are confident in the outlook for 2021. We anticipate a strong second half for the economy once the virus has been subdued, enabling it to snap back toward full strength.
We recommend clients remain at target portfolio allocations in all three risk categories – higher, medium and lower. We are not taking on additional risk in portfolios but maintain tactical overweights to two areas within the higher-risk category that we believe are particularly well-positioned in this recovery environment: U.S. large-cap and small-cap stocks.
Please read on as we analyze the economy and markets and discuss our views through five key themes.
1. The recovery is revving up and should provide more upside for markets.
After some challenges posed by new COVID-19 waves and growth setbacks, the V-shaped recovery that never quite took hold last year is under way and accelerating. Enormous stimulus appropriations and the vaccine rollout’s effectiveness have given the economy even more momentum than anticipated ahead of this summer’s “grand reopening.”
While the economy and markets can move at much different speeds, as was emphatically demonstrated last year, we believe a more robust economy should nudge stocks still higher this year.
Real GDP growth so far in 2021 is expanding at close to an 8% annual rate, according to the tracking models of the Federal Reserve Banks in both Atlanta and New York. The recovery is so vigorous that even after last year’s 3.5% decline – the biggest drop since 1946 – the International Monetary Fund estimates the U.S. economy will overtake the level of output forecast before the pandemic by 2024.
Positive signs from consumers and businesses alike are driving optimistic forecasts.
Sources: Institute of Supply Management, University of Michigan, Altair Advisers
Consumers – The American consumer is well-armed with cash and willing to spend it. Personal savings is approximately $1.3 trillion more than a year ago, an excess so substantial that Fed officials expect it to help fuel growth in 2022 and 2023 as well. Consumer confidence rose to a one-year high in March, and real-time indicators show sharp recent increases in credit-card spending, airline bookings, restaurant reservations, box-office ticket sales and hotel occupancy.
Businesses – U.S. companies appear poised for a massive rebound, with supply-chain issues now the primary concern as businesses scramble to keep up with a surge in demand. Both the manufacturing and service industries reported the best business conditions of the 21st century in the April monthly surveys conducted by the Institute of Supply Management. The housing market also is booming. S&P 500 companies are forecast to report earnings growth of at least 28% for the first quarter, according to FactSet – the most in more than a decade due in part to easier comparisons from the same time last year.
Sources: FactSet, Altair Advisers
The bounceback will mean the world’s two biggest economies have emerged strongly from last year’s recession. The IMF predicts 2021 growth of 6.4% for the United States and 8.4% for China, resulting in the best year for global growth as a whole since at least 1980.
Sources: IMF, Altair Advisers
One lingering black hole in the recovery: About 40% of the 22 million U.S. jobs eliminated early in the pandemic are still missing. But the labor market has made encouraging progress lately, including adding back a seven-month high 916,000 jobs in March, many of them in hospitality and construction, and reducing the unemployment rate to 6.0%.
We do not count on the stock market being as hot as the economy in 2021 given the impressive gains over the past year. But we feel confident maintaining our recommended allocations at target levels given the rock-solid underpinning the economy should provide.
The outlook for the second year of this bull market remains bright. There have been six bull markets since World War II that followed bear-market drops of 30% or more and the gains continued for a second year in every one, averaging 16.9%.
2. A market rotation has taken place and we feel we are well-positioned for it.
The stock market has a new look since the end of the COVID-19 tunnel first came into view with the development of vaccines in late 2020. Stocks that will benefit more from the reopening have taken over market leadership from the big tech stocks that supercharged last year’s rally. We think this rotation has a good chance to remain in place in the months ahead as more rapid growth takes hold.
Companies with a smaller market capitalization collectively doubled the returns of the blue chips that make up the S&P 500 Index in the first quarter. While volatility surfaces more often with small caps, the outpouring of stimulus should help extend their strong performance. Smaller companies’ stocks and value stocks – which are more cyclical in nature – tend to outperform in a rising economy, and both categories have held true to form year-to-date.
Sources: Morningstar, Altair Advisers
Small caps’ acceleration traces to early November, when Pfizer and Moderna announced their vaccine breakthroughs and investors saw heightened potential for smaller companies that rely much more on domestic revenue than larger firms. The small-cap benchmark added more than 40% in the next four months before temporarily pausing its climb in March. We have maintained our tactical overweight to small caps since last year.
Our recommended managers for smaller stocks, too, have shifted their holdings within that universe to increasingly favor companies with greater opportunities post-lockdown. As one related recently: “For the first half of the last 12 months, the market has really been about pandemic beneficiaries. As it became clear we’d have effective vaccines emerge, I’ve started shifting my emphasis and looking for companies that will benefit most from a reopening.”
Our other tactical overweight within the higher-risk category – leaning toward large-cap U.S. stocks with a slight underweight to international developed and emerging-market stocks – has paid off with domestic outperformance again so far this year. We believe this trend will continue given the outsized fiscal support from Washington and the effective vaccination programs in the U.S., which are showing better progress against the pandemic than in most other countries.
Value stocks have finally emerged from the shadow of growth stocks in recent months as cyclical firms such as banks and energy companies perform well. The S&P 500’s energy sector added 31% in the first quarter, followed by financials (+16%) and industrials (11%). We think value can continue its strong performance in the near term, although we believe in growth stocks’ potential over the longer term and maintain balanced exposure to both style categories. Since the advent of the Russell 1000 growth and value indexes in 1979 the two have produced nearly identical returns – 12.1% for growth, 12.0% for value – and growth in particular has flourished since 2008. We expect the reopening economy to eventually help growth, too, and do not expect a repeat of the first-quarter when value outperformed growth by 10.4 percentage points.
3. Inflation concerns are valid but overstated.
Investors’ inflation worries have grown, understandably, with every new spending plan and upgraded growth projection. We are watching closely for any conditions that could spark an extended run of higher prices. Inflation surges that persist, after all, tend to go hand-in-hand with interest-rate hikes that can then pressure the stock market. All signs, however, point to a 2021 rise in prices that will not linger.
Sources: St. Louis Federal Reserve, FOMC, Altair Advisers
To be clear, we do anticipate a swift escalation in inflation this spring and summer, just not to a level that poses danger for markets.
Government spending is a primary catalyst, although not the only one. The American Rescue Plan Act pushed the amount spent or committed by Congress and the Federal Reserve to fight the pandemic to about $9 trillion. On top of that will likely come a reduced but still massive version of President Biden’s $2.3 trillion infrastructure plan plus other spending initiatives in the works. Pent-up demand and supply-chain bottlenecks also will contribute to higher inflation numbers.
The core personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, is now anticipated by the central bank to come in at 2.2% for 2021, up from the December forecast of 1.8%. The Consumer Price Index, which includes food and energy, increased 2.6% in March from its weak year-ago level.
This rising trend and any jarring headlines to come should be viewed in context, however.
Inflation has remained under 2% for a decade, so any leap above that barrier could seem disproportionately meaningful. And any spike this summer will be artificially magnified by the comparison with year-ago price pressures that were very weak because of the pandemic. In addition, the massive amount of government spending that has investors worried about inflation was necessary to fill a huge, potentially disastrous void due to the impact of the pandemic rather than stimulating a normal slow-growing economy.
We see several other reasons why a sustained higher inflationary environment is unlikely to be a problem any time soon.
The forces that have kept inflation tame for years – core PCE rose at an average annual rate of just 1.6% during the economic expansion from 2009-20 and 1.8% from 2000-09 – will remain strong. Those factors include globalization and automation, both of which restrain wage and price hikes; aging populations, which slow economic growth; and the Fed’s proven track record in keeping inflation under control.
Persistently higher inflation will be difficult to achieve in the current environment, too. Much of the stimulus consists of one-time distributions or benefits that will expire this year. And the economy remains 8 million or more jobs short of its February 2020 pre-pandemic level.
The concern for markets is how the Fed responds once higher inflation is present. The repeated answer from Powell and company has been that they will not end their bond purchases or lift their benchmark short-term interest rate from near-zero until full employment is achieved.
Sources: St. Louis Federal Reserve, Altair Advisers
Despite all the stimulus, it will be very difficult to restore those millions of missing jobs. This strongly suggests to us that while it is possible the Fed could hike rates before its rough timeline of the end of 2023, that would happen only under very favorable conditions for employment and otherwise. The Fed will avoid tightening if it is likely to produce an economic shock.
For those reasons, we agree with Powell’s prediction that the coming inflation increase “will be neither particularly large nor persistent.” We view the chances of runaway inflation as very low.
4. Bonds are having a rare negative year but should stabilize.
The bond market is under pressure from both the accelerating economy as yields rise and from fears the Fed will raise rates sooner than their guidance. While the upward march of yields has paused recently, we anticipate they will drift higher as the economy accelerates through the end of the year. But we do not expect them to rise aggressively.
Bond yields have risen sharply since the Democrats won a Senate majority and gained nominal control of the U.S. legislative agenda in January, fueling expectations of increased stimulus, growth and inflation. The yield on the 10-year U.S. Treasury, below 1% throughout 2020 during the pandemic, climbed above 1.7% by late March before pausing, resulting in one of the biggest quarterly declines for bonds in years.
Sources: St. Louis Federal Reserve, Altair Advisers
This trend should not be cause for alarm, however. Rates remain historically low; the 10-year yield has averaged 4.5% over the last 150 years, according to Bloomberg, yet has remained almost entirely below 3% for the past decade. The recent increase comes largely for a good reason: The economy is recovering well and even stronger growth is on the way.
Could rates go still higher, then? Certainly. But neither we nor our bond managers anticipate another giant leap upward from the current level.
Inflation expectations have contributed to the rise. But, as stated in the previous section, we do not expect inflation to persist beyond later this year or to become a sustained problem.
Rising rates and falling bond prices are not just a U.S. phenomenon but a global one due to reflation expectations. While the short-term drop in prices has been painful for bond investors, we view it as positive in the broad picture for what it says about the economy. And our recommended bond managers are positioning to take advantage of the changing conditions they anticipate ahead.
These managers believe rates and inflation will likely move marginally higher this year but they do not foresee runaway inflation or a spike in yields. They have been intentionally positioned at or near the bottom end of the duration range, meaning they hold a lot of shorter-term bonds that are less interest rate-sensitive. In a sign of their confidence in the bond market’s future direction, they now have begun buying slightly longer-dated bonds with higher yields as they believe rates will not move much higher in the near term.
Diversified exposure within other areas of the bond markets such as securitized credit, which includes mortgage-backed and asset-backed securities, continues to generate positive returns.
Our long-held view that bonds merit a core holding in any diversified portfolio has not changed. They may not help deliver the highest returns in a given year, but they play a key role as an anchor for portfolios. That was evident over the first six months of the pandemic when they lent stability to portfolios and cushioned the blow of extreme volatility.
Given the continuing risks in the stock market and the impossibility of predicting economic shocks (as was the case last year), we recommend that clients retain their target weighting to bonds. We expect returns for the rest of the year to be better.
5. Biden’s first 100 days put spending and future tax hikes in the spotlight, leave many questions unanswered.
Occasionally the first 100 days of a U.S. presidency leave a lasting legacy. Franklin D. Roosevelt signed 76 major pieces of legislation and launched the New Deal. John F. Kennedy ordered the ill-fated Bay of Pigs invasion. Gerald Ford pardoned Richard Nixon. William Henry Harrison died.
Joe Biden’s term has seen no defining event as he nears Day 100 in office on April 30th. Much of his energy has necessarily been absorbed by the COVID-19 pandemic, with his $1.9 trillion American Rescue Plan Act focused largely on coronavirus relief and vaccine distribution. The ultimate fate of his $2.3 trillion infrastructure proposal, along with the size, shape and outcome of other big-ticket initiatives and the corporate tax increase he wants, will take months to determine.
Source: Altair Advisers
Biden’s potential for legislative achievement has narrowed considerably from the time less than six months ago when he was hoping to ride into office on a blue wave.
The president faces a very short political runway for any major initiative to take off. Without any bipartisan support, his agenda is constrained by an ultra-slim majority in the Senate. No bill can pass without unanimous support from his party, meaning it must pass muster with conservative Democrat Joe Manchin of West Virginia.
What does this mean for investors? In the near to intermediate term, the benefits of any additional big spending items the president manages to get passed will outweigh the higher taxes that are likely coming in the future. His initiatives should be a tailwind for the economy and likely for stocks as well. Longer-term, many questions remain that cannot be answered until more specifics and the prospects for the final legislation are fully known.
Mostly, however, it means Biden will be hard-pressed to enact legislation calling for dramatic changes – anything that might be perceived by moderates or conservatives as excessive or extreme. It does not appear based on current political realities that the Democrats will be able to end the filibuster to enable easier passage of their priorities, although they may be able to use budget reconciliation to pass more focused legislation.
We do not think a corporate tax hike, assuming it takes place, is likely to result in a market shock. Already, the administration has sent signals it is willing to negotiate down its initial proposal to raise the tax from the current 21% to 28%.
Whether there will be future tax increases on higher-income individuals is yet to be determined. The administration must move carefully on that to avoid jeopardizing the recovery.
Also still taking shape is President Biden’s policy on China and whether he will pursue as hard-line a stance toward Beijing as President Trump did, with or without tariffs. He is talking tough, vowing not to let China become the world’s most powerful country on his watch and learning from missteps during the Obama administration that largely left Beijing unchecked and from the Trump administration that tariffs alone cannot fix the China issue. What methods he pursues in any crackdown on China over technology or Taiwan should give investors more insight soon.
- A well-stimulated economy should produce much higher growth in the second half of 2021 and into 2022. The biggest potential threat to a full recovery is a surge of virus mutations that outpaces the rollout of vaccines, forcing a return to widespread lockdowns.
- U.S. stocks and small caps in particular stand to benefit from the resumption of more normal economic activity, particularly with the United States leading the global recovery. We retain our tactical overweights to both these areas within the higher-risk category.
- Huge government spending commitments and ramped-up growth forecasts have fueled investors’ fears about higher inflation. All signs point to this rise being temporary. We do not believe higher inflation poses a major threat or currently merits revising investment allocations.
- Tax hikes planned by the Biden administration pose a future headwind for stocks. Based on the Democrats’ narrow Senate majority, however, we do not anticipate any drastic increases or a major threat for markets.
- Bonds’ performance should improve following a poor quarter as yields and growth expectations surged. Rates may move marginally higher, but we do not anticipate another meaningful or lasting spike.
Quotes of the Quarter
“The outlook is brighter because millions of people are benefiting from vaccines and because of further policy support, especially in the United States.” – Kristalina Georgieva, International Monetary Fund managing director
“China was leading the recovery last year and the U.S. is picking up the baton this year.” – Adam Posen, Peterson Institute for International Economics president
“We won’t be preemptively taking the punchbowl away.” – Mary Daly, Federal Reserve Bank of San Francisco president
The stock market kept rising as it powered to and through the one-year mark since the pandemic low, buoyed by investor optimism over government stimulus and expanding COVID-19 vaccinations. For a second straight quarter, small-cap stocks dominated the rally.
The primary U.S. benchmark, the large-cap iShares S&P 500 ETF, slowed its pace from last year but still added a robust 6.3%. That was its lowest return of the last four quarters, testament to the record speed of the rally that lifted the index 56.5% in 12 months. The pent-up demand for travel and leisure activities fueled value stocks as gauged by the iShares Russell 1000 Value ETF to an 11.3% quarter while, in a complete turnaround of investing-style performance from last year, the corresponding growth index eked out just a 0.9% gain – the widest margin in nearly two decades. Technology stocks fell to the back of the pack with a 2.1% rise as energy (30.6%), financials (15.9%) and industrials (11.3%) led the sectors. Apple, Amazon and Microsoft, which had accounted for 53% of the S&P 500’s total return in 2020, slipped to a collective single-digit decline in the first quarter.
Small caps climbed sharply along with the economic outlook. The iShares Russell 2000 ETF rose 12.9% in the quarter for a gain of close to 50% in the previous six months.
Non-U.S. stocks advanced at a more modest pace than their domestic peers in the first quarter, a reflection of both the record amount of U.S. stimulus and the decline of foreign currencies against the dollar.
The iShares MSCI EAFE ETF, a measure of large- and mid-sized stocks in Europe, Australia, Asia, and the Far East, advanced 4.0% as governments got vaccine shots into arms and governments added stimulus. The dollar’s nearly 4% rise against a basket of other major currencies crimped returns for overseas investments converted into dollars; in local currencies, the EAFE index was up 7.7%. The best-performing developed market was Canada’s, up 11%, while New Zealand’s skidded nearly 10%.
The emerging-markets index overcame a negative quarter from Chinese stocks that dominate it – an unsurprising consolidation following their strong 2020 performance. EM stocks benefited from not only signs of a global economic recovery but also strong semiconductor demand and rising commodity prices. The iShares MSCI Emerging Markets ETF added 3.2%. Biggest winners included Chile (+15.6%) and Saudi Arabia (+15.5%) as oil prices rose. Turkey’s stock market fell 15.4%.
Real estate investment trusts bounced back as vaccinations brought the economy’s full reopening nearer and improved the outlook for retail and lodging, among other sectors. The Vanguard REIT Index Fund rose 8.7% year-to-date through March. Internationally, where the return to normal economies was more clouded by COVID-19 resurgences, returns were more modest; the Vanguard Global ex-US Real Estate ETF added 2.6%.
Hedged and opportunistic strategies collectively managed a small gain. The HFRX Global Index, measuring the average hedge-fund performance, added 1.3% in the quarter, slightly off the pace of its 6.8% full-year rise in 2020.
Altair’s blended benchmark for closed-end funds increased by 5.7% in the first three months of 2021. Performance was aided by discounts narrowing as well as by market appreciation of underlying funds’ holdings, particularly for equity closed-end funds.
Our benchmark for securitized credit, or distressed debt, a blend of 65% mortgage-backed bonds and 35% high-yield bonds, edged 0.6% lower. Rising rates were a headwind, but this was largely offset by improving credit conditions for these securitized fixed-income instruments.
Both taxable and tax-exempt bonds had down quarters, pressured by the sharp rise in interest rates as expectations for a post-pandemic surge in growth and inflation continued to build.
The Vanguard Total Bond Market ETF, which delivered steady returns in the chaotic early months of the pandemic, reversed course with the changing outlook and fell 3.6% to start 2021. The 10-year U.S. Treasury interest rate closed the quarter near a 14-month high at 1.7%, up from 0.9% at year-end 2020 and the all-time low of 0.4% a year ago March.
Altair’s municipal bond benchmark, a blend of the Market Vectors short and intermediate ETFs, fared better. It ended the quarter with a minimal decline of 0.4% after gaining in March, partially due to funding from the American Rescue Plan Act boosting the outlooks for municipal borrowers from state and local governments for airports, toll roads and mass transit.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.