After historic market chaos in 2020, investors would be forgiven if they assumed 2021 might be a tad calmer. Instead, events of the first quarter each read as their own outlandish movie script (and, in fact, big screen deals are already in progress): the Capitol Storming, Reddit message board traders battling hedge funds by piling into GameStop and other “meme” stocks, a massive container ship wedged into the Suez Canal, the family office Archegos blowing up… to name a few. These epic dramas unfolded one after another, captivating investors who surely thought, “ok, now, I’ve seen it all”. While blockbuster stories garnered headlines, they weren’t the only market feature during the first quarter. Interest rates spiked over inflation concerns, tech stock leadership faltered, and a rotation into value stocks took hold (though we’re not expecting any movie deals on these). Interestingly, for all that occurred during the past three months, stocks are currently resting comfortably near all-time highs.
What’s Going on Under the Surface?
Last April, we said a vaccine was the only sure-fire solution to the Covid-19 economic problem. Over the past several months, vaccine distribution has indeed ramped-up, with 20% of the U.S. population now fully vaccinated. Optimism is growing that a vigorous economic reopening isn’t far behind. That confidence is clearly reflected in the broader stock market and types of individual companies to which investors are now flocking. On that note, you may recall our discussion last October about a K-shaped market recovery. Specifically, we noted companies were experiencing two entirely separate paths depending upon their roles within the economy. With Americans stuck at home, seemingly every tech company supporting remote work and play was benefiting. On the other hand, energy producers, airlines, retailers, and travel companies were deep in the doldrums. Since early November, investors have shifted from the “work from home” trade to an “economic reopening” trade. The below chart indicates the breathtaking manner in which stock market sector leadership has evolved over the course of the pandemic:
It’s a truly staggering role reversal, with a pronounced investor rotation into sectors of the market most negatively impacted during the height of the pandemic. Investors are now betting on value-oriented, economically-sensitive cyclical stocks. It should be noted that rising interest rates are playing a role in this shift as well. When rates rise, investors are less willing to pay up for cash flows that may be further out in the future for growthy tech companies.
What About Those Rising Interest Rates?
Covid vaccines are not the only driver of growing economic optimism. In early March, Congress passed a $1.9 trillion coronavirus relief package, sending cash directly to a decent chunk of Americans. Consumers were already eagerly anticipating trips back to restaurants, booking vacations, and buying new clothes. Additional stimulus should only further fuel this significant pent-up consumer demand. More recently, the Biden administration has proposed a $2 trillion infrastructure spending package, which could result in additional spending and job growth.
The prospect of a rapid economic recovery is spurring concerns over inflation. The Federal Reserve continues to message they will let the economy “run hot”, with no immediate plans to hike interest rates – even if inflation rises above their 2% target. As a result, interest rates spiked during the first quarter, with the 10-year Treasury yield going from approximately 0.9% to 1.7%. When rates increase, the prices of bonds decrease, which is why bonds of nearly every flavor came under pressure during the quarter.
So, What Does This All Mean?
The good news for diversified investors is the pivot away from higher growth tech companies and towards more value-oriented, cyclical stocks hasn’t impacted broad market returns. It’s simply a different group of stocks now doing the heavy lifting. Optimism for a strong economic rebound and an accommodative Fed is typically a healthy combination for stocks. There are certainly pockets of froth in the markets that bear watching. One only needs to look at the record number of SPACs (blank check companies) going public or the rise of non-fungible tokens (NFTs), including Christie’s recently auctioning an NFT for $69 million dollars. However, while elevated overall, stock valuations aren’t astronomical – particularly if corporate earnings moving forward are reflective of the anticipated economic growth.
That said, the potential for meaningful inflation and further rising rates are risks that could ultimately put a dent in stocks and cause further damage to bonds. In particular, we believe bond investors should be adopting a more conservative mindset at this juncture, with a focus on higher quality and lower duration. Diversification into areas such as inflation-protected bonds also seems prudent.
For all of the wild events in the first quarter, the bottom line is investors shouldn’t lose focus on what’s most important. With stocks near all-time highs and bonds coming under pressure, now is the perfect time to reevaluate your appetite for risk, time horizon, and investment goals. One year ago, the world was in the throes of a global pandemic, markets were in turmoil, and the economy was at a standstill. A year later, while the world and markets continue delivering hard-to-believe headlines, the pandemic is slowly receding, markets are up considerably, and the economy appears on the mend. For investors who stayed the course, maintained a proper investment allocation, and put available cash to work, they are in a better position today than before all of this began. As dark as this situation was and still is, it has provided a stark reminder that investors will always face challenges. It’s how investors prepare for and react to those challenges that can be the difference between success and disappointment.