Index1st Qtr Return
S&P 5006.17%
Barclay's Bond Index-3.37%
Consumer Price Index1.24%
September 8, 2021

Market Commentary

The S&P 500 returned 6.2% for the first quarter of 2021. In a continuation from the fourth quarter of 2020, smaller capitalization stocks in the U.S. did significantly better with the Russell 2000 returning 12.7% over the same period.

International stocks also fared well with the MSCI ACWI Ex USA index up 3.8%. After a strong start compared to developed markets, emerging market stocks started to pull back midway through the quarter as higher interest rates in the U.S. negatively impacted prospects for emerging economies.

Last quarter we wrote about our distaste for the bond market, and those concerns bore out in first quarter fixed income index performance. The Bloomberg Barclays Aggregate Bond index dropped 3.4% during the quarter, primarily driven by rising interest rates.

Investment Outlook

While certain measures of economic activity are not on the same strong bounce back trajectory that we saw in late 2020, many are still trending in the right direction including employment, manufacturing and trade sales, and retail sales. Real personal income, which includes both wages and government benefits, has dropped; however, it remains above prepandemic levels. Industrial production has not yet recovered to prepandemic levels and experienced a decline in February. This is perhaps due to factors we highlighted early last year, whereby the pandemic recession was rare in its combination of decreased demand and simultaneous (nearly instantaneous) decreased supply. There have been
reports of industrial production suffering due to lack of materials such as semiconductors. As the backlog for these intermediate goods ebbs and as more workers return to factories, we are likely to see a pickup in the production of finished goods.

Increased distribution of the vaccine is a clear positive for economic activity as the expectations of the “reopening trade” are met and consumers return to retail centers, book flights, stay in hotels, etc. These expectations largely square with the current pace of vaccine rollout and suggest the return to pre-pandemic levels of expected earnings is likely justified. As we have discussed in the past, low interest rates are supportive of high multiples on these earnings. However, as we’ve seen interest rates increase, stock valuations have also increased, which, everything else held constant, is generally not the expected direction.

In order for the above circumstances (rising rates, rising multiples) to “pencil out”, one would expect higher earnings growth expectations than in the period prior to the changes in valuations. That has indeed been observed. We are not of the opinion that earnings growth expectations are too high, however now that the market has priced in a great deal of the reopening trade, forward returns on stocks are likely to be lower.

During the quarter the yield on the 10-year U.S. Treasury bond increased from 0.9% to 1.7%. This near-doubling impacted just about every financial market one could think of. While we are not ruling out the possibility of continued increases in interest rates, in our estimation it is a lower risk now than it was at the beginning of the first quarter.

One explanation given for the increase in interest rates has been increases in inflation expectations as a result of the trillions of dollars of fiscal stimulus, as well as very accommodative monetary policy globally. While we understand most of this rationale, we think the most likely course is a return to pre-pandemic levels of inflation for the next several years. If there is a looming inflation risk, we think there is a higher probability of it being several years away as opposed to imminent. One likely cause of new inflationary pressures that we are watching carefully is a potential increase in wages, especially at the lower end of the wage earner spectrum in the U.S. This could come about due to a federal increase in the minimum wage, or perhaps as a result of post-pandemic labor shortages or mismatches leading to the need for employers to increase wages to attract or retain workers. It is possible that we will see relatively high year-over-year inflation as we put the pandemic farther behind us, but these elevated headline numbers should be seen as a return to prepandemic prices.

Portfolio Strategy

The most notable change in client portfolios came towards the end of the quarter and will continue to be implemented throughout the first few weeks of the second quarter. As a result of shrinking risk premiums, largely resulting from increased interest rates, we reduced our allocation to U.S. stocks. Generally speaking, this was sourced from large cap index positions as we believe that cyclically oriented value stocks are likely to continue to do better than the broad market. This change also increases our relative equity allocation to international stocks. Again, due to the composition of international markets as well as more favorable relative valuations, we believe they may fare better in the early stages of the global recovery. Earlier in the quarter, we also slightly increased exposure to emerging markets, sourced generally from U.S. large cap indices. Finally, while we began the year with a negative outlook for the bond market, higher yields have moderated that position going forward from our point of view. While our return outlook is still very modest for bonds, we think the probability for negative returns in the bond market has gone
down in the near term. Cash still looks likely to have negative returns

As we look back at a strong quarter coming on the back of two consecutive strong years for financial markets, we continue to emphasize to clients that we are entering an environment where clients should reign in return expectations. Valuations and interest rates continue to point to a period in which returns from financial assets will likely be lower than what investors have become accustomed to in recent years.

As we see the world around us return to some semblance of normalcy, we appreciate that this is not only a positive for markets, but a positive for our clients. Many of you are no doubt looking forward to more opportunities to spend time with loved ones – we wish you continued health and happiness as we emerge from this pandemic.

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