Note: This market review was published on May 3rd, 2021 and may not be reflective of current market or investing issues.
The first quarter saw strong equity returns in the US with the S&P 500 up just over 7%1. International markets lagged the US, with the MSCI ACWI ex US increasing almost 3.6%2. Under the surface, there was a rotation of leadership that took place in the market from growth to value assets. Many of the large cap growth companies, that were up strong following the COVID-19 crash, have begun to lag the more cyclical companies. The largest company in the world, Apple, has experience two 20% drawdowns in the last six months3. In spite of the declines in large cap tech companies, like Apple, the broader market has been able to push to all time highs because of this rotation. Along with the rotation from growth to value, small cap stocks have also started to outperform large cap names. It begs the question “what’s going on?”
The simplest way to answer that is the expected, and ongoing, economic recovery. With the rollout of the COVID-19 vaccines in the United States going better than expected, and states beginning to reopen their economies, economic activity is increasing. When there is strong economic growth, along with expectations that growth will continue or accelerate, value stocks tend to outperform their growth counterparts and small cap stocks tend to outperform large cap.
There are still a few concerns that could de-rail this economic recovery. First of all, while the vaccine rollout in the United States has been faster and more effective than most thought it would be, countries around the world are not seeing the same success. If other countries are not able to increase the speed of their vaccinations, their economic issues could affect our economy due to how intertwined global trade is. Second, it seems that every few weeks there is another variant of the COVID-19 virus that pops up somewhere around the world. We have seen the UK variant that seemed to have a higher transmission rate, the South African variant that seemed to have a higher fatality rate, and now there is an Indian variant that has started to spread. If one or more of these variants are found to be transmittable despite one being vaccinated, then we could end up seeing mask mandates, social distancing, and lockdown protocols being issued again, which would at best slow the economic recovery and at worst send us into another recession.
While the economy seems to be off to a strong new expansionary period, there are also concerns as to whether or not the expansion is sustainable once fiscal and monetary support are scaled back or removed. Currently, the Federal Reserve Bank of the United States has their primary interest rate set between 0% and 0.25%, making capital very cheap for businesses that need it. The federal government has been spending money at a record pace in order to support businesses, state and local governments, and individuals. Unemployment insurance has been expanded to support more people, at a higher level, for longer periods of time. Direct payments have been sent to individuals who meet certain income requirements, state and local governments have received monetary support due to decreased tax revenue, and businesses were able to apply for PPP loans that for many were forgiven. Once these support systems of the economy begin to fade away it is unclear if the economy will be able to stand on its own.
Additionally, with the amount of spending that has been seen there is an increased fear that inflation could see a meaningful increase for the first time in well over a decade. There have already been a few companies that have come out publicly and said that they are going to have to raise their prices due to increasing costs that they have seen over the past few months. If these trends continue, inflation could exceed the Federal Reserve target of 2%, which they have said they would welcome based on their new average inflation target. It is important to know what the effects would be if inflation were to see a sustainable increase of over 2%. Some of the first effects would likely be commodity prices and interest rates rising, and the value of the US Dollar declining. What would this mean for asset prices though? Bonds, especially treasuries, would decrease in value as interest rates rise. Stocks would most likely have a mixed reaction. Growth stocks that have done so well over the past decade, especially those that have not proven profitable, would likely struggle as the cost of capital rises for them and they are no longer able to fund their growth with cheap debt. Value stocks, especially those that have higher pricing power, would likely benefit from the strong economic growth and increased spending of consumers.
While there will always be more questions than answers when it comes to future performance in markets, we can use current data and historical references to make informed investment decisions. As the supposed quote from Mark Twain goes, “history doesn’t repeat, but it does rhyme.”
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