2021 1st Quarter Update
Top Headline for Q1: Investors Predict a Recovery
The most noteworthy price action of the first quarter occurred in long-duration bonds where a sharp decline suggests continued optimism among investors. With COVID vaccine rollouts accelerating and more “easy money” policies from federal banks throughout the world, investors have hopped on the reopening bandwagon. As investors anticipated a potential pick-up in business activity and possible inflation, long duration bonds saw significant declines. The 30-year US treasury bond plummeted about 15% - an abrupt and massive move for a market that had been relatively quiet.
The bond market action and investor enthusiasm carried over to the equity market. 2020 “winners” (i.e., high growth companies that saw massive price/earnings multiple expansion) began to move sideways or down. Growth companies did not react well to increasing interest rates as their future value is more sensitive to higher rates. The 10-year treasury started 2021 at 0.92% and ended the quarter at 1.75%. Investors shifted to previously beaten-up sectors such as financials, industrials and energy. Patina Wealth investors benefited from this shift as we began shifting some portfolio allocation from Growth and Technology into Financials and Industrials beginning in 4Q 2020.
General Market Update
US Equities: The S&P 500 Index finished up 5.8% for the quarter, while the more growth-oriented Nasdaq Composite was up only 2.8%. After Growth significantly outperformed Value last year, the opposite happened in Q1. Schwab’s Large Cap Value ETF was +9.7% while Schwab Large Cap Growth was only +1.1%. The big winner for the quarter was small capitalization stocks which were up 12.4%. The small-cap segment benefitted from a number of tailwinds including, (1) a heavy value orientation given its exposure to financial service companies and (2) a massive run up in heavily shorted growth-oriented stocks stemming from the Gamestop retail investor frenzy. Small-cap performance, especially small-cap growth, is likely to be a bit choppier going forward as many of these heavily-shorted names are likely to return to appropriate prices. US equity market valuations generally remain elevated relative to historical norms driven mostly by the growth sector whereas many value-oriented sectors are trading at more reasonable valuations.
International and Emerging Market Equities: The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 4.5% in Q1 and the Schwab Emerging Markets ETF was up 3.7%. The developed international market has struggled in recent years relative to tech-heavy US large-cap indices which generally prove more attractive in a low interest rate environment. If bond markets continue to trend down thereby lifting prevailing interest rates, we may see some renewed investor enthusiasm for the developed foreign equity markets. Emerging markets appear to be a bright spot for investors on a forward-looking basis where below average stock valuations, favorable demographics and positive GDP forecasts offer enticing tailwinds.
Fixed Income and Credit: As mentioned above, Q1 2021 was a rough quarter for the bond market. Mid to long-term bonds saw substantial price declines. Corporate bonds faired a bit better than treasuries given (1) the re-opening enthusiasm and corresponding risk-taking that led to an exodus from the “safe haven” of US Treasuries and (2) the higher-yielding corporates are slightly less impacted from a rise in inflation expectations.
Commodities and Precious Metals: There was an unusual divergence in Q1 between commodities and precious metals. Most commodity sectors rose significantly while precious metals saw a substantial decline. Inflation expectations certainly rose during the quarter which generally would be favorable to both sectors. However, the rise in bond yields was a drag on precious metals. More specifically, precious metals tend to perform best when “real yields” (i.e., bonds yields net of inflation) are negative. In Q1, interest rates surged higher such that real-yields outpaced inflation expectations leading to a sell-off in precious metal. As we will discuss below, action by federal banks going forward will be a key driver of performance for these segments.
A Look Ahead
It seems like we’re beginning to sound like a broken record, but government intervention continues to be one of the largest drivers of market performance on all fronts. Starting first with the bond market, one has to try to predict government action in order to forecast bond prices. For one, the Federal Reserve Bank impacts interest rates by adjusting the Federal Funds Rate. As we’re often reminded, Jerome Powell isn’t even “thinking about thinking about raising rates,” but the market may force the hand of the Federal Reserve Bank. That is, if growth and inflation expectations accelerate, bond prices will continue to plummet thereby driving bond yields and prevailing interest rates higher. Federal officials will then have to make a decision (i.e., allow rates to continue to climb thereby putting pressure on many businesses or step in with some form of intervention). Intervention at that point is likely either (1) to raise rates or (2) to increase their bond buying activities to support bond prices and cap yields. So, what is the most likely outcome and where are bond prices going? Our bet is that the Federal Reserve Bank will continue to do nothing until they are forced to do something. That forecast would suggest bond prices may continue to trend lower for the foreseeable future before eventually stabilizing through increased bond buying. If that occurs, we’d likely see a surge in demand for inflation hedges and assets that perform well in a negative real-yield environment.
On the equity market front, it’s clear that continued positive vaccine news and easy-money federal policies are positive for the market. The real question remains: When will these policies end and what happens then? In general, equity market valuations remain inflated by historical standards. But, we continue to have unprecedented monetary stimulus (i.e., “lower for longer” interest rates and fiscal stimulus via massive direct payments to individuals and businesses). As long as these continue it should be good for the equity market. Our belief is that, in the near term, we will continue to see improvement in previously beaten down sectors. In the growth category, investors need to be more selective where some high quality companies (e.g., Apple, Microsoft) are cash heavy and well positioned for any outcome whereas others with high multiples and weak balance sheets are likely to struggle in a rising rate environment.
In summary, the “fed watching” will continue throughout 2021. If the Biden administration follows through on the planned fiscal spending, it will be good for the economy in the short term. This activity is likely good for the stock market, but not good for the bond market which will likely continue to sell off on inflation fears and risk taking via higher equity allocations. High growth stocks, especially with weak balance sheets, become an increasingly dangerous investment with improving economic conditions and the prospect of rising interest rates to follow. We continue to be bullish on precious metal and commodities in the long-term given the risk of inflation generally and the potential for negative real yields. In the short run, precious metals are likely to continue to struggle as bonds sell off and bond yields drift higher. Lastly, sentiment matters, and a continued vaccine rollout leading to reopening enthusiasm should create a favorable environment for all risk assets.
