STIMULUS AND VACCINE OPTIMISM POWER MARKETS HIGHER IN THE FIRST QUARTER
SUMMARY
The markets are trading at historic highs as stimulus hits and the distribution of COVID-19 vaccines accelerates. Market valuations and investor optimism are also near historic highs as we enter what we hope to be the end of the pandemic. We are watching for signs of increasing inflation as interest rates rise, which could disrupt the uptrend. At this juncture, we are cautiously optimistic and are ready to act should the trend weaken.
GREEN SHOOTS VS. THIN AIR
The first quarter of 2021 was marked by several macro- and microeconomic surprises that resulted in increased market volatility compared to the fourth quarter of 2020. However, additional economic stimulus combined with accelerating COVID-19 vaccine distribution and a decline in coronavirus cases helped stocks start the new year with solid gains.
In late January, after two weeks of relative calm, market volatility returned, this time driven by a historic short squeeze in videogame retailer GameStop (GME). The disorderly trading in GameStop and select other stocks caused broader market volatility, primarily due to fears of losses inflicted on large hedge funds because of the various short squeezes. Those factors combined to pressure stocks, and the S&P 500 finished January with a modest loss.
But concerns of widespread losses due to GameStop trading ultimately proved unfounded, and the volatility linked to the GameStop saga dissipated in early February. And as trading returned to normal, investors began to focus on macroeconomic positives. First, the Democrat-controlled government immediately began steps to pass another massive economic stimulus bill, which helped stocks rally in early February. Second, vaccine distribution throughout the U.S. meaningfully accelerated in February. Increased distribution combined with the authorization of a single-dose Johnson & Johnson COVID-19 vaccine helped investors embrace the idea that the end of the pandemic was possibly just months away, and that sentiment helped stocks rally further. Finally, COVID-19 cases began to decline rapidly in the U.S., leading to economic reopenings in several states. The S&P 500 recouped all of January’s losses and ended February slightly positive for the year.
Markets continued to rally in early March as investors began to price in a looming economic recovery following the passage of the massive $1.9 trillion economic stimulus bill, which President Biden signed on March 11. That new stimulus, combined with COVID-19 vaccine distribution reaching 2.5 million doses/day, resulted in growing expectations for a full economic reopening and recovery in the coming months.
As we have seen for most of this year, Treasury yields continue to be pushed higher by expectations for an acceleration in economic growth and concerns around an above-average inflation environment. The 10-year Treasury yield surged to a fresh one-year high of 1.746%, causing the iShares 20-year Treasury Bond ETF (TLT) to decline -15.56% along with putting pressure on the broader bond market. The rapid rise in bond yields started to weigh on stocks periodically throughout March, as higher borrowing costs could become a future headwind on economic growth. But while the risk of high yields and inflation must be monitored going forward, it was not enough to offset the reality of historic economic stimulus and improvement in the pandemic, and stocks drifted higher to finish the quarter with solid gains.
1ST QUARTER PERFORMANCE REVIEW
Expectations of a post-COVID-19 economic recovery drove market performance in the first quarter, as the Dow Jones Industrial Average outperformed both the S&P 500 and the Nasdaq 100 due to the underperformance of technology shares.
By market capitalization, small-cap stocks, which are historically more sensitive to changes in economic growth, outperformed large-cap stocks as COVID-19 cases declined and numerous states partially or fully reopened their economies, leading investors to expect a broad acceleration in future economic activity.
From an investment style standpoint, value handily outperformed growth for a second consecutive quarter. The substantial outperformance by value stocks once again underscored increasing investor optimism for an economic rebound in the coming months.
On a sector level, all 11 S&P 500 sectors finished the first quarter with positive returns. Cyclical sectors, including energy, financials, industrials, and materials, led markets higher for the second straight quarter. As mentioned, expectations of an acceleration in future economic growth (again, mainly a product of stimulus and COVID-19 vaccine distribution), combined with higher bond yields and fears of potentially rising inflation, drove the cyclical sector outperformance in the first quarter.
One of the biggest sector laggards in the first quarter was tech. Investors rotated out of tech stocks and into cyclical sectors to position for an acceleration of economic activity that is expected to come with a full economic reopening. Traditionally defensive sectors such as utilities, health care, and consumer staples also underperformed the S&P 500 on the expectations of a strong economic rebound.
| US Equity Indexes | Q1 Returns | YTD |
|---|---|---|
| S&P 500 | 6.18% | 6.18% |
| DJ Industrial Average | 8.29% | 8.29% |
| NASDAQ 100 | 1.76% | 1.76% |
| S&P 500 MidCap 400 | 13.36% | 13.36% |
| Russell 2000 | 12.70% | 12.70% |
| Figure 1: Q1 2021 returns for the U.S. Equity Indexes. Source: YCharts. | ||
Internationally, foreign markets saw positive returns in the first quarter thanks to declining COVID-19 cases, continued progress on vaccinations, and initial signs of an economic reopening across the EU and UK. Emerging markets also rallied in the first quarter on hopes of a global economic recovery, although they underperformed foreign developed markets due to headwinds from a stronger U.S. dollar and economic turmoil in Turkey following the firing of the head of the Turkish central bank. Both foreign developed and emerging markets underperformed the S&P 500 in the first quarter.
| International Equity Indexes | Q1 Return | YTD |
|---|---|---|
| MSCI EAFE TR USD (Foreign Developed) | 3.60% | 3.60% |
| MSCI EM TR USD (Emerging Markets) | 2.34% | 2.34% |
| MSCI ACWI Ex USA TR USD (Foreign Dev & EM) | 3.60% | 3.60% |
| Figure 2: Q1 2021 returns for the International Equity Indexes. Source: YCharts. | ||
Commodities posted strong gains for the second quarter in a row and notably outperformed the S&P 500 over the past three months. Major commodity indices were led higher by a large rally in crude oil futures as investors anticipated an increase in demand for both oil and refined products as the global economy begins to normalize. Gold, however, posted another quarterly decline despite rising fears of higher inflation, as a stronger U.S. dollar combined with the increasing popularity of alternative investments such as Bitcoin dampened demand for the precious metal.
| Commodity Indexes | Q1 Return | YTD |
|---|---|---|
| S&P GSCI (Broad-Based Commodities) | 13.55% | 13.55% |
| WTI Crude Oil | 22.54% | 22.54% |
| Gold Price | -9.77% | -9.77% |
| Figure 3: Q1 2021 returns for the Commodity Indexes. Source: YCharts/Koyfin.com. | ||
Switching to fixed income markets, quarterly total returns for most bond classes were negative for the first time in more than two years. Massive economic stimulus combined with COVID-19 vaccinations led to an acceleration in economic growth expectations in the coming months, but that also resulted in a surge in inflation estimates, which topped a five-year high in the first quarter and weighed broadly on the fixed income markets.
Looking deeper into the bond markets, longer-duration bonds underperformed those with shorter durations in the first quarter. That substantial underperformance was driven by the Fed’s consistent promise to keep short duration interest rates unchanged while the market priced in higher future levels of inflation, which pressured bonds with longer-dated maturities.
In the corporate debt markets, lower quality but higher yielding bonds handily outperformed investment-grade bonds. That further confirms that during the first quarter of 2021 investors were positioning for a broad economic rebound later in the year. Investment-grade corporate bonds underperformed as investors embraced more risk in their fixed income portfolios and as the decline in longer-dated Treasury bonds weighed on higher quality debt.
| US Bond Indexes | Q1 Return | YTD |
|---|---|---|
| BBgBarc US Agg Bond | -3.37% | -3.37% |
| BBgBarc US T-Bill 1-3 Mon | 0.02% | 0.02% |
| ICE US T-Bond 7-10 Year | -5.81% | -5.81% |
| BBgBarc US MBS (Mortgage-backed) | -1.10% | -1.10% |
| BBgBarc Municipal | -0.35% | -0.35% |
| BBgBarc US Corporate Invest Grade | -4.65% | -4.65% |
| BBgBarc US Corporate High Yield | 0.85% | 0.85% |
| Figure 4: Q1 2021 returns for the U.S. Bond Indexes. Source: YCharts. | ||
2ND QUARTER MARKET OUTLOOK
While the COVID-19 outlook has recently dimmed in Europe, the outlook for the U.S. remains generally positive. Vaccine distribution continues to accelerate, with the goal of having vaccines available to all adults nationwide by May. As a result, it is not unreasonable to think the pandemic will be declared “over” by the early summer (although obviously COVID-19 infections will continue, just not at a pandemic level that requires a large-scale government response).
Meanwhile, the outlook for the economic recovery remains bright, with improvement across multiple economic indicators. The Federal Reserve has pledged numerous times in recent months to continue to keep interest rates low and its quantitative easing (QE) program going until the economy returns to pre-pandemic activity levels. These reassurances have kept credit and liquidity readily available in the markets, causing measures of credit stress, which are typically early warning signs of financial dislocation, to remain low.
Those factors all provide substantial support for markets as we begin the second quarter.
Those of you who are long-time clients are acutely aware that Day Hagan’s founding principles built the firm on the precept of risk management. The famous investor Benjamin Graham said, “The essence of investment management is the management of risks, not the management of returns.”
First, rising bond yields caused volatility in late February and throughout March. If the pace of the rise in bond yields accelerates, we can expect more stock and bond market volatility, as high interest rates are a threat to the economic recovery. While we believe there is limited risk to a continued substantial increase in rates in the near term, this is something we are watching and a going concern in the intermediate to long term.
Similarly, investors are expecting inflation to accelerate as historically massive stimulus fuels the economic recovery. Right now, Federal Reserve officials expect any increase in inflation to be temporary, but if that expectation proves to be incorrect, then the Fed will have to remove stimulus via a reduction in the current QE program, and that is not priced into markets right now. This is where we could see a rise in the measures of credit stress we monitor, and, if so, we would be quick to act in reducing risk.
From a fiscal standpoint, the multiple rounds of stimulus unleashed upon the economy since the pandemic began have resulted in exceptionally large increases to the national debt and federal deficits, and the recently passed stimulus bill only exacerbated those existing issues. So far, markets have not seen any negative impacts related to the growing debt or deficits, but these high levels of debt and deficits represent longer-term risks to U.S. financial stability. It remains unclear when those risks will begin to impact asset prices.
Finally, so far in 2021 markets have embraced the Democratic agenda of more economic stimulus, but numerous prominent Democrats also are in favor of increased corporate, personal, and investment taxes. If those efforts gain momentum, we can expect market volatility to increase as well.
All of this has led to markets trading at historically high valuations. In addition, the FOMO and TINA (there is no alternative) attitudes have caused investor optimism to reach levels historically seen leading up to times of weakness in the markets. While neither of these alone are reasons to reduce risk, they are warning signs, and we are watching for more indicators to show signs of weakness. If that does occur, we will act accordingly and reduce risk across the strategies that construct your portfolios. As experienced investors know, optimism and confidence can override weak fundamentals and valuations for extended periods, but eventually, fundamentals and valuations matter.
In sum, the start of 2021 showed that even though 2020 is behind us and the pandemic is likely closer to the end than the beginning, volatility and macroeconomic surprises will remain with us. As such, we should all remain prepared for continued volatility.
Importantly, though, the start of 2021 again clearly demonstrated that a well-executed and diversified, long-term focused financial plan can overcome temporary bouts of volatility, just like it did in 2020.
At Day Hagan Private Wealth, we understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this still-challenging investment environment. Successful investing is a marathon, not a sprint, and even intense volatility like we experienced in the first half of 2020 is unlikely to alter a diversified approach set up to meet your long-term investment goals.
Therefore, it is critical to remain unemotional and patient, and to stick to the plan, as we have worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.
The resilient nature of markets in 2021 notwithstanding, we remain vigilant towards risks to portfolios and the economy, and we thank you for your ongoing confidence and trust. Please rest assured that our entire team will remain dedicated to helping you successfully navigate this market environment.
Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.
Sincerely,
Regan Teague, CFA®
Senior Investment Officer
Day Hagan Private Wealth
—Written 4.07.2021.
Print PDF Copy of the Article: Day Hagan Private Wealth Insights: Stimulus and Vaccine Optimism Power Markets Higher In The First Quarter (pdf)
Disclosure: The data and analysis contained herein are provided “as is” and without warranty of any kind, either express or implied. Day Hagan Private Wealth (DHPW), any of its affiliates or employees, or any third-party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Private Wealth literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing.
Investment advisory services offered through Donald L. Hagan, LLC, a SEC registered investment advisory firm. Accounts held at Raymond James and Associates, Inc. (member FINRA, SIPC) and Charles Schwab & Co., Inc. (member FINRA, SIPC). Day Hagan Asset Management and Day Hagan Private Wealth are both dbas of Donald L. Hagan, LLC.
The S&P 500® Index is a broad based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.