Stocks extended their rally into 2021 as the global economy continued to grapple with the effects of the pandemic. First quarter returns for the S&P 500 Index were 6.2% as equities were bolstered by continued progress on vaccine rollout, loosening public health restrictions, an additional $1.9 trillion fiscal stimulus package, and ongoing expansionary monetary policy.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on March 31, 2021
|Total Return Index||Market Sector||Quarter||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||6.2%||56.3%||16.8%||16.3%||13.9%|
|Russell 2000||Small U.S. Companies||12.7%||94.8%||14.8%||16.4%||11.7%|
|MSCI EAFE||Developed Int’l Markets||3.5%||44.6%||6.0%||8.9%||5.5%|
|MSCI EM||Emerging Int’l Markets||2.3%||58.4%||6.5%||12.1%||3.7%|
Throughout the first quarter there was a continued reversal of market trends which began shortly after the stay-at-home orders were imposed last year. At that time, shares of companies that would benefit from people living and working from home (e.g., technology, online retail, digital entertainment) outperformed the broad market, while other businesses such as travel, restaurants, brick-and-mortar retail, and commercial real estate significantly underperformed. Economically sensitive industries, such as financial, manufacturing, and energy suffered as the economy sank into a recession. As positive news regarding vaccines circulated last fall, these trends began to reverse and have picked up momentum in 2021.
On January 2, Johns Hopkins University reported a peak in new COVID-19 cases of 300,308. Today, the seven-day average of new cases is below 65,000, marking a decline of more than 75%. Although the current infection rate has moved slightly higher in the past two weeks, most experts forecast fewer new cases as more individuals are vaccinated. Recent success in controlling the virus can be attributed to various factors: effective social distancing procedures, less favorable climate for transmission, a higher percentage of natural antibodies in the population, and an effective vaccination campaign. To date, roughly 195.5 million doses have been distributed, of which 76.8% have been administered. The Biden Administration now predicts enough vaccine inventory for every adult by May 31. Approximately 16.4% of Americans are fully inoculated and 29.4% of Americans have received at least one dose.
Promising data is giving local officials increased confidence to ease up on economic restrictions. Though specific guidelines differ from state to state, the New York Times reports that 44 states now allow businesses to remain “mostly open.” Stay-at-home mandates have been removed in 44 states, and 7 states have almost entirely lifted restrictions. One poll found that 57% of small businesses (<500 employees) are now fully open. We acknowledge that while the current trend has been positive, the outlook could change rapidly. New variants could render current vaccines ineffective, and antibody protection could deteriorate at rates faster than expected. Still, we remain optimistic that the virus will be controlled and the global economy will continue on a path to a strong recovery.
U.S. equity markets enjoyed additional support from the passage of a new round of fiscal stimulus. The American Rescue Plan—a series of federal relief packages totaling $1.9 trillion—was enacted on March 11, 2021. Of that $1.9 trillion, approximately $1.1 trillion will go directly to consumers and businesses in the form of direct payments, unemployment benefits, and tax incentives.
While some portion of the direct payments could make its way into speculative stock investments and cryptocurrency, policy makers expect a significant amount of the direct payments to be spent on goods and services, sparking economic activity. It is estimated that the $2 trillion CARES act package of last March boosted aggregate consumption by 2%. The most recent round of stimulus will likely result in a similar increase in consumer spending, boosting revenue and earnings for many companies.
The easing of COVID-19 related restrictions and fiscal stimulus positions the U.S. economy for a strong rebound. After slamming the brakes in 2020, the federal government is now hitting the gas. The Federal Reserve expects inflation-adjusted GDP growth of 6.5% this year, the highest growth rate since 1984. The unemployment rate is 6.2%, well below the April 2020 peak of 14.7%. It is expected to fall to 4.5% by the end of the year.
Sitting on the cusp of an economic boom largely financed by government borrowing, we believe the potential for rising inflation and higher interest rates to be the greatest risks for current equity valuations. A combination of sweeping fiscal stimulus and vigorous monetary policy have substantially increased the available supply of money. From January 2020 to January 2021, money in circulation increased by roughly 26%. Historically, large increases in the money supply have led to higher inflation. While the price indices closely monitored by the Federal Reserve currently show inflation running below 2% annually, these indices do not reflect the significant increases in the prices of major assets, such as stocks and residential real estate. The price appreciation in these assets usually leads to higher consumer confidence, increased spending, and ultimately higher inflation as measured by the Fed. If inflation were to reach levels deemed unsuitable by the Fed, it would probably take actions to increase interest rates. Even without Fed action, the fixed income markets could demand higher rates due to the federal government’s deteriorating balance sheet. The federal deficit is now approaching $30 trillion, up from just $20 trillion in 2017. Significantly higher interest rates would likely cause a drop in equity valuations and a shift of money out of the stock market and into higher yielding fixed income investments.
“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” — Mark Twain
We believe one of the unintended consequences of direct payments to those who don’t need them and a dramatic increase in the supply of money has been a relatively high level of speculation in certain assets. While there are numerous examples of speculation, such as the rapid price appreciation in meme stocks like GameStop and the proliferation of special acquisition companies (companies that go public without any operating business), one that frequently receives a lot of attention in the face of inflation is Bitcoin. Bitcoin proponents argue that it will become a major global currency at some point in the future. Currencies have two primary functions: 1) a medium of exchange and 2) a store of value. Although Bitcoin has been around for more than 10 years, it has failed to become a meaningful medium of exchange. Very few merchants accept it as payment in part because Bitcoin payments currently have an average transaction fee of $18. (Transaction fees exist as an incentive for miners to add a transaction to the “blockchain” or distributed ledger.) It is often used in connection with illegal activities, such as drug trafficking and ransomware, because market participants are not vetted and transactions cannot be reversed. Bitcoin has been a poor store of value due to its high level of volatility. In the past 10 years, it has suffered four declines of greater than 80%. More recently, Bitcoin’s environmental impact has come into focus, shedding light on the vast amounts of energy consumed in mining—the process by which transactions are written to the distributed ledger. On an annual basis, Bitcoin mining is estimated to consume the amount of energy used by the country of Ukraine. This energy use will continue to scale over time. We currently regard Bitcoin as a purely speculative investment and have no plans on adding exposure to clients’ portfolios.
The S&P 500 currently trades at a forward price-to-earnings (P/E) ratio of 22.6, considerably above the 10-year average of 15.9. An above-average P/E ratio can be justified by the low interest rate environment and the outlook for strong earnings growth over the next year. But there is also a premium paid for equities because there are few alternatives for investors seeking a reasonable return in this environment. The high P/E ratio also reflects a level of speculation in certain segments of the market, which we have attempted to avoid. We believe that holdings in client accounts are reasonably valued given these factors.
With the economy picking up steam, long-term interest rates rose sharply during the first quarter. The yield on the 10-year Treasury bond increased from 0.92% to 1.74% during the quarter. The rise in rates produced a 3.4% loss for the widely used Bloomberg Barclays Aggregate Bond Index. At its March meeting, the Federal Reserve maintained its benchmark short-term interest rate at a range of 0% to 0.25%, where it has stood since March 2020. The Fed projects that this rate will remain at this level through the end of 2023. If the economy continues to strengthen, we expect to see further losses for longer maturity bonds. We continue to maintain fixed income exposures that are relatively short in duration to reduce the risk of loss related to increases in long-term interest rates.
The end of this quarter coincides with the one year anniversary of the shutdown last March, when stock markets suffered a sharp decline of more than 30%. At the time, we remained positive about the long-term prospects for the global economy based on the belief that we would eventually emerge from the pandemic with the help of new treatments and vaccines. As we continue to battle the virus and its mutations, we recognize that the work is far from finished. Nevertheless, we remain optimistic that the pandemic will be contained, the economy will recover, and we will soon realize the benefits of technological advances in healthcare that were accelerated because of the crisis.
While our country has endured significant hardship and a staggering loss of life, the sacrifices made to try to halt the pandemic have been remarkable and inspiring. We wish you and your family the best as we move into the next stage of recovery.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.