Global stocks rose in the first quarter as vaccines were distributed, economies reopened, and the $1.9 trillion American Rescue Plan passed. Investors are optimistic that we have passed a tipping point with the pandemic.
Despite the possibility of real GDP growth of 7% in 2021, a variety of risks remain that curtail our exuberance and keep us prepared for unexpected volatility.
At the start of the first quarter, US households held more than 27% of their wealth in equities exceeding the previous record of 25% at the peak of the 2000 technology bubble.
Retail investors accounted for 20% of trading volume in the first quarter (up from 10% in 2016) signaling an increase in speculative behavior.
Interest rates rose in the first quarter negatively affecting bond returns. We are actively replacing our core-intermediate bond holdings with income oriented “strategic income” investments which offer more attractive 3-5 year returns with similar volatility (risk).
The S&P 500 reached an all-time high in the first quarter as the economy appeared poised to rebound sharply. Once again Value/Dividend stocks outpaced Growth stocks as sectors hit hardest by the stay-at-home order benefited from a cyclical recovery.
The vaccination rollout combined with prior COVID-19 infections means 60-70% of the population in most developed economies should have some immunity by the 3rd quarter. This plus the large US fiscal stimulus has investors optimistic that a significant recovery is at our doorstep. So much so they are now worrying that growth may be too fast which would continue to put upward pressure on interest rates as the 10-year Treasury yield jumped 89% in the first quarter to 1.74%.
Despite the possibility of real GDP growth of 7% in 2021, a variety of risks remain that curtail our exuberance and keep us prepared for unexpected volatility. We will address 4 of these risks in this quarter’s commentary.
At the start of the first quarter, US households held more than 27% of their wealth in equities exceeding the previous record of 25% at the peak of the 2000 technology bubble, the most speculative period in the last 50 years. Retail investors accounted for 20% of trading volume in the first quarter (up from 10% in 2016).
Reddit trading boards fueled wild surges in several stocks with dreadful fundamentals such as GameStop and AMC. Prices of unregulated digital assets such as cryptocurrencies and NFTs (non-fungible tokens) surged due to increased investor demand.
Meanwhile SPACs (“blank check” companies used to speed up the path to market for private companies) raised more money in the first quarter than all of 2020.
Interest Rate Risk
Rising Treasury yields have prompted questions about the potential of rising rates to derail stock market gains. However, historically rising rates are not necessarily bad for stocks, as they usually accompany an acceleration of economic and corporate earnings growth. And while the 10-year Treasury yield has surged recently, the Fed made it clear during its mid-March meeting that short-term rate hikes are unlikely before the end of 2023. As previously mentioned, the rotation away from tech-heavy growth stocks to more cyclical value stocks is underway.
As Treasury yields rise, the present values of future earnings become less valuable, particularly for growth stocks which tend to have earnings in the more distant future. Meanwhile higher yields have the exact opposite effect on many value stocks. For example, financials are the largest sector in the Value index, and they become more profitable when the spread between short and long-term interest rates widens.
On the fixed income front, traditional core intermediate bonds have benefitted from a 40-year secular trend of declining interest rates. As a reminder, as interest rates fall, bond prices rise and vice versa.
While rates may possibly fall again should our recovery have a hiccup, our base-case scenario is for rising rates over the next 3-5 years which we believe could lead to negative real returns (inflation adjusted) for core bonds. Therefore, after significant research and consideration, we have decided to replace a large portion of our traditional core bonds with fixed income alternatives, many of which are not bonds at all.
Rather these investments are a combination of income focused hedged equity and merger arbitrage strategies, all of which have similar volatility to intermediate bonds with significantly higher expected returns in the current environment.
Recently there has been a lot of good news regarding the pandemic: reduced cases and positivity rates, vaccine distribution, and the reopening of the economy. But there are still lingering concerns about new COVID variants that may be resistant to vaccines, as well as slow vaccine rollouts in certain communities and countries. And while the vaccines themselves have been developed and approved for emergency use in the quickest amount of time in human history, the possibility remains of unknown side effects that could have significant consequences over time.
Just last month the AstraZeneca vaccine, and more recently JNJ, were temporarily halted due to concerns over blood clotting. While these occurrences were extremely rare and scientists believe the benefits far outweighed the risks, the possibility of a setback in vaccine health, distribution or efficacy could deliver a significant blow to stock markets.
“New Normal” Risk
When the shutdown occurred last year, business visibility in many hard-hit industries disappeared. And while economies are beginning to reopen, many questions about what the “new normal” will look like remain unanswered.
Will office buildings, airlines and hotels face an oversupply? If rates continue to rise, will companies burdened with debt face financing risks? Will a hot residential real estate market cool off? Will the surge in public spending and stimulus lead to inflation and higher taxes? And what about geopolitical risk which dropped off the radar screens last year but may become more prominent post-pandemic? There are not simple answers, but these questions all point to the fact we do not know exactly what the “new normal” will look like.
As economies reopen and the worst of the pandemic seems to be behind us, there are many reasons to be optimistic. It is easy to forget the market is at an all-time high even though many risks remain. Intense positive sentiment can seduce investors to forget about fundamentals and abandon prudent investment principles. Piling into a single group of stocks or speculative assets that are suddenly breaking out can be tempting, but it is not a recipe for long-term success.
Positioning for the recovery requires patience and focus, particularly on the factors you can control: your financial plan and investment allocation. As always, we are here to help you rise above the headline noise and guide you through these extraordinary times.