The 1st quarter of 2021 saw a continuation of the stock price gains that have been the general trend for the last 12 years. Fed largesse, in the form of emergency measures, direct lending and balance sheet expansion, as well Congressional stimulus in the form of direct payments to qualifying individuals, continued unabated. The stock market itself, as measured by the S&P 500, made new highs on an almost daily basis returning 6.2% for the latest quarter.
But for the first time in a while, tech stocks were not the market leaders, probably due to the prospect of higher corporate taxes and rising interest rates. Previously, taxes and interest rates were two forces, when they declined, that propelled tech stocks to market leadership. The NASDAQ returned 2.8%. It could also be that tech stocks underperformed last quarter simply because as a group they are astronomically expensive and only offer massive long-term downside with very little upside.
‘Value’ stocks, as measured by the Russell 1000 Value Index, were up 11.3% last quarter while ‘growth’ stocks, as measured by the Russell 1000 Growth Index, languished with a gain of 0.7%. Longer term interest rates rose during the quarter, which means that bonds overall declined. The 10-year treasury bond declined 6.4%. And gold also declined 8.8% with the increase in interest rates.
Going forward the global economy should rebound from the pandemic for the remainder of the year. The US economy has outperformed the rest of the world through the 1st quarter for two reasons: 1) The successful launch of the US vaccination campaign has allowed state and local governments to begin dismantling lockdown measures; and 2) US fiscal policy has been more stimulative than other countries. Under the America Rescue Plan Act there are direct payments to lower- and middle-class households, an extension and expansion of unemployment benefits and aid to state and local governments.
As of February, US households were sitting on around $1.7 trillion in excess savings. About 2/3 of that was from reduced spending during the pandemic, with the remaining third coming from stimulus payments. The recent stimulus bill will add about $300 billion to household savings. This will support spending. Already, real-time measures of economic activity have increased a lot in the 1st quarter. Traffic congestion in cities have approached pre-pandemic levels. OpenTable’s measure of restaurant occupancy is almost back to where it was before the pandemic. And JP Morgan reported that credit card spending was up 23% year over year as the stimulus payments reached bank accounts.
And then there is the biggest stimulus of all: A stock market at all-time highs. This all by itself supports spending and economic activity in the US as the country emerges from the pandemic and continues to open.
It is important for investors to realize that the economy is not the stock market and the two are often totally disconnected. In many respects the economy lags any stock market gains or declines. In 2008, we saw the economy collapse because stock and real estate price declined. The economy did not collapse first. And as we emerged from that recession, stock market gains have led to economic growth (before and after COVID). Knowing this, the most important factor for investors to consider is what stocks are priced to expect today. At this point, given the valuation levels of US stocks, it is safe to say that stocks are priced to expect huge gains in aggregate earnings ahead. Whether those earnings expectations materialize remains to be seen.
The expectations implied by stock prices and how realistic those expectations are define the level of risk. Of course, there are other factors that affect stock prices in the shorter-term such as investor confidence, behavior and preferences, Federal Reserve communications and policy, the credit environment, the level of interest rates, the regulatory environment and the sector concentration of the market itself. And there is also a momentum factor – people tend to gravitate to what the crowd has done and is currently excited about. But that only works until it stops.
At present, the market is not pricing in much possibility of inflation ahead. While there may not be inflation pressure in the near term, there are factors to consider that may lead to increasing consumer prices. And markets will change before inflation shows up:
- In the late 1960s – early 1970s, baby boomers entered the labor force which tempered wage pressures at the time. Today baby boomers are leaving the labor force, which could put upward pressure on wages.
- Baby boomers have accumulated more than half of all US wealth. As they leave the labor force, they will run down that wealth meaning that the household savings rate will likely drop. And a lower savings rate implies more spending in relation to economic output, which is inflationary.
- The Federal Reserve used to use inflation forecasts to decide when to raise rates. Now the Fed focuses on actual rather than forecasted inflation, which all but guarantees that the Fed will overshoot its 2% inflation target. Since monetary policy fully affects the economy with a 12 – 18-month lag, by the time the Fed decides to clamp down on inflation, it will already be high and rising.
In terms of investment strategy -- because most advisors are positioned for what has worked well over the last ten years, and not for what will likely perform well in the next ten years ‘value’ stocks are still exceptionally cheap in relation to growth. Traditional value sectors (banks, cyclicals, energy, consumer staples, etc.) have seen stronger upward earnings revisions than tech stocks since the start of the year. This partly explains their outperformance. The high probability that bond yields have put in a strong secular bottom last year, combined with the emergence of a new bull market in commodities (see copper and corn price charts below), makes us think that the nascent outperformance of value stocks has years to run. Rising rates and commodity prices are good for value stocks and bad for growth stocks.
Also favoring our view that foreign stocks, cyclical, and value stocks will continue to outperform is that US corporate taxes are heading higher. The statutory corporate tax rate will probably be increased from 21% to 28% to fund, among other things, a major infrastructure investment program. Capital gains taxes will also likely rise. While these tax hikes are unlikely to bring down the whole stock market, they will detract from US stocks relative to their international peers, and tech stocks will likely continue to see pressure especially if the tax bill includes a minimum corporate tax on book income and raises taxes on overseas profits.
The investment environment is highly complex and reactive to government policy decisions and pronouncements. If you would like to discuss your personal finances and how Highgate can improve your investment strategy, reduce your risk or both we are always available in person, by phone at 303-968-1230, email at firstname.lastname@example.org, Zoom and Skype. Thank you for reading our letter and for any referrals that you may recommend. We work hard to make high-quality decisions for our clients, and we are thoughtful in our investment approach with a goal of earning high returns with low downside risk.