The US economy has entered a new phase in its economic cycle. Just over a year ago, the country reeled from the impacts of the COVID-19 pandemic. For much of the past year, business activity has been significantly curtailed due to the severity of the pandemic. However, in the past few weeks the economy has begun to largely reopen. The CDC has loosened travel restrictions, restaurants are expanding in-person dining, movie theatres and other entertainment venues are reopening, and Disneyland will open again at the end of April.
The impact of this “Great Reopening” is already showing up in several economic indicators. The US labor market added 916,000 jobs in March - the strongest employment growth since August 2020, with the unemployment rate dropping to 6%. Consumer confidence, which had languished since the beginning of the pandemic, rose to levels nearly indicating that people feel the economy is becoming prosperous once again. The US Gross Domestic Product is expected to grow as much as 6% in 2021. And a closely-watched survey from the Institute for Supply Management surged to a record high due to the positive impacts of increased vaccinations and federal stimulus on consumer demand.
While the economy is entering a period of strong growth, it’s success is still tenuous. Even though employment growth was strong in March, the labor market still has 8.4 million fewer workers than before the pandemic. And there are fears that strong economic growth may lead to much higher inflation than the current annual rate of 1.7%. Right now, the Federal Reserve is more concerned about restoring lost jobs than the possible impacts of high inflation, especially if it only turns out to be short-lived. But if this inflation becomes high (above 4%) or seems more permanent, they may be forced to increase interest rates to slow economic growth and bring inflation back down. Overall, the economy is gaining strength but still has some time to go before it can be called healthy again.
U.S. stocks, as measured by the S&P 500 Index, generated a 6.2% total return for the first quarter. For a second consecutive quarter the equal-weighted S&P 500 (+11.5%) gained additional ground on the market cap-weighted S&P 500 (+6.1%). Furthermore, value stocks made a comeback as they outperformed growth stocks (+11.3% vs 0.9%) as measured by the Russell 1000 index. These developments continue to point to broadening market participation. Small cap stocks continued their sharp run up posting a 12.7% return as measured by the Russell 2000 Index. Continued optimism of an anticipated full reopening of the economy not only fueled small cap stocks but more economically sensitive share prices as well.
Despite a bout of volatility that surfaced in the back end of the quarter, U.S. equity markets surged higher in the quarter on the back of two overriding themes – greater than expected stimulus and vaccine progress. The stimulus at the end of 2020 ($900B) and the relief package signed in early March ($1.9T) equate to nearly 14% of US GDP.
The American Jobs Plan announced on the last day of March proposes an additional $2.25 trillion in spending geared largely toward improving transportation, communication, and power infrastructure. The infrastructure plan could be paired with an additional $1 trillion in spending focused on social programs and is expected to be unveiled in April. Time will tell how much stimulus will be passed by Congress; however, overall fiscal spending is unprecedented and clearly larger than what markets were pricing at the start of 2021. To fund the infrastructure plan, the Biden administration suggested hiking the corporate tax rate to 28% from 21%, which one estimate indicated could cost 9% of next year’s S&P 500 earnings.
Earnings season is soon upon us, and expectations are high. According to FactSet, the estimated Q1 earnings growth rate for S&P 500 companies is 23.3%, which is up from the 15.8% growth forecast expected at the beginning of the year. The previous high was in the third quarter of 2018 when earnings grew 26.1%. Analysts are forecasting double-digit earnings growth for all four quarters of 2021. Revenues are expected to grow 6.3%, which is up from 3.9% estimated at the start of the quarter. According to Bloomberg, the forward 12-month P/E ratio for the S&P 500 was 22.7 at the end of Q1, which is well above the 5-year (17.8) and 10-year (15.9) averages.
While valuations are meaningfully elevated versus historical norms, the current environment is unlike anything our generation has ever seen. Massive fiscal stimulus (25% of GDP) and stronger vaccine rollout (30% of the U.S. population thus far) are larger and faster than what most expected just three months ago at the start of 2021. Accordingly, economic data and future projections continue to improve. U.S GDP is forecasted to grow at its fastest pace (6%) since 1984, with unemployment falling towards 5% by the end of 2021. The recent rise in Covid cases is far outweighed by the average rate of inoculation. While the path ahead is sure to be bumpy, the reopening of the economy and historic stimulus efforts could continue to support equity markets.
Developed International equities (+3.5%) lagged U.S. equities as measured by the MSCI EAFE Index for the three-month period. The underperformance can be attributed to the fact that economic prospects are improving more slowly outside the U.S. due to a slower pace of vaccinations for Covid-19 and the policy mix is less skewed toward fiscal stimulus. Emerging Markets (+2.3%), according to the MSCI EM Index, also underperformed and can point to similar issues as well as a stronger U.S. Dollar during the latter part of the quarter which can create a headwind for emerging markets companies.
Longer term interest rates rose sharply throughout the first quarter with the 10-yr U.S. Treasury rising 83 bps (0.83%). This was the largest quarterly increase in yield since the fourth quarter of 2016 (85 bps) and the second quarter of 2009 (87 bps). Not surprisingly, with the Federal Reserve keeping a lid on short rates, the yield curve steepened significantly with the 10yr/2yr U.S. Treasury spread widening by 79 bps in the first three months of the year.
Yields have been in an uptrend ever since a stimulus package passed last December. The powerful combination of multiple stimulus packages, progress being made to reopen the economy as a result of vaccinations and pent-up consumer demand is pushing long term rates higher towards more normalized levels. Importantly, however, today’s Federal Reserve is not contemplating near-term tightening, and interest rates are still very low on a historical basis. While there may be rate-related volatility we expect short term rates to remain low for some time as central banks globally look to maintain support and see economies recovery fully. Further significant increases in long term interest rates will depend on whether or not inflationary pressures are transient or more permanent.
The sharp rise in bond yields translated into negative returns for most fixed income sectors of the market. Having an allocation to higher-yielding securities helped mitigate some of the losses as they generated positive results due to their higher yields helping offset price declines. Higher-quality municipal bond prices were not immune from the rise in interest rates and posted modest losses.
Hedge funds, as measured by the HFRX Global Hedge Fund Index, posted positive returns for the first quarter. Most sub-indices were higher for the three-month period with Equity Long/Short leading the way amongst the core strategies. Recent hedge fund gains accelerated through February, marking one of the strongest 4-month periods in the past 20 years before easing slightly in March. Drivers of performance widened to include not only Equity Long/Short and Event Driven but were also captured by trend-following Macro and interest rate sensitive Relative Value Arbitrage strategies. After navigating extreme dislocations and volatility in 2020, hedge funds are keeping a watchful eye on ongoing new strains of coronavirus as well as vaccination progress, while also focusing on risks and opportunities including interest rate sensitivity, increasing inflation expectations, and geopolitical tensions.
Master Limited Partnerships (MLPs)
Ongoing focus on balance sheet management coupled with rising energy prices propelled MLPs higher during the first quarter. With the capital spending boom brought on by the Shale Revolution now behind them, companies are now focused on growing free cash flow, committing to higher return projects and share buybacks.
Real Estate (REITs)
REITs generated a second consecutive strong quarterly showing led by a rotation to value and reopening economy companies including Malls and Shopping Centers followed by Hotels. These sectors were
the worst performers in 2020 and have the most to gain from virus containment. Meanwhile, laggards included sectors that performed well over the past 12 months, namely Data Centers, Towers, and Industrial Warehouses. The prospect of accelerating economic growth outweighed the effects of rising long-term interest rates leading to outperformance for REITs over broader equities as a whole.
Commodities were up 6.9% as measured by the Bloomberg Commodity Index for the first quarter of 2021. The notable outperforming sector was Energy as the supply for oil was managed with cuts by OPEC members as well as the new administration in Washington suspending licenses to drill while it reviews domestic energy policy. Industrial metals, led by copper, also posted an increase in prices benefitting from expectations of rising industrial actively and global re-opening. A notable underperformer during the quarter was gold, which fell by over 9%, due to lower market volatility and higher interest rates.
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