The new year brought mostly good news regarding a potential return to normalcy for economies. The introduction of the $1.9 trillion U.S. fiscal stimulus package and the ongoing coronavirus vaccine rollout boosted expectations for economic growth and higher inflation, both of which caused interest rates to spike and the U.S. Treasury yield curve to steepen over the quarter. As investors raised concerns over the prospect of higher inflation, the Federal Reserve remained unmoved, indicating that it believed the rise in rates was orderly and that elevated inflation is likely to be transitory. Although the Fed did indeed raise its economic growth projections, the U.S. central bank maintained its program of purchasing $120 billion of Treasuries and agency mortgage-backed securities a month and continued to indicate that the federal-funds rate will likely remain close to zero through the end of 2023.
Long rates exploded higher throughout Q1, with the UST 10YR Yield rising 15bps (Jan), 34bps (Feb), and 34bps (March). The 83bps rise in Q1 was the largest quarterly gain since Q4 2016 (85bps) and Q2 2009 (87bps). Accordingly, the yield curve steepened meaningfully with the 10YR- 2YR UST spread widening by 79bs in Q1. While this is the highest rise since Q1 2008, which nearly marked the onset of the Great Recession, the prior highs occurred in the early 1980’s in the early stages of a historic bull market. For a deeper historical view and potentially contrarian approach we have attached the current Hoisington letter titled:
“The Case for Decelerating Inflation”
“Contrary to the conventional wisdom, disinflation is more likely than accelerating inflation. Since prices deflated in the second quarter of 2020, the annual inflation rate will move transitorily higher. Once these base effects are exhausted, cyclical, structural, and monetary considerations suggest that the inflation rate will moderate lower by year end and will undershoot the Fed Reserve’s target of 2%. The inflationary psychosis that has gripped the bond market will fade away in the face of such persistent disinflation.”
U.S. equity markets surged higher in Q1 2021 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 in March proposes an additional $2.25 trillion in spending geared largely toward improving transportation, communication, and power infrastructure. The infrastructure plan will 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.
Q1 continued the trend, which began in October with a rotation from Growth to Value and large- cap to small-cap. For the quarter, the Russell 1000 Value Index (+10.7%) outperformed the Russell 1000 Growth Index (+0.7%) by 9.9 percentage points, its largest outperformance in 20 years. Small-cap stocks were also effected by the “meme stock” revolution. We have included our Small Cap Value Insights letter which reviews this further.
Earnings season is soon upon us, and expectations are high. According to FactSet, the estimated Q1 EPS growth rate for S&P 500 companies is 23.3%, which is up from the 15.8% growth forecast expected at the start of the quarter. The previous high was in Q3’18 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 forecasts of 3.9% 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 and stronger vaccine rollout are larger and faster than what most expected just three months earlier 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 (7%) 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 are likely to support equity markets. Therefore, we recommend continuing with our asset allocation targets set forth in the first quarter of this year.
During the quarter, benchmark performance was impacted by several factors. Notably, the benchmark was materially aided by several stocks that were part of the Robinhood/Reddit/Wall Street Bets “meme stock” revolution that saw a coordinated attack by retail investors on names heavily shorted by hedge funds, the most cited example being GameStop (GME). In a “meme stock”, the “flows” into the stock matter more than “fundamentals” of the underlying business. To capitalize on heavily shorted GME, retail investors coordinated, through online chat boards like Reddit/Wall Street Bets, efforts to drive the shares up and force a short squeeze. The retail “flows” soon combined with forced short covering volume (more “flows”) to create stunning stock price movements completely disengaged with the company’s underlying fundamentals. During the quarter, GameStop had surged from under $20 per share to nearly $500 before finishing the quarter at $189.45—up over 900% for the first quarter. More than an interesting tale, “meme stocks” had a material impact on the benchmark. GameStop finished the quarter as one of the largest stocks in the Russell 2000® Value with a market capitalization over $13 billion and contributed 0.75% of performance to the benchmark in the quarter. Other “meme stocks” combined with GameStop helped the top 15 stocks in the benchmark achieve 330 basis points of performance. This narrowness at the top made it a challenge to keep up with the benchmark.
Another notable factor impacting the benchmark was strong performance from low quality stocks. The benchmark performance was driven by the lowest quintile ROE stocks, which outperformed the aggregate total return by over 560 basis points in the quarter. A lot of the low-quality effect was concentrated within energy, retail, and basic materials where companies with high levels of leverage, combined with vulnerable business models, saw investors jump in to chase the value rotation. We believe this low-quality effect is transitory and investors will again favor companies with more attractive valuations and sustainable fundamentals. Keep in mind that a third of the companies in the benchmark were losing money before the pandemic.
Director of Consulting
Timothy J. Vos, CIMA, AIFA
Director of Research
Past performance is no guarantee of future results. This article contains the current opinions of the author and does not represent a recommendation of any particular security, strategy, or investment product; and such opinions are subject to change without notice. This article is distributed for informational purposes and should not be considered investment advice. The information contained herein has been obtained from sources we believe reliable, but we make no representations, warranties or guarantees as to the accuracy or completeness of the statements or information contained herein. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission.