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Wall Street Crushes It


Wall Street continued its rally in quarter 1 of 2021, as America’s economy grew at a greater than expected pace, and vaccination rates exceeded even the most optimistic estimates. The Federal Reserve’s promise to keep rates lower for longer and additional rounds of stimulus spending, provided additional support. The three major stock indexes — the Dow, the S&P 500 and the Nasdaq Composite — rallied 7.8%, 5.8% and 2.8%, respectively, in the first-quarter of 2021.


Value stocks, which have long been treated by Mr. Market as an unwanted stepchild, were a top performer in quarter 1, as investors became leery of richly valued growth stocks, and their ability to generate sufficient earnings to justify their high prices in a rising interest rate environment. 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 also outperformed the overall market, on expectations that a strengthening economy will be especially helpful to their bottom lines. The two most widely followed small-cap indexes — the Russell 2000 and the S&P 600 — jumped 12.4% and 17.9%, respectively.


The bond market did not share in the equity market’s good fortunes, as rising interest rates drove bond prices lower. Rates on 10-year Treasury notes surged 83bps in Q1 for its largest net gain since the last quarter of 2016. Treasuries had the toughest time, while high-yield bonds managed to eke out a small gain. Pushing rates higher were fears that accelerated economic growth and an unprecedent expansion in money supply will lead to inflation, which in turn could force the Fed to raise rates.




While the economy is expected by most economists to continue to expand at a rapid clip throughout 2021, threats remain.


  • Parts of the U.S., and several other regions around the globe are in the midst of a fourth wave of the pandemic, as more contagious variants of the coronavirus have begun to dominate new cases.

  • The Biden administration has proposed hiking the corporate tax rate to 28% from the 21% to help finance a massive infrastructure program, which could cost as much 9% of next year’s S&P 500 earnings.

  • The near 40% jump in the U.S. money supply over the past year sparked concerns about rising inflation if (when) all that money moves out of banks and into the economy.

  • Persistently high inflation rates have historically led to higher interest rates, which also pose a threat to the ongoing economic recovery.


Predictions as to what comes next are always problematic, and especially now as the current environment is unlike anything our generation has ever seen. In our view, the risk of further hikes in interest rates warrants favoring high quality, shorter term, lower duration debt instruments, notwithstanding the somewhat lower interest payments they provide. We also suggest investigating bond alternatives to counterweight equity risk.


Shifting focus to equities, stocks are trading at very high valuations with less clarity than usual as to what to expect in the coming months. Investors with a shorter time horizon or who are less able to maintain a long-term commitment to stocks may way to revisit their portfolio’s equity exposure. By comparison, we suggest investors who are prepared to tolerate a bout of increased volatility stick to their long-term investment plan.


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US Economic Growth Expected To Accelerate In 2021.


Forecasts are always dicey affairs, but taking recent projections at face value paints a bullish outlook for the U.S. economy. Gross domestic product this year, according to several accounts, is on track to grow at the strongest rate in nearly four decades.


For example, the International Monetary Fund (IMF) expects that U.S. economic activity will rise roughly 6.4% in 2021. That’s not only impressive in absolute terms, it stacks up rather well on a relative basis, too. The projection “makes the United States the only large economy projected to surpass the level of GDP it was forecast to have in 2022 in the absence of this pandemic,” IMF chief economist Gita Gopinath said earlier this month.


A lot could go wrong, of course, including a rebound in the pandemic. In early April there are hints that a fourth wave of new U.S. Covid-19 cases may be brewing. It could be noise and so it’s premature to assume the worst. But if new coronavirus cases rebound, fueled by the spread of new variants, the rosy economic outlook could suffer.


Numbers in hand at the moment, however, suggest a roaring year of recovery. The upbeat data is expected to start with the government’s initial estimate of gross domestic product (GDP) for this year’s first quarter, which is due on April 29. The Atlanta Fed’s GDPNow model is projecting that GDP growth will accelerate to a real annualized 6.0% rate in Q1 (as of the April 9 nowcast) – a strong improvement over Q4’s 4.3% increase.


Federal Reserve Chair Jerome Powell is on board with a bullish outlook, telling CBS News’ “60 Minutes” this month that the US economy is at an "inflection point” and growth and job creation is set to strengthen.


"And that's because of widespread vaccination and strong fiscal support, strong monetary policy support,” Powell explained. “We feel like we're at a place where the economy's about to start growing much more quickly and job creation coming in much more quickly. The outlook has brightened substantially."


There’s no doubt the economy is poised for a growth boom in 2021 as the pandemic eases. At the same time, Chairman Powel acknowledged that a resurgence of Covid-19 remains a serious threat to the economic recovery.


Another unanswered question: what will be the future impact of the Fed’s highly accommodative monetary policies? Unfortunately, history provides little insight, as the U.S. has never engaged in governmental spending and monetary expansion anywhere close to what we are doing now, not to mention that the economy is already in the midst of a strong recovery.


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Is Inflation Set To Accelerate?


US consumer inflation ramped up in March, rising 2.6% over the year-earlier level. That’s a sharp increase from previous months and reflects the strongest run of inflation since the summer of 2018. Is this an early warning that a sustained period of higher inflation has arrived?


The jump in March year over year numbers can be explained in part by the temporary bout of deflation that occurred a year ago due to the initial shock of the pandemic. When 2020’s brief foray into deflation fades from the data, there will be a mitigating effect on the annual comparisons for the Consumer Price Index (CPI).


That said, concerns remain that ongoing economic stimulus from monetary and fiscal policies will soon lead to higher, sustained inflation over an extended period. Combined with expectations for a strong economic rebound this year, some economists are warning that inflation risk is now heavily skewed to the upside.


Hotter inflation, however, still faces several hurdles, starting with a large, lingering loss in employment from the pandemic. Despite substantial employment gains in recent months, the economy is nursing a net loss of about 10 million jobs lost during the pandemic in 2020.


Note that core inflation – widely considered to be a more reliable measure of the inflation trend – remained relatively muted in the year-over-year comparison through March. Core CPI edged up to a 1.6% annual pace, but that’s still well below the low-2% increases that prevailed pre-pandemic. It’s also comfortably below the Federal Reserve’s 2% inflation target.



Note, too, that while huge amounts of liquidity have been pumped into the financial system in recent years, much of that remains trapped in banks and other institutions. As one example, lending (a key factor for a higher inflation outlook) remains subdued.


Then again, banks are sitting on huge stockpiles of cash which they are anxious to lend once the pandemic ends. That, combined with pent-up savings by consumers and pent-up animal spirits, could trigger a post-Covid boom in demand that business supply is unable to meet. Should that occur, inflation could once again become a major cause for concern.


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Are Stocks Overvalued?


Value-minded investors have been perplexed and frustrated in recent years as equity valuations entered record territory. Yet the market has continued to trend upward, albeit with some sharp but so far fleeting corrections along the way. Is this rational? Or has Mr. Market finally lost its marbles?


The answer depends on whether interest rates inform your analysis. By many standard metrics, equity market valuations looked stretched. Consider the Cyclically Adjusted Price Earnings ratio (CAPE) published by Yale professor Robert Shiller. A recent estimate for early April shows CAPE at a nosebleed 36.6, the second-highest level since the late-19th century.



That would seem to suggest that expected returns are likely to be much lower in the years ahead… or does it?


Professor Shiller recently outlined an alternative reading of CAPE that factored in interest rates, which have been unusually low in recent years. Specifically, he unveiled what he calls the Excess CAPE Yield (ECY), which is the inverse of CAPE (earning/price ratio) less the real (inflation-adjusted) 10-year Treasury yield.


ECY “is somewhat like the equity market premium and is a useful way to consider the interplay of long-term valuations and interest rates. A higher measure indicates that equities are more attractive,” Shiller explained recently.


Shiller’s data shows that ECY is moderately correlated with the stock market’s subsequent 10-year real return. By that standard, the recent 2.6% ECY implies a middling risk premium (relative to the past two decades) for the S&P 500 Index over the next 10 years. That’s not likely to get hearts racing, but neither does it suggest that equity returns will be unusually light or negative in the years ahead. More importantly, ECY’s history as an estimate of the equity market’s future return is impressive, as well as moderately encouraging in terms of anticipating a reasonable performance in the years ahead.



All the usual caveats of forecasting apply, of course. That includes the observation that ECY suffers from a fair amount of noise in the short term. More significantly, interest rates could continue to rise, in which case the ECY would point to an elevated risk of falling stock prices. However, for the time being, an argument can be made that the stock market is behaving rationally.


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Climate change is a risk factor for the economy and the financial markets.


Investment strategists and economists are increasingly focused on the potential for economic disruption in the years ahead due to climate change. Although the debate about climate change rages, increasingly the disagreements are about details. How soon will the blowback arrive? By what degree? Which regions and industries will suffer the most? And the big one: How should nations react?


“Climate change is no longer a hypothetical risk. Our planet is warming at an accelerating pace,” advises “Top-Down Portfolio Implications of Climate Change,” a white paper published by Quantitative Management Associates, a division of Prudential Financial.


The impacts of climate change are likely to affect many aspects of human life, including the global economy. Environmental changes throughout the remainder of this century, as well as political responses to these changes, will undoubtedly influence economic trends worldwide. From the perspective of a long-term investor, climate change is a source of considerable uncertainty.


The entire study is worth reading, including the highlights that model possible impacts to asset class returns. “The most direct impact will be on growth-oriented assets, such as equities and corporate credit,” the paper reports. On the other hand, “we find that the impact on developed sovereign bonds, REITs and commodities is likely to be more localized at the micro level of individual securities, rather than at the asset-class level.”


Overall, the authors explain that the top-down strategic return expectations suggest that “a climate risk-aware portfolio would tilt away from regions and assets that are expected to be adversely affected for better risk-adjusted returns.”


It’s all speculative, of course, since there’s no precedent for climate change in the modern era. Nonetheless, considering how macro conditions could change is a useful exercise, if only to think through various scenarios for the years ahead.


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